**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**
| **ý**                                                                                                                                                                                                         | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                               |       |                                                                                                     |
| **For the quarterly period ended June 30,  2005**                                                                                                                                                             |
|                                                                                                                                                                                                               |       | ** **                                                                                               |
| **OR**                                                                                                                                                                                                             |
|                                                                                                                                                                                                               |       |                                                                                                     |
| **o**                                                                                                                                                                                                              | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                                                                                                                                                                               |       |                                                                                                     |
| **For the transition period from                  to                ** |

 

**Commission file number 0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Maryland**                                                    | ** ** | **52-0898572**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  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’s telephone number, including area code)

 

**NONE**

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

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes ý  No o

 

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

 

As of July 22, 2005,82,000,159 shares of registrant’s Common Stock, $2 par value per share, wereoutstanding.

 

 

----

 

**MERCANTILE BANKSHARES CORPORATION**

Quarterly Report on Form 10-Q

June 30, 2005

 

**Table of Contents**

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

 

2

----

 

# **PART I– FINANCIAL INFORMATION**

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

 

**MERCANTILE BANKSHARES CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| **(Dollars in thousands, except  per share data)**                                                                                                                              | ** ** | **June 30,  2005** | ** **     | **December 31,  2004** | ** ** | **June 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|----------------|-----------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                                      | ** ** | ** **              | ** **     | ** **                  |       |                    |       |
| Cash and due from banks                                                                                                                                                         | ** ** | **$**                   | **382,695**    | ** **                  | $          | 244,875                 |       | $ | 296,046 |   |
| Interest-bearing deposits in  other banks                                                                                                                                       | ** ** | **200**                 | ** **     | 158                         |       | 158                     |       |
| Federal funds sold                                                                                                                                                              | ** ** | **95,102**              | ** **     | 101                         |       | 125,000                 |       |
| Total cash and cash  equivalents                                                                                                                                                | ** ** | **477,997**             | ** **     | 245,134                     |       | 421,204                 |       |
| Investment securities  available-for-sale                                                                                                                                       | ** ** | **2,960,275**           | ** **     | 2,908,694                   |       | 2,935,462               |       |
| Investment securities  held-to-maturity fair value of $18,788 (2005) $21,094 (December 2004)  and $26,590 (June 2004)                                                 | ** ** | **18,056**              | ** **     | 20,176                      |       | 25,663                  |       |
| Total investment securities                                                                                                                                                     | ** ** | **2,978,331**           | ** **     | 2,928,870                   |       | 2,961,125               |       |
| Loans held-for-sale                                                                                                                                                             | ** ** | **16,754**              | ** **     | 11,000                      |       | 747                     |       |
| Loans:                                                                                                                                                                          | ** ** | ** **              | ** **     |                        |       |                    |       |
| Commercial                                                                                                                                                                      | ** ** | **2,867,315**           | ** **     | 2,813,325                   |       | 2,715,173               |       |
| Commercial real estate                                                                                                                                                          | ** ** | **3,585,592**           | ** **     | 3,122,701                   |       | 2,918,642               |       |
| Construction                                                                                                                                                                    | ** ** | **1,560,149**           | ** **     | 1,268,350                   |       | 1,129,208               |       |
| Residential real estate                                                                                                                                                         | ** ** | **1,581,472**           | ** **     | 1,486,106                   |       | 1,468,804               |       |
| Consumer                                                                                                                                                                        | ** ** | **1,713,674**           | ** **     | 1,484,583                   |       | 1,472,300               |       |
| Lease financing                                                                                                                                                                 | ** ** | **56,104**              | ** **     | 53,368                      |       | 57,983                  |       |
| Total loans                                                                                                                                                                     | ** ** | **11,364,306**          | ** **     | 10,228,433                  |       | 9,762,110               |       |
| Less: allowance for loan  losses                                                                                                                                                | ** ** | **(157,101**            | **)**          | (149,002                    | )          | (158,431                | )          |
| Loans, net                                                                                                                                                                      | ** ** | **11,207,205**          | ** **     | 10,079,431                  |       | 9,603,679               |       |
| Bank premises and equipment,  less accumulated depreciation of $151,132 (2005), $142,384 (December 2004)  and $156,722 (June 2004)                                    | ** ** | **147,774**             | ** **     | 139,946                     |       | 141,523                 |       |
| Other real estate owned, net                                                                                                                                                    | ** ** | **777**                 | ** **     | 212                         |       | 402                     |       |
| Goodwill                                                                                                                                                                        | ** ** | **667,465**             | ** **     | 507,791                     |       | 517,615                 |       |
| Other intangible assets, net                                                                                                                                                    | ** ** | **49,830**              | ** **     | 48,226                      |       | 52,478                  |       |
| Other assets                                                                                                                                                                    | ** ** | **546,861**             | ** **     | 465,080                     |       | 431,372                 |       |
| Total assets                                                                                                                                                                    | ** ** | **$**                   | **16,092,994** | ** **                  | $          | 14,425,690              |       | $ | 14,130,145 |   |
|                                                                                                                                                                            |       |                    | ** **     |                        |       |                    |       |
| **LIABILITIES**                                                                                                                                                                 |       |                    | ** **     |                        |       |                    |       |
| Deposits:                                                                                                                                                                       |       |                    | ** **     |                        |       |                    |       |
| Noninterest-bearing deposits                                                                                                                                                    | ** ** | **$**                   | **3,293,344**  | ** **                  | $          | 3,049,031               |       | $ | 3,043,242 |   |
| Interest-bearing deposits                                                                                                                                                       | ** ** | **8,537,407**           | ** **     | 7,750,168                   |       | 7,600,452               |       |
| Total deposits                                                                                                                                                                  | ** ** | **11,830,751**          | ** **     | 10,799,199                  |       | 10,643,694              |       |
| Short-term borrowings                                                                                                                                                           | ** ** | **1,192,782**           | ** **     | 887,857                     |       | 891,879                 |       |
| Accrued expenses and other  liabilities                                                                                                                                         | ** ** | **140,390**             | ** **     | 129,996                     |       | 115,705                 |       |
| Long-term debt                                                                                                                                                                  | ** ** | **807,954**             | ** **     | 690,955                     |       | 637,570                 |       |
| Total liabilities                                                                                                                                                               | ** ** | **13,971,877**          | ** **     | 12,508,007                  |       | 12,288,848              |       |
|                                                                                                                                                                            | ** ** | ** **              | ** **     |                        |       |                    |       |
| **COMMITMENTS and CONTINGENCIES**                                                                                                                                               | ** ** | ** **              | ** **     |                        |       |                    |       |
|                                                                                                                                                                            | ** ** | ** **              | ** **     |                        |       |                    |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                                   | ** ** | ** **              | ** **     |                        |       |                    |       |
| Preferred stock, no par value;  authorized 2,000,000 shares; issued and outstanding - None                                                                                      |       |                    | ** **     |                        |       |                    |       |
| Common stock, $2 par value;  authorized 130,000,000 shares; issued and outstanding shares - 81,982,375  (2005), 79,300,506 (December 2004) and 79,088,986 (June 2004) | ** ** | **163,965**             | ** **     | 158,601                     |       | 158,178                 |       |
| Capital surplus                                                                                                                                                                 | ** ** | **665,006**             | ** **     | 530,705                     |       | 522,758                 |       |
| Retained earnings                                                                                                                                                               | ** ** | **1,302,869**           | ** **     | 1,231,102                   |       | 1,168,462               |       |
| Accumulated other  comprehensive loss                                                                                                                                           | ** ** | **(10,723**             | **)**          | (2,725                      | )          | (8,101                  | )          |
| Total shareholders’ equity                                                                                                                                                 | ** ** | **2,121,117**           | ** **     | 1,917,683                   |       | 1,841,297               |       |
| Total liabilities and  shareholders’ equity                                                                                                                                | ** ** | **$**                   | **16,092,994** | ** **                  | $          | 14,425,690              |       | $ | 14,130,145 |   |

 

See notes to consolidatedfinancial statements

 

3

----

 

**MERCANTILE BANKSHARES CORPORATION**

**STATEMENTS OF CONSOLIDATED INCOME**

 
| ** **                                               | ** ** | **For the 6  months  ended June 30,** | ** **  | **For the 3  months  ended June 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|-------------|--------------------------------------------|------------|
| **(Dollars in thousands, except  per share data)**       | ** ** | **2005**                                   |        | **2004**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **INTEREST INCOME**                                      |       |                                       |        |                                       |       |   |   |   |   |
| Interest and fees on loans                               | ** ** | **$**                                      | **322,421** |                                       | $          | 261,300 | ** ** | **$** | **169,877** |   | $ | 132,171 |   |
| Interest and dividends on  investment securities:        |       |                                       |        |                                       |       |   |   |   |   |
| Taxable interest income                                  | ** ** | **50,366**                                 |        | 53,566                                     | ** ** | **25,374** |   | 26,165 |   |
| Tax-exempt interest income                               | ** ** | **1,509**                                  |        | 1,697                                      | ** ** | **788** |   | 820 |   |
| Other investment income                                  | ** ** | **1,227**                                  |        | 685                                        | ** ** | **583** |   | 352 |   |
| Total interest and dividends  on investment securities   | ** ** | **53,102**                                 |        | 55,948                                     | ** ** | **26,745** |   | 27,337 |   |
| Other interest income                                    | ** ** | **786**                                    |        | 640                                        | ** ** | **442** |   | 534 |   |
| Total interest income                                    | ** ** | **376,309**                                |        | 317,888                                    | ** ** | **197,064** |   | 160,042 |   |
| **INTEREST EXPENSE**                                     |       |                                       |        |                                       |       |   |   |   |   |
| Interest on deposits                                     | ** ** | **56,689**                                 |        | 40,640                                     | ** ** | **31,384** |   | 19,873 |   |
| Interest on short-term  borrowings                       | ** ** | **9,526**                                  |        | 2,899                                      | ** ** | **5,484** |   | 1,480 |   |
| Interest on long-term debt                               | ** ** | **14,644**                                 |        | 10,460                                     | ** ** | **7,829** |   | 5,205 |   |
| Total interest expense                                   | ** ** | **80,859**                                 |        | 53,999                                     | ** ** | **44,697** |   | 26,558 |   |
| **NET INTEREST INCOME**                                  | ** ** | **295,450**                                |        | 263,889                                    | ** ** | **152,367** |   | 133,484 |   |
| Provision for loan losses                                | ** ** | **756**                                    |        | 4,779                                      | ** ** | **—** |   | 2,353 |   |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES** | ** ** | **294,694**                                |        | 259,110                                    | ** ** | **152,367** |   | 131,131 |   |
| **NONINTEREST INCOME**                                   |       |                                       |        |                                       |       |   |   |   |   |
| Investment and wealth  management                        | ** ** | **47,837**                                 |        | 44,919                                     | ** ** | **23,780** |   | 22,936 |   |
| Service charges on deposit  accounts                     | ** ** | **21,514**                                 |        | 21,673                                     | ** ** | **11,088** |   | 10,981 |   |
| Mortgage banking related fees                            | ** ** | **5,178**                                  |        | 5,233                                      | ** ** | **2,895** |   | 2,293 |   |
| Investment securities gains                              | ** ** | **513**                                    |        | 535                                        | ** ** | **99** |   | 590 |   |
| Nonmarketable investments                                | ** ** | **9,493**                                  |        | 4,654                                      | ** ** | **4,222** |   | 450 |   |
| Other income                                             | ** ** | **33,400**                                 |        | 27,266                                     | ** ** | **17,982** |   | 13,876 |   |
| Total noninterest income                                 | ** ** | **117,935**                                |        | 104,280                                    | ** ** | **60,066** |   | 51,126 |   |
| **NONINTEREST EXPENSES**                                 |       |                                       |        |                                       |       |   |   |   |   |
| Salaries                                                 | ** ** | **96,734**                                 |        | 89,477                                     | ** ** | **50,180** |   | 44,689 |   |
| Employee benefits                                        | ** ** | **23,853**                                 |        | 23,441                                     | ** ** | **11,956** |   | 10,928 |   |
| Net occupancy expense of bank  premises                  | ** ** | **13,779**                                 |        | 11,879                                     | ** ** | **6,857** |   | 5,819 |   |
| Furniture and equipment  expenses                        | ** ** | **15,203**                                 |        | 14,937                                     | ** ** | **7,924** |   | 7,573 |   |
| Communications and supplies                              | ** ** | **8,059**                                  |        | 8,499                                      | ** ** | **4,019** |   | 4,195 |   |
| Other expenses                                           | ** ** | **46,438**                                 |        | 38,520                                     | ** ** | **22,977** |   | 20,163 |   |
| Total noninterest expenses                               | ** ** | **204,066**                                |        | 186,753                                    | ** ** | **103,913** |   | 93,367 |   |
| Income before income taxes                               | ** ** | **208,563**                                |        | 176,637                                    | ** ** | **108,520** |   | 88,890 |   |
| Applicable income taxes                                  | ** ** | **78,063**                                 |        | 64,627                                     | ** ** | **40,647** |   | 32,577 |   |
| **NET INCOME**                                           | ** ** | **$**                                      | **130,500** |                                       | $          | 112,010 | ** ** | **$** | **67,873** |   | $ | 56,313 |   |
| **NET INCOME PER SHARE OF COMMON  STOCK:**               |       |                                       |        |                                       |       |   |   |   |   |
| Basic                                                    | ** ** | **$**                                      | **1.63**    |                                       | $          | 1.41 | ** ** | **$** | **0.84** |   | $ | 0.71 |   |
| Diluted                                                  | ** ** | **$**                                      | **1.62**    |                                       | $          | 1.40 | ** ** | **$** | **0.84** |   | $ | 0.71 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                      | ** ** | **$**                                      | **0.73**    |                                       | $          | 0.68 | ** ** | **$** | **0.38** |   | $ | 0.35 |   |

 

See notes toconsolidated financial statements

 

4

----

 

**MERCANTILE BANKSHARES CORPORATION**

**STATEMENTS OF CHANGES INCONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**For the 6 months ended June 30, 2005 and 2004**

 
| **(Dollars in thousands, except  per share data)**                                                     | ** ** | **Total** | ** **    | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **  | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-------------------|------------|----------------------|------------|------------------------|-------------|------------------------------------------------------|------------|
| BALANCE, DECEMBER 31,  2003                                                                       |       | $         | 1,841,441     |              | $          | 159,545              |       | $                      | 548,664     |                                                 | $          | 1,110,748 |   | $ | 22,484 |   |
|                                                                                                   |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Net income                                                                                             |       | 112,010   |          |              |       |                 |       | 112,010                |        |                                                 |       |
| Unrealized losses on  securities available-for-sale, net of reclassification adjustment, net of  taxes |       | (30,585   | )             |              |       |                 |       |                   |        | (30,585                                              | )          |
| Comprehensive income                                                                                   |       | 81,425    |          |              |       |                 |       |                   |        |                                                 |       |
| Cash dividends paid:                                                                                   |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Common stock ($.68 per share)                                                                          |       | (53,957   | )             |              |       |                 |       | (53,957                | )           |                                                 |       |
| Issuance of 61,696 shares for  dividend reinvestment and stock purchase plan                           |       | 2,639     |          | 123               |       | 2,516                |       |                   |        |                                                 |       |
| Issuance of 12,660 shares for  employee stock purchase dividend reinvestment plan                      |       | 557       |          | 25                |       | 532                  |       |                   |        |                                                 |       |
| Issuance of 215,631 shares for  employee stock option plan                                             |       | 3,894     |          | 432               |       | 3,462                |       |                   |        |                                                 |       |
| Directors’ deferred  compensation plan:                                                           |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Transfer opening balance                                                                               |       | 6,406     |          |              |       | 6,406                |       |                   |        |                                                 |       |
| Contribution                                                                                           |       | 196       |          |              |       | 196                  |       |                   |        |                                                 |       |
| Dividend                                                                                               |       | —    |          |              |       | 54                   |       | (54                    | )           |                                                 |       |
| Restricted stock awards                                                                                |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Issuance of 26,294 shares                                                                              |       | 1,199     |          | 53                |       | 1,146                |       |                   |        |                                                 |       |
| Deferred compensation                                                                                  |       | (1,320    | )             |              |       |                 |       | (1,320                 | )           |                                                 |       |
| Amortization                                                                                           |       | 1,035     |          |              |       |                 |       | 1,035                  |        |                                                 |       |
| Purchase of 1,000,000 shares  under stock repurchase plan                                              |       | (44,110   | )             | (2,000            | )          | (42,110              | )          |                   |        |                                                 |       |
| Vested stock options                                                                                   |       | 1,892     |          | —            |       | 1,892                |       | —                 |        | —                                               |       |
| BALANCE, JUNE 30, 2004                                                                            |       | $         | 1,841,297     |              | $          | 158,178              |       | $                      | 522,758     |                                                 | $          | 1,168,462 |   | $ | (8,101 | ) |
| BALANCE, DECEMBER 31,  2004                                                                       |       | $         | 1,917,683     |              | $          | 158,601              |       | $                      | 530,705     |                                                 | $          | 1,231,102 |   | $ | (2,725 | ) |
|                                                                                                   |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Net income                                                                                             |       | 130,500   |          |              |       |                 |       | 130,500                |        |                                                 |       |
| Unrealized losses on  securities available-for-sale, net of reclassification adjustment, net of  taxes |       | (7,998    | )             |              |       |                 |       |                   |        | (7,998                                               | )          |
| Comprehensive income                                                                                   |       | 122,502   |          |              |       |                 |       |                   |        |                                                 |       |
| Cash dividends paid:                                                                                   |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Common stock ($.73 per share)                                                                          |       | (57,897   | )             |              |       |                 |       | (57,897                | )           |                                                 |       |
| Issuance of 2,444,408 shares  for bank acquisition                                                     |       | 124,335   |          | 4,889             |       | 119,446              |       |                   |        |                                                 |       |
| Fair value of 138,764  converted options related to employee stock option plan of acquired bank        |       | 5,182     |          |              |       | 5,182                |       |                   |        |                                                 |       |
| Issuance of 54,750 shares for  dividend reinvestment and stock purchase plan                           |       | 2,677     |          | 110               |       | 2,567                |       |                   |        |                                                 |       |
| Issuance of 11,740 shares for  employee stock purchase dividend reinvestment plan                      |       | 592       |          | 23                |       | 569                  |       |                   |        |                                                 |       |
| Issuance of 132,034 shares for  employee stock option plan                                             |       | 1,957     |          | 265               |       | 1,692                |       |                   |        |                                                 |       |
| Directors’ deferred  compensation plan:                                                           |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Issuance of 1,599 shares                                                                               |       | —    |          | 2                 |       | (2                   | )          |                   |        |                                                 |       |
| Contribution                                                                                           |       | 370       |          |              |       | 370                  |       |                   |        |                                                 |       |
| Dividend                                                                                               |       | —    |          |              |       | 127                  |       | (127                   | )           |                                                 |       |
| Restricted stock awards                                                                                |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Issuance of 37,338 shares                                                                              |       | 1,906     |          | 75                |       | 1,831                |       |                   |        |                                                 |       |
| Deferred compensation                                                                                  |       | (2,000    | )             |              |       |                 |       | (2,000                 | )           |                                                 |       |
| Amortization                                                                                           |       | 1,291     |          |              |       |                 |       | 1,291                  |        |                                                 |       |
| Vested stock options                                                                                   |       | 2,519     |          | —            |       | 2,519                |       | —                 |        | —                                               |       |
| **BALANCE, JUNE 30, 2005**                                                                        |       | **$**     | **2,121,117** | ** **        | **$**      | **163,965**          | ** ** | **$**                  | **665,006** | ** **                                           | **$**      | **1,302,869** | ** ** | **$** | **(10,723** | **)** |

 

See notes toconsolidated financial statements

 

5

----

 

**MERCANTILE BANKSHARES CORPORATION**

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

 
| **Increase (decrease) in cash and  cash equivalents**                              | ** ** | **For the 6  months ended June 30,** | ** **  |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| **(Dollars in thousands)**                                                         | ** ** | **2005**                                  | ** **  | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         |       |                                      | ** **  |   |   |
| Net income                                                                         | ** ** | **$**                                     | **130,500** | ** ** | $ | 112,010 |   |
| Adjustments to reconcile net  income to net cash provided by operating activities: |       |                                      | ** **  |   |   |
| Provision for loan losses                                                          |       | **756**                                   | ** **  | 4,779 |   |
| Depreciation                                                                       |       | **7,560**                                 | ** **  | 7,787 |   |
| Amortization of other  intangible assets                                           |       | **4,251**                                 | ** **  | 4,088 |   |
| Write-downs of other real  estate owned                                            |       | **1**                                     | ** **  | — |   |
| Gains on sales of other real  estate owned                                         |       | **(153**                                  | **)**       | (13 | ) |
| Gains on sales of investments  securities                                          |       | **(513**                                  | **)**       | (535 | ) |
| Gains on sales of premises                                                         |       | **(4,541**                                | **)**       | (963 | ) |
| Loans held-for-sale                                                                |       | **(5,754**                                | **)**       | 14,178 |   |
| Net (increase) decrease in  assets:                                                |       |                                      | ** **  |   |   |
| Interest receivable                                                                |       | **(444**                                  | **)**       | 3,954 |   |
| Nonmarketable investments                                                          |       | **(6,683**                                | **)**       | (4,519 | ) |
| Other assets                                                                       |       | **(4,472**                                | **)**       | 1,598 |   |
| Net increase (decrease) in  liabilities:                                           |       |                                      | ** **  |   |   |
| Interest payable                                                                   |       | **3,591**                                 | ** **  | (1,125 | ) |
| Other liabilities                                                                  |       | **(27,333**                               | **)**       | (15,066 | ) |
| Net cash provided by operating  activities                                         |       | **96,766**                                | ** **  | 126,173 |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         |       |                                      | ** **  |   |   |
| Proceeds from maturities of  investment securities held-to-maturity                | ** ** | **2,120**                                 | ** **  | 3,913 |   |
| Proceeds from maturities of  investment securities available-for-sale              | ** ** | **425,262**                               | ** **  | 532,465 |   |
| Proceeds from sales of  investment securities available-for-sale                   | ** ** | **89,878**                                | ** **  | 42,055 |   |
| Purchases of investment  securities held-to-maturity                               | ** ** | **—**                                | ** **  | (5,195 | ) |
| Purchases of investment  securities available-for-sale                             | ** ** | **(408,727**                              | **)**       | (514,304 | ) |
| Net increase in customer loans                                                     | ** ** | **(465,812**                              | **)**       | (493,705 | ) |
| Proceeds from sales of other  real estate owned                                    | ** ** | **273**                                   | ** **  | 75 |   |
| Capital expenditures                                                               | ** ** | **(10,189**                               | **)**       | (5,403 | ) |
| Proceeds from sales of  premises                                                   | ** ** | **5,893**                                 | ** **  | 2,594 |   |
| Business acquisitions (net of  cash received)                                      | ** ** | **(78,655**                               | **)**       | — |   |
| Purchase of nonmarketable  investments                                             | ** ** | **(3,926**                                | **)**       | (2,956 | ) |
| Net cash used in investing  activities                                             |       | **(443,883**                              | **)**       | (440,461 | ) |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         |       |                                      | ** **  |   |   |
| Net increase in  noninterest-bearing deposits                                      | ** ** | **136,463**                               | ** **  | 292,521 |   |
| Net increase in  interest-bearing deposits                                         | ** ** | **268,181**                               | ** **  | 88,620 |   |
| Net increase in short-term  borrowings                                             | ** ** | **295,219**                               | ** **  | 82,858 |   |
| Repayment of long-term debt                                                        | ** ** | **(67,212**                               | **)**       | (231 | ) |
| Proceeds from issuance of  shares                                                  | ** ** | **5,226**                                 | ** **  | 7,090 |   |
| Repurchase of common shares                                                        | ** ** | **—**                                | ** **  | (44,110 | ) |
| Dividends paid                                                                     | ** ** | **(57,897**                               | **)**       | (53,957 | ) |
| Net cash provided by financing  activities                                         | ** ** | **579,980**                               | ** **  | 372,791 |   |
| Net increase in cash and cash  equivalents                                         | ** ** | **232,863**                               | ** **  | 58,503 |   |
| Cash and cash equivalents at  beginning of period                                  | ** ** | **245,134**                               | ** **  | 362,701 |   |
| Cash and cash equivalents at  end of period                                        | ** ** | **$**                                     | **477,997** | ** ** | $ | 421,204 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |                                      | ** **  |   |   |
| Cash payments for interest                                                         | ** ** | **$**                                     | **75,916**  | ** ** | $ | 55,125 |   |
| Cash payments for income taxes                                                     | ** ** | **91,109**                                | ** **  | 64,245 |   |

 

See notes toconsolidated financial statements

 

6

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**MERCANTILE BANKSHARES CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

1. Basis ofPresentation

 

The consolidatedfinancial statements, which include the accounts of Mercantile BanksharesCorporation (“Bankshares”) (Nasdaq: MRBK) and all of its affiliates, areprepared in conformity with accounting principles generally accepted in theUnited States of America and follow general practice within the bankingindustry.  In the opinion of management,the consolidated financial statements include all adjustments necessary for afair presentation of the interim period. These adjustments are of a normal nature and include adjustments toeliminate all significant intercompany transactions.  In view of the changing conditions in the nationaleconomy, the effect of actions taken by regulatory authorities and normalseasonal factors, the results for the interim period are not necessarilyindicative of annual performance.  Forcomparability, certain prior period amounts have been reclassified to conformwith current period presentation.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andcontingent assets and liabilities in the financial statements, and thedisclosure of revenue and expenses during the reporting period.  These assumptions are based on informationavailable as of the date of the financial statements and could differ fromactual results.  See Annual Report on Form 10-Kfor more detail.

 

2. BusinessCombinations / Restructuring

 

The followingprovides information concerning acquisitions and restructurings. Acquisitionsare accounted for as purchases with the results of their operations subsequentto the acquisition date included in Bankshares’ Statements of ConsolidatedIncome.

 

On May 18,2005, Bankshares completed its acquisition of Community Bank of NorthernVirginia (“CBNV”), a bank headquartered in Sterling, Virginia, which was mergedinto Mercantile-Safe Deposit & Trust Company.  CBNV operated fourteen branch offices in theNorthern Virginia metropolitan market at the time of the acquisition. Theprimary reason for the merger with CBNV was to expand Bankshares’ distributionnetwork in Northern Virginia, a higher growth market. The total considerationpaid to CBNV shareholders in connection with the acquisition was $82.9 millionin cash and 2.4 million shares of Bankshares’ common stock.  CBNV transactions have been included inBankshares’ financial results subsequent to May 18, 2005.  The assets and liabilities of CBNV wererecorded on the Consolidated Balance Sheet at their respective fair values. Thefair values have been determined as of June 30, 2005 and are subject torefinement, as further information becomes available. The transaction resultedin total assets acquired as of May 18, 2005 of $888.2 million, including$671.0 million of loans and leases; liabilities assumed were $842.3 million,including $626.9 million of deposits. Additionally, Bankshares had recorded$159.7 million of goodwill and $4.8 million of core deposit intangible.Intangible assets subjected to amortization are being amortized on astraight-line basis. The weighted average amortization period for thenewly-acquired core deposit intangible is nine years.

 

Bankshares’ exitcosts, referred to herein as “merger-related” costs, are defined to includethose costs for its branch closings and related severance, combining operationssuch as systems conversions, and printing/mailing costs incurred by Banksharesprior to and after the merger date and are included in Bankshares’ results ofoperations.  Bankshares expensedmerger-related costs totaling $302.0 thousand and $44.1 thousand for the sixand three-month periods ended June 30, 2005, respectively. The costsassociated with these activities are included in noninterest expenses.Merger-related expenses incurred year to date consisted largely of expenses forsystems conversion costs. Bankshares will incur additional merger-relatedexpenses in the third and fourth quarter as systems conversions, branchclosings and integration of operations continue and these expenses will bereflected when incurred.

 

In the second quarterof 2005, Bankshares consolidated Fidelity Bank into Farmers &Mechanics Bank. The consolidation of these banks allows the surviving bank toserve its local customers with greater scale and expertise. Also, in the secondquarter of 2005, Mercantile Potomac Bank merged into Mercantile-Safe Depositand Trust Company. This combination allows Bankshares to provide the resourcesnecessary for greater expansion into the Washington, D.C. and Northern Virginiamarkets.

 

In 2004,Bankshares initiated a significant reorganization within its Bankingnetwork.  In a move designed to createbanks of sufficient size and depth to compete more effectively today and in thefuture, Bankshares combined 11 affiliate banks to create four neworganizations, all with a more prominent Mercantile identity. Thisreorganization has enabled Bankshares to operate more effectively andefficiently in the face of increased competitive and regulatory pressures.  Fewer, larger banks allow better leverage ofour branch network, reduce administrative and operational redundancies andincrease the breadth and depth of expertise within our banks. All banks thatwere combined are geographically contiguous, share increasingly common marketdynamics and offer the opportunity to create scale efficiencies. In 2004,Bankshares accrued approximately $2.3 million in restructuring charges due tothis reorganization. At June 30, 2005, $0.9 million remains to be paid.

 

7

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3. Earnings PerShare

 

Basic earnings pershare (“EPS”) is computed by dividing income available to common shareholdersby weighted average common shares outstanding. Diluted EPS is computed using the same components as basic EPS with thedenominator adjusted for the dilutive effect of stock awards.  The following tables provide reconciliationbetween the computation of basic EPS and diluted EPS for the six months andquarters ended June 30, 2005 and 2004, respectively.

 
| ** **                                                    | ** ** | **For the 6 months ended June 30,** | ** **  |
|---------------------------------------------------------------|------------|------------------------------------------|-------------|
| ** **                                                    | ** ** | **2005**                                 | ** **  | **2004** | ** ** |
| **(In thousands, except per share data)**                     | ** ** | **Net  Income**                          | ** **  | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                     |       | **$**                                    | **130,500** | ** ** | **79,875** | ** ** | **$** | **1.63** |   | $ | 112,010 |   | 79,422 |   | $ | 1.41 |   |
| Dilutive effect of stock  options and restricted stock awards |       | ** **                               |        | **476** |   |   |   |   |   | 510 |   |   |   |
| Vested directors deferred  compensation plan shares           |       | ** **                               |        | **170** |   |   |   |   |   | 75 |   |   |   |
| Diluted EPS                                                   |       | **$**                                    | **130,500** | ** ** | **80,521** | ** ** | **$** | **1.62** |   | $ | 112,010 |   | 80,007 |   | $ | 1.40 |   |

 
| ** **                                                    | ** ** | **For the 3  months ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **(In thousands, except per share  data)**                    | ** ** | **Net  Income**                           | ** ** | **Weighted  Average  Common Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                     |       | **$**                                     | **67,873** | ** ** | **80,514** | ** ** | **$** | **0.84** |   | $ | 56,313 |   | 79,119 |   | $ | 0.71 |   |
| Dilutive effect of stock  options and restricted stock awards |       | ** **                                |       | **475** |   |   |   |   |   | 483 |   |   |   |
| Vested directors deferred  compensation plan shares           |       | ** **                                |       | **172** |   |   |   |   |   | 149 |   |   |   |
| Diluted EPS                                                   |       | **$**                                     | **67,873** | ** ** | **81,161** | ** ** | **$** | **0.84** |   | $ | 56,313 |   | 79,751 |   | $ | 0.71 |   |

 

Antidilutiveoptions and awards excluded from the computation of diluted earnings per sharewere 209,974 and 445,909 for the six months ended June 30, 2005 and 2004,respectively, and 312,322 and 593,500 for the second quarter of 2005 and 2004,respectively.

 

# **4.Investment Securities**

 

At June 30,2005 and December 31, 2004, securities with an amortized cost of $1.3billion and $1.1 billion, respectively, were pledged as collateral for certaindeposits as required by regulatory guidelines. The following table showsamortized cost and fair value of investment securities at June 30, 2005and December 31, 2004.

 
| ** **                                | ** ** | **June 30, 2005** | ** **    | **December 31, 2004**   | ** ** |
|-------------------------------------------|------------|------------------------|---------------|------------------------------|------------|
| **(Dollars in thousands)**                | ** ** | **Amortized  Cost**    | ** **    | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Investment securities  held-to-maturity   | ** ** | ** **             | ** **    | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political  subdivisions        | ** ** | **$**                  | **18,056**    | ** **                   | **$**      | **743** | ** ** | **$** | **11** | ** ** | **$** | **18,788** |   | $ | 20,176 |   | $ | 921 |   | $ | 3 |   | $ | 21,094 |   |
|                                      |       |                   |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment securities  available-for-sale |       |                   |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                             | ** ** | **$**                  | **475,206**   | ** **                   | **$**      | **873** | ** ** | **$** | **1,725** | ** ** | **$** | **474,354** |   | $ | 605,505 |   | $ | 4,534 |   | $ | 980 |   | $ | 609,059 |   |
| U.S. Government agencies                  | ** ** | **924,286**            | ** **    | **1,498**                    | ** ** | **7,716** | ** ** | **918,068** |   | 853,930 |   | 3,742 |   | 4,699 |   | 852,973 |   |
| Mortgage-backed securities                | ** ** | **1,436,562**          | ** **    | **2,263**                    | ** ** | **14,592** | ** ** | **1,424,233** |   | 1,326,056 |   | 4,372 |   | 13,127 |   | 1,317,301 |   |
| States and political  subdivisions        | ** ** | **78,028**             | ** **    | **890**                      | ** ** | **50** | ** ** | **78,868** |   | 61,984 |   | 917 |   | 31 |   | 62,870 |   |
| Other investments                         | ** ** | **63,266**             | ** **    | **1,626**                    | ** ** | **140** | ** ** | **64,752** |   | 65,323 |   | 1,294 |   | 126 |   | 66,491 |   |
| Total                                     | ** ** | **$**                  | **2,977,348** | ** **                   | **$**      | **7,150** | ** ** | **$** | **24,223** | ** ** | **$** | **2,960,275** |   | $ | 2,912,798 |   | $ | 14,859 |   | $ | 18,963 |   | $ | 2,908,694 |   |

 

The followingtable shows the unrealized gross losses and fair value of securities in thesecurities available-for-sale portfolio at June 30, 2005, by length oftime that individual securities in each category have been in a continuous lossposition.

 

8

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| ** **                         | ** ** | **Less than 12 Months**         | ** ** | **12 months or more** | ** ** | **Total**                       | ** ** |
|------------------------------------|------------|---------------------------------|------------|-----------------------|------------|---------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **Gross  Unrealized****Losses** | ** ** | **Fair****Value**     | ** ** | **Gross  Unrealized****Losses** | ** ** | **Fair****Value** | ** ** | **Gross  Unrealized****Losses** | ** ** | **Fair****Value** | ** ** |
| U.S. Treasury                      | ** ** | **$**                           | **1,620**  | ** **            | **$**      | **471,370**                     | ** ** | **$** | **105** | ** ** | **$** | **2,984** | ** ** | **$** | **1,725** | ** ** | **$** | **474,354** | ** ** |
| U.S. Government agencies           | ** ** | **7,042**                       | ** ** | **892,179**           | ** ** | **674**                         | ** ** | **25,889** | ** ** | **7,716** | ** ** | **918,068** | ** ** |
| States and political  subdivisions | ** ** | **59**                          | ** ** | **78,768**            | ** ** | **2**                           | ** ** | **100** | ** ** | **61** | ** ** | **78,868** | ** ** |
| Mortgage-backed securities         | ** ** | **5,884**                       | ** ** | **1,137,052**         | ** ** | **8,708**                       | ** ** | **287,181** | ** ** | **14,592** | ** ** | **1,424,233** | ** ** |
| Other investments                  | ** ** | **140**                         | ** ** | **64,752**            | ** ** | **—**                      | ** ** | **—** | ** ** | **140** | ** ** | **64,752** | ** ** |
| Total bonds                        | ** ** | **$**                           | **14,745** | ** **            | **$**      | **2,644,121**                   | ** ** | **$** | **9,489** | ** ** | **$** | **316,154** | ** ** | **$** | **24,234** | ** ** | **$** | **2,960,275** | ** ** |
|                                    |            |                                 |            |                       |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At June 30,2005, there were $316.2 million of individual securities that had unrealizedlosses for a period greater than 12 months. At June 30, 2005, thesesecurities had an unrealized loss of $9.5 million of which 91.8% weremortgage-backed securities. Management has assessed the impairment of thesesecurities and determined that the impairment is temporary. All principal andinterest payments on available-for-sale debt securities in an unrealized lossposition for greater than 12 months are expected to be collected given the highcredit quality of the U.S. government agency debt securities and Bankshares’ability and intent to hold the securities. Because the declines in fair valuewere due to changes in market interest rates, not in estimated cash flows, noother-than-temporary impairment was recorded at June 30, 2005.

 

# **5.Impaired Loans**

 

When scheduled principal or interest payments are past due 90 days ormore at quarter-end on any loan, the accrual of interest income is discontinuedand subsequent receipts on these loans are recorded as a reduction ofprincipal, and interest income is recorded only once principal recovery isreasonably assured. Previously accrued but uncollected interest on these loansis charged against interest income. Generally, a loan may be restored toaccruing status when all past due principal, interest and late charges havebeen paid and the bank expects repayment of the remaining contractual principaland interest on a timely basis.

 

Under Statements of Financial Accounting Standards (SFAS) Nos. 114 and118, “Accounting by Creditors for Impairment of a Loan-an amendment of FASBStatements Nos. 5 and 15,” a loan is considered impaired, based on currentinformation and events, if it is probable that Bankshares will not collect allprincipal and interest payments according to the contractual terms of the loanagreement. The impairment of a loan is measured based on the present value ofexpected future cash flows discounted at the loan’s effective interest rate, orthe fair value of the collateral if the repayment is expected to be providedpredominantly by the underlying collateral. Information with respect toimpaired loans and the related valuation allowance (if the measure of theimpaired loan is less than the recorded investment) at June 30, 2005, December 31,2004 and June 30, 2004 is shown below. See Annual Report on Form 10-K for more detail.

 
| **(Dollars in thousands)**                                                       | ** ** | **June 30,  2005** | ** **  | **December 31,  2004** | ** ** | **June 30,  2004** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|-------------------------|------------|
| Impaired loans with a specific  valuation allowance                              | ** ** | **$**                   | **16,460**  |                        | $          | 18,365                  |       | $ | 24,864 |   |
| All other impaired loans                                                         | ** ** | **8,746**               |        | 9,113                       |       | 12,160                  |       |
| Total impaired loans                                                             | ** ** | **$**                   | **25,206**  |                        | $          | 27,478                  |       | $ | 37,024 |   |
|                                                                             |       |                    |        |                        |       |                    |       |
| Specific allowance for loan  losses applicable to impaired loans                 | ** ** | **$**                   | **10,225**  |                        | $          | 10,611                  |       | $ | 14,497 |   |
| General allowance for loan  losses applicable to other than impaired loans       | ** ** | **146,876**             |        | 138,391                     |       | 143,934                 |       |
| Total allowance for loan  losses                                                 | ** ** | **$**                   | **157,101** |                        | $          | 149,002                 |       | $ | 158,431 |   |
|                                                                             |       |                    |        |                        |       |                    |       |
| Year-to-date interest income  on impaired loans recorded on the cash basis       | ** ** | **$**                   | **53**      |                        | $          | 379                     |       | $ | 212 |   |
| Year-to-date average recorded  investment in impaired loans during the period    | ** ** | **$**                   | **27,887**  |                        | $          | 39,025                  |       | $ | 41,116 |   |
| Quarter-to-date interest  income on impaired loans recorded on the cash basis    | ** ** | **$**                   | **30**      |                        | $          | 79                      |       | $ | 109 |   |
| Quarter-to-date average  recorded investment in impaired loans during the period | ** ** | **$**                   | **26,993**  |                        | $          | 35,583                  |       | $ | 39,752 |   |
|                                                                                  |            |                         |             |                             |            |                         |            |  |  |  |  |  |  |

 

**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 generalallowance for loan losses applicable to other than impaired loans.

 

9

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On May 18,2005, Bankshares acquired approximately $671.0 million in loans as part of theCBNV acquisition. At acquisition, CBNV had $7.4 million in an allowance forloan losses of which $7.1 million was carried over to Bankshares in accordancewith SFAS 141, “Business Combinations,” for those loans that do not fall withinthe scope of the American Institute of Certified Public Accountants issuedStatement of Position (“SOP”) 03-3, “Accounting for Certain Loans or DebtSecurities Acquired in a Transfer.” Under SOP 03-3, Bankshares determined thatcertain loans acquired at the CBNV acquisition displayed evidence ofdeterioration of credit quality since their origination for which it wasprobable that all contractual payments would not be collected. Banksharesdetermined two commercial real estate loans totaling $4.9 million were withinthe scope of SOP 03-3. The carrying value and accretable yields of these loansas of June 30, 2005 are shown below.

 
| **(Dollars in thousands)** | ** ** | **June 30,  2005** | ** ** |
|----------------------------|------------|-------------------------|------------|
| Commercial real estate     |       | $                       | 4,865      |   |
| Total contractual balance  |       | $                       | 4,865      |   |
|                       |       |                    |       |
| Carrying amount            |       | $                       | 3,500      |   |

 
| ** **                    | ** ** | **Accretable  yield** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| Balance at May 18, 2005  |       | $                     | —     |   |
| Addition - due to acquisition |       | 680                   |       |
| Accretion                     |       | (46                   | )          |
| Balance at June 30, 2005 |       | $                     | 634        |   |

 

6. Commitments &Contingencies

 

Bankshares is aparty to financial instruments that are not reflected in the balance sheet,which include commitments to extend credit and standby letters of credit.Various commitments to extend credit (lines of credit) are made in the normalcourse of banking business. Letters of credit are issued for the benefit ofcustomers by affiliated banks. These commitments are subject to loanunderwriting standards and geographic boundaries consistent with Bankshares’loans outstanding. Bankshares’ lending activities are concentrated in Maryland,Delaware and Virginia.

 

Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. Total commitments to extend credit were $4.7 billionat June 30, 2005, $4.2 billion at December 31, 2004, and $3.9 billionat June 30, 2004.

 

Letters of creditare commitments issued to guarantee the performance of a customer to a thirdparty. Outstanding letters of credit were $438.3 million at June 30, 2005,$379.8 million at December 31, 2004 and $320.9 million at June 30,2004.  Fees received for issuing lettersof credit are deferred and amortized over the life of the commitment.  The unamortized fees on letters of credit at June 30,2005, December 31, 2004, and June 30, 2004 had a carrying value of$1.5 million, $1.3 million and $1.2 million, respectively.

 

Bankshares’mortgage banking subsidiary is a Fannie Mae Delegated Underwriting andServicing lender and has a loss sharing arrangement for loans originated onbehalf of and sold to Fannie Mae.  Theunamortized principal balance of the underlying loans totaled $225.8 million,$190.7 million and $183.9 million at June 30, 2005, December 31, 2004and June 30, 2004, respectively.  Aminimal loss reserve has been established for potential losses on loansoriginated and sold in the secondary market at June 30, 2005.  The mortgage subsidiary also has originatedand sold loans with recourse in the event of foreclosure on the underlying realestate.  The unamortized amount ofprincipal balance of loans sold with recourse totaled $1.3 million at June 30,2005, $1.7 million at December 31, 2004 and $2.0 million at June 30,2004.  These mortgages are generally ingood standing, are well-collateralized and no loss has ensued and no futureloss is expected.

 

Bankshares hascommitted to invest funds in third-party private equity investments. At June 30,2005, December 31, 2004 and June 30, 2004, $30.0 million, $28.9million and $18.7 million, respectively, remained unfunded.

 

In the ordinarycourse of business, Bankshares and its subsidiaries are involved in a number ofpending and threatened legal actions and proceedings. In certain of theseactions and proceedings, claims for substantial monetary damages are assertedagainst Bankshares and its subsidiaries. In view of the inherent difficulty ofpredicting the outcome of such matters, Bankshares cannot state what theeventual outcome of pending matters will be. However, based on currentknowledge, management does not believe that liabilities, if

 

10

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any, arising frompending litigation matters, will have a material adverse effect on theconsolidated financial position or liquidity of Bankshares. If paymentassociated with a claim becomes probable and the cost can be reasonablyestimated, a contingent liability would be established based on informationcurrently available, advice of counsel and available insurance coverage.

 

Between 2001 and2003, on behalf of either individual plaintiffs or a putative class ofplaintiffs, eight separate actions were filed in state and federal courtagainst Community Bank of Northern Virginia (“CBNV”) and other defendantschallenging the validity of second mortgage loans the defendants made to theplaintiffs.  All of the cases were eitherfiled in or removed to the federal district court for the Western District ofPennsylvania.  In June 2003, theparties to the various actions informed the court that they had reached anagreement in principle to settle the various actions.  On July 17, 2003, the courtconditionally certified a class for settlement purposes, preliminarily approvedthe class settlement, and directed the issuance of notice to the class.

 

Thereafter,certain plaintiffs opted out of the proposed settlement and challenged thevalidity of the settlement in the district court.  The district court denied their arguments andapproved the settlement.  These “opt out”plaintiffs appealed the district court’s approval of the settlement to theThird Circuit Court of Appeals.  TheThird Circuit heard oral argument on February 17, 2005 and has not yetissued its decision. Certain individuals who were excluded from the settlementclass have filed two actions on behalf of a putative class of plaintiffsalleging claims similar to those raised in the initial filing.  These actions recently were consolidated inthe Western District of Pennsylvania. Bankshares believes these actions are without merit and intends todefend the actions vigorously.

 

The contingency,which is estimable and probable, was incorporated in determining the fair valueof the liability assumed at the acquisition of CBNV.

 

# **7.Goodwill and Other Intangible Assets**

 

Bankshares’Consolidated Balance Sheet included goodwill of $667.5 million at June 30,2005 and $507.8 million at December 31, 2004. In 2005, Bankshares recorded$159.7 million in goodwill and $4.8 million in estimated core depositintangible in connection with the CBNV acquisition, which was allocated toBankshares’ banking segment. The core deposit intangible from CBNV is beingamortized over a weighted average remaining useful life of nine years.

 

The followingtable discloses the gross carrying amount and accumulated amortization ofintangible assets subject to amortization at June 30, 2005 and December 31,2004.

 
| ** **                 | ** ** | **June 30, 2005**      | ** ** | **December 31, 2004**    | ** ** |
|----------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Core deposits              | ** ** | **$**                       | **54,660** | ** **                    | **$**      | **(17,828** | **)** | **$** | **36,832** |   | $ | 49,881 |   | $ | (15,014 | ) | $ | 34,867 |   |
| Mortgage servicing         | ** ** | **2,445**                   | ** ** | **(1,156**                    | **)**      | **1,289** |   | 1,370 |   | (1,013 | ) | 357 |   |
| Customer lists and other   | ** ** | **17,010**                  | ** ** | **(5,301**                    | **)**      | **11,709** |   | 17,010 |   | (4,008 | ) | 13,002 |   |
| Total                      | ** ** | **$**                       | **74,115** | ** **                    | **$**      | **(24,285** | **)** | **$** | **49,830** |   | $ | 68,261 |   | $ | (20,035 | ) | $ | 48,226 |   |

 

Identifiableintangible assets are amortized based on estimated lives of up to 15 years.Management reviews other intangible assets for impairment yearly, or wheneverevents or changes in circumstances indicate that their carrying amounts may notbe recoverable. For those intangible assets subject to amortization, impairmentis indicated if the sum of undiscounted estimated future net cash flows is lessthan the carrying amount of the asset. Impairment is recognized by writing downthe carrying value or adjusting the estimated life of the asset. Any impairmentrecognized in a valuation account is reflected in the income statement in thecorresponding period.

 

The followingtable shows the current period and estimated future amortization expense foramortized intangible assets. The projections of amortization expense shown formortgage servicing rights are based on asset balances and the interest rateenvironment as of June 30, 2005. Future amortization expense may besignificantly different depending upon changes in the mortgage servicingportfolio, mortgage interest rates and market conditions.

 

11

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The following table showsthe current period and estimated future amortization expense for amortizedintangible assets.

# ** **

| **(Dollars in thousands)**                              | ** ** | **Core  deposits** | ** ** | **Mortgage  servicing** | ** ** | **Customer  lists  and other** | ** ** | **Total** | ** ** |
|---------------------------------------------------------|------------|--------------------|------------|-------------------------|------------|--------------------------------|------------|-----------|------------|
| Six months ended June 30, 2005 (actual)            | ** ** | **$**              | **2,814**  | ** **              | **$**      | **136**                        | ** ** | **$**     | **1,301**  | ** ** | **$** | **4,251** | ** ** |
| Six months ended December 31, 2005 (estimated)     |       | 2,974              |       | 201                     |       | 1,293                          |       | 4,468     |       |
| Twelve months ended December 31,  2005 (estimated) |       | 5,788              |       | 337                     |       | 2,594                          |       | 8,719     |       |
|                                                    |       |               |       |                    |       |                           |       |      |       |   |
| Estimate for year ended December 31,               | 2006       |               | 5,950      |                    | 259        |                           | 2,343      |      | 8,552      |   |
|                                                    |       | 2007               |       | 5,691                   |       | 210                            |       | 2,149     |       | 8,050 |   |
|                                                    |       | 2008               |       | 4,827                   |       | 192                            |       | 1,968     |       | 6,987 |   |
|                                                    |       | 2009               |       | 4,502                   |       | 187                            |       | 1,028     |       | 5,717 |   |
|                                                         |            |                    |            |                         |            |                                |            |           |            |  |  |  |  |  |  |

 

# **8.Comprehensive Income**

 

The followingtable summarizes the market value change and related tax effect of unrealizedgains (losses) on securities available-for-sale for the six months ended June 30,2005 and 2004.  The net amount isincluded in accumulated other comprehensive income (loss) in the Statements ofChanges in Consolidated Shareholders’ Equity.

 
| ** **                                                             | ** ** | **For the 6  months ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **(Dollars in thousands)**                                             | ** ** | **Pretax  Amount**                        | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Net Income                                                             | ** ** | ** **                                |       |   |   | **$** | **130,500** | ** ** |   |   |   |   | $ | 112,010 |   |
| Other comprehensive income                                             |       |                                      |       |   |   |   | ** ** |   |   |   |   |   |   |
| Unrealized holding gains  (losses) arising during the period           | ** ** | **(12,454**                               | **)**      | **4,766** | ** ** | **(7,688** | **)** | (48,260 | ) | 17,998 |   | (30,262 | ) |
| Reclassification adjustment  for (gains) losses included in net income | ** ** | **(513**                                  | **)**      | **203** | ** ** | **(310** | **)** | (535 | ) | 212 |   | (323 | ) |
| Total other comprehensive  income                                      | ** ** | **(12,967**                               | **)**      | **4,969** | ** ** | **(7,998** | **)** | (48,795 | ) | 18,210 |   | (30,585 | ) |
| Total comprehensive income                                             | ** ** | ** **                                |       |   |   | **$** | **122,502** | ** ** |   |   |   |   | $ | 81,425 |   |

 
| ** **                                                             | ** ** | **For the 3  months ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **(Dollars in thousands)**                                             | ** ** | **Pretax  Amount**                        | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Net Income                                                             | ** ** | ** **                                |       |   |   | **$** | **67,873** | ** ** |   |   |   |   | $ | 56,313 |   |
| Other comprehensive income                                             |       |                                      |       |   |   |   | ** ** |   |   |   |   |   |   |
| Unrealized holding gains  (losses) arising during the period           | ** ** | **19,767**                                | ** ** | **(7,265** | **)** | **12,502** | ** ** | (67,503 | ) | 25,019 |   | (42,484 | ) |
| Reclassification adjustment  for (gains) losses included in net income | ** ** | **(99**                                   | **)**      | **39** | ** ** | **(60** | **)** | (590 | ) | 233 |   | (357 | ) |
| Total other comprehensive  income                                      | ** ** | **19,668**                                | ** ** | **(7,226** | **)** | **12,442** | ** ** | (68,093 | ) | 25,252 |   | (42,841 | ) |
| Total comprehensive income                                             | ** ** | ** **                                |       |   |   | **$** | **80,315** | ** ** |   |   |   |   | $ | 13,472 |   |

 

12

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# **9.Capital Adequacy**

 

Bankshares and itsbank affiliates are subject to various regulatory capital adequacy requirementsadministered by federal and state banking agencies.  These requirements include maintainingcertain capital ratios above minimum levels. These capital ratios include tier I capital and total risk-based capitalas percentages of net risk-weighted assets and tier I capital as a percentageof adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacypurposes are 4.00%, 8.00% and 4.00%, for the tier I capital, total capital andleverage ratios, respectively.  To becategorized as *well capitalized,* a bank mustmaintain minimum ratios of 6.00%, 10.00% and 5.00%, for its tier I capital,total capital and leverage ratios, respectively.  As of June 30, 2005, Bankshares and allof its bank affiliates exceeded all capital adequacy requirements to beconsidered well capitalized.

 

Capital ratios andthe amounts used to calculate them are presented in the following table forBankshares and Mercantile-Safe Deposit & Trust Company (MSD&T),the lead bank, as of June 30, 2005 and December 31, 2004. The June 30,2005 MSD&T capital ratios reflect the impact of the consolidation ofMercantile Potomac Bank into MSD&T and the acquisition of CBNV.

 
| ** **                    | ** ** | **June 30,  2005** | ** **    | **December 31,  2004** | ** ** |
|-------------------------------|------------|-------------------------|---------------|-----------------------------|------------|
| **(Dollars in thousands)**    | ** ** | **Bankshares**          | ** **    | **MSD&T**               | ** ** | **Bankshares** | ** ** | **MSD&T** | ** ** |
| Tier I capital                |       | **$**                   | **1,422,079** |                        | $          | 468,540 |   | $ | 1,370,112 |   | $ | 411,587 |   |
| Total risk-based capital      | ** ** | **1,882,496**           |          | 580,685                     |       | 1,802,520 |   | 459,812 |   |
| Net risk-weighted assets      | ** ** | **12,373,131**          |          | 5,575,052                   |       | 11,109,137 |   | 3,847,161 |   |
| Adjusted average total assets | ** ** | **14,438,084**          |          | 5,963,921                   |       | 13,674,386 |   | 4,504,451 |   |
|                          |       |                    |          |                        |       |   |   |   |   |
| Tier I capital ratio          | ** ** | **11.49**               | **%**         | 8.40                        | %          | 12.33 | % | 10.70 | % |
| Total capital ratio           | ** ** | **15.21**               | **%**         | 10.42                       | %          | 16.23 | % | 11.95 | % |
| Leverage ratio                | ** ** | **9.85**                | **%**         | 7.86                        | %          | 10.02 | % | 9.14 | % |
|                               |            |                         |               |                             |            |  |  |  |  |  |  |  |  |

 

Bankshares has an ongoing share repurchase program.  Purchases may be made from time to time,subject to regulatory requirements, in open market or in privately negotiatedtransactions. Purchased shares are retired. At June 30, 2005, there were476,327 shares remaining available for repurchase under the plan.

 

10. SegmentReporting

 

Operating segments asdefined by SFAS No. 131 *Disclosures about Segmentsof an Enterprise and Related Information* are components of anenterprise with separate financial information. The component engages in business activities from which it derivesrevenues and incurs expenses and whose operating results management relies on fordecision-making and performance assessment. Bankshares has two reportablesegments – Banking and Investment and Wealth Management (“IWM”).

 

The following tablespresent selected segment information for the three and six months ended June 30,2005 and 2004. The components in the “Other” column consist of amounts for thenonbank affiliates, unallocated corporate expenses including income taxes andintercompany eliminations. Certain expense amounts such as operations overheadhave been reclassified in order to provide for full cost absorption. Thesereclassifications are shown on the “Adjustments” line.  Results of the CBNV acquisition have beenincluded in the “Banking” column from its acquisition date in the secondquarter of 2005.

 
| ** **                         | ** ** | **For the 6 months ended June 30,  2005** | ** **     | **For the 6 months ended June 30,  2004** | ** ** |
|------------------------------------|------------|------------------------------------------------|----------------|------------------------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **Banking**                                    | ** **     | **IWM**                                        | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                          | **295,666**    | ** **                                     | **$**      | **—** | ** ** | **$** | **(216** | **)** | **$** | **295,450** | ** ** | $ | 263,740 |   | $ | — |   | $ | 149 |   | $ | 263,889 |   |
| Provision for loan losses          | ** ** | **(756**                                       | **)**          | **—**                                     | ** ** | **—** | ** ** | **(756** | **)** | (4,779 | ) | — |   | — |   | (4,779 | ) |
| Noninterest income                 | ** ** | **62,479**                                     | ** **     | **47,841**                                     | ** ** | **7,615** | ** ** | **117,935** | ** ** | 56,154 |   | 45,229 |   | 2,897 |   | 104,280 |   |
| Noninterest expenses               | ** ** | **(164,620**                                   | **)**          | **(35,303**                                    | **)**      | **(4,143** | **)** | **(204,066** | **)** | (152,764 | ) | (33,809 | ) | (180 | ) | (186,753 | ) |
| Adjustments                        | ** ** | **8,100**                                      | ** **     | **(1,443**                                     | **)**      | **(6,657** | **)** | **—** | ** ** | 8,386 |   | (1,926 | ) | (6,460 | ) | — |   |
| Income (loss) before income  taxes | ** ** | **200,869**                                    | ** **     | **11,095**                                     | ** ** | **(3,401** | **)** | **208,563** | ** ** | 170,737 |   | 9,494 |   | (3,594 | ) | 176,637 |   |
| Income tax (expense) benefit       | ** ** | **(69,923**                                    | **)**          | **(4,438**                                     | **)**      | **(3,702** | **)** | **(78,063** | **)** | (59,982 | ) | (3,797 | ) | (848 | ) | (64,627 | ) |
| Net income (loss)                  | ** ** | **$**                                          | **130,946**    | ** **                                     | **$**      | **6,657** | ** ** | **$** | **(7,103** | **)** | **$** | **130,500** | ** ** | $ | 110,755 |   | $ | 5,697 |   | $ | (4,442 | ) | $ | 112,010 |   |
| Average loans                      | ** ** | **$**                                          | **10,608,029** | ** **                                     | ** ** | ** ** | **$** | **399** | ** ** | **$** | **10,608,428** | ** ** | $ | 9,480,967 | ** ** | ** ** |   | $ | 192 |   | $ | 9,481,159 |   |
| Average earning assets             | ** ** | **13,516,688**                                 | ** **     | ** **                                     | ** ** | **16,125** | ** ** | **13,532,813** | ** ** | 12,494,449 | ** ** | ** ** |   | 23,950 |   | 12,518,399 |   |
| Average assets                     | ** ** | **14,718,009**                                 | ** **     | ** **                                     | ** ** | **154,924** | ** ** | **14,872,933** | ** ** | 13,227,398 | ** ** | ** ** |   | 550,019 |   | 13,777,417 |   |
| Average deposits                   | ** ** | **11,188,466**                                 | ** **     | ** **                                     | ** ** | **(190,934** | **)** | **10,997,532** | ** ** | 10,299,390 | ** ** | ** ** |   | (66,939 | ) | 10,232,451 |   |
| Average equity                     | ** ** | **1,852,056**                                  | ** **     | ** **                                     | ** ** | **144,388** | ** ** | **1,996,444** | ** ** | 1,383,980 | ** ** | ** ** |   | 464,858 |   | 1,848,838 |   |

 

13

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| ** **                         | ** ** | **For the 3 months ended June 30,  2005** | ** **     | **For the 3 months ended June 30,  2004** | ** ** |
|------------------------------------|------------|------------------------------------------------|----------------|------------------------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **Banking**                                    | ** **     | **IWM**                                        | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                          | **152,572**    | ** **                                     | **$**      | **—** | ** ** | **$** | **(205** | **)** | **$** | **152,367** | ** ** | $ | 133,395 |   | $ | — |   | $ | 89 |   | $ | 133,484 |   |
| Provision for loan losses          | ** ** | **—**                                     | ** **     | **—**                                     | ** ** | **—** | ** ** | **—** | ** ** | (2,353 | ) | — |   | — |   | (2,353 | ) |
| Noninterest income                 | ** ** | **32,988**                                     | ** **     | **23,528**                                     | ** ** | **3,550** | ** ** | **60,066** | ** ** | 29,059 |   | 22,847 |   | (780 | ) | 51,126 |   |
| Noninterest expenses               | ** ** | **(84,169**                                    | **)**          | **(18,457**                                    | **)**      | **(1,287** | **)** | **(103,913** | **)** | (77,237 | ) | (16,430 | ) | 300 |   | (93,367 | ) |
| Adjustments                        | ** ** | **4,171**                                      | ** **     | **(234**                                       | **)**      | **(3,937** | **)** | **—** | ** ** | 5,155 |   | (1,130 | ) | (4,025 | ) | — |   |
| Income (loss) before income  taxes | ** ** | **105,562**                                    | ** **     | **4,837**                                      | ** ** | **(1,879** | **)** | **108,520** | ** ** | 88,019 |   | 5,287 |   | (4,416 | ) | 88,890 |   |
| Income tax (expense) benefit       | ** ** | **(36,876**                                    | **)**          | **(1,932**                                     | **)**      | **(1,839** | **)** | **(40,647** | **)** | (30,936 | ) | (2,114 | ) | 473 |   | (32,577 | ) |
| Net income (loss)                  | ** ** | **$**                                          | **68,686**     | ** **                                     | **$**      | **2,905** | ** ** | **$** | **(3,718** | **)** | **$** | **67,873** | ** ** | $ | 57,083 |   | $ | 3,173 |   | $ | (3,943 | ) | $ | 56,313 |   |
| Average loans                      | ** ** | **$**                                          | **10,898,888** | ** **                                     | ** ** | ** ** | **$** | **375** | ** ** | **$** | **10,899,263** | ** ** | $ | 9,623,698 | ** ** | ** ** |   | $ | 186 |   | $ | 9,623,884 |   |
| Average earning assets             | ** ** | **13,830,457**                                 | ** **     | ** **                                     | ** ** | **10,534** | ** ** | **13,840,991** | ** ** | 12,640,594 | ** ** | ** ** |   | 28,080 |   | 12,668,674 |   |
| Average assets                     | ** ** | **15,083,362**                                 | ** **     | ** **                                     | ** ** | **150,209** | ** ** | **15,233,571** | ** ** | 13,385,094 | ** ** | ** ** |   | 554,091 |   | 13,939,185 |   |
| Average deposits                   | ** ** | **11,470,481**                                 | ** **     | ** **                                     | ** ** | **(197,261** | **)** | **11,273,220** | ** ** | 10,459,934 | ** ** | ** ** |   | (61,677 | ) | 10,398,257 |   |
| Average equity                     | ** ** | **1,898,013**                                  | ** **     | ** **                                     | ** ** | **144,091** | ** ** | **2,042,104** | ** ** | 1,394,812 | ** ** | ** ** |   | 456,949 |   | 1,851,761 |   |

 

11. DerivativeInstruments and Hedging Activities

 

FASB Statement No. 133(SFAS No. 133), *Accounting for DerivativeInstruments and Hedging Activities,*FASB Statement No. 138(SFAS No. 138), *Accounting for CertainDerivative Instruments and Certain Hedging Activities – an amendment to FASBStatement No. 133*and**FASB StatementNo. 149 (SFAS No. 149), *Amendment of Statement No. 133on Derivative Instruments and Hedging Activities*(collectivelyreferred to as “derivatives”), establishes accounting and reporting standardsfor derivative 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.  Currently, derivative instruments that areused as part of the interest rate risk management strategy have been restrictedto interest rate swaps.  Interest rateswaps generally involve the exchange of fixed-rate and variable-rate interestpayments between two parties, based on a common notional principal amount andmaturity date. As of June 30, 2005, Bankshares had interest rate swaps toconvert a portion of its nonprepayable fixed-rate debt to floating-ratedebt.  Bankshares also arranges interestrate swaps, caps and swaptions for commercial loan customers through itscapital markets group.  Derivativetransactions done with loan customers are hedged by means of an off-setting derivativetrade with a third party.  In this way,Bankshares manages the market risk arising from capital markets relatedderivative activity.

 

The fair value ofderivative instruments relating to hedging activities recorded in other assetswas $12.8 million (notional $327.4 million) and $7.1 million (notional $294.5million) at June 30, 2005 and December 31, 2004, respectively.  The fair value of derivative instrumentsrelating to hedging activities recorded in other liabilities was $8.1 million(notional $158.6 million) and $6.8 million (notional $136.0 million) at June 30,2005 and December 31, 2004, respectively.

 

Changes in thefair value of a derivative that is designated and qualifies as a fair valuehedge, along with the gain or loss on the hedged asset or liability that isattributable to the hedged risk, are recorded as other noninterest income inthe results of operations. For all hedge relationships, ineffectivenessresulting from differences between the changes in fair values or cash flows ofthe hedged item and changes in fair value of the derivative are recognized asother noninterest income in the results of operations. The net interestsettlement on derivatives designated as fair value or cash flow hedges istreated as an adjustment of the interest income or interest expense of the hedgedassets or liabilities. The fair-value hedges of nonprepayable fixed-rate debtwere effective for the reported periods. The impact of the hedges decreasedinterest expense $2.8 million in the first half of 2005 and $5.7 million forthe same period in 2004.

 

14

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The followingtables summarize the gross position of derivatives relating to hedgingactivities at June 30, 2005 and December 31, 2004.

 
| ** **                           | ** ** | **June 30,  2005**               | ** **  | **December 31,  2004**  | ** ** |
|--------------------------------------|------------|---------------------------------------|-------------|------------------------------|------------|
| **(Dollars in thousands)**           | ** ** | **Notional  or  Contractual  Amount** | ** **  | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** | **Notional  or  Contractual  Amount** | ** ** | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** |
| *Asset/Liability Management  Hedges* |       |                                  |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Interest Rate Contracts:             |       |                                  |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                 | **350,000** | ** **                   | **$**      | **8,220** | ** ** | **$** | **3,605** | ** ** | $ | 350,000 |   | $ | 6,297 |   | $ | (143 | ) |
|                                 |       |                                  |        |                         |       |   | ** ** |   |   |   |   |   |   |
| *Customer Accommodations*            |       |                                  |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Interest Rate Contracts:             |       |                                  |        |                         |       |   | ** ** |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                 | **124,178** | ** **                   | **$**      | **2,180** | ** ** | **$** | **1,086** | ** ** | $ | 68,575 |   | $ | 684 |   | $ | 398 |   |
| Swaptions/Caps Purchased             | ** ** | **5,911**                             | ** **  | **53**                       | ** ** | **53** | ** ** | 5,971 |   | 80 |   | 80 |   |
| Swaptions/Caps Sold                  | ** ** | **5,911**                             | ** **  | **—**                   | ** ** | **(53** | **)** | 5,971 |   | — |   | (80 | ) |

 

----

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

 

Mortgage loansheld-for-sale have inherent forward contract (agreements to sell or purchaseloans at a specific rate or yield) characteristics. Risk may arise from thecorresponding parties’ inability to meet the terms of their contracts and frommovement in interest rates. Bankshares had forward commitments to sell and fundindividual fixed-rate and variable-rate mortgage loans that are reported atfair value. The fair value of the forward contracts recorded as otherliabilities was $4.0 million at June 30, 2005 and $1.2 million at December 31,2004.

 

12. Stock-basedCompensation Expense

 

Bankshares hasseveral stock-based compensation programs for its directors, management andemployees. Compensation costs for stock options and restricted stock awards aremeasured under the fair value method and are included in salary expense. At theAnnual Shareholders’ Meeting held on May 10, 2005, Bankshares’stockholders approved the Mercantile Bankshares’ Corporation Stock Retainer andDeferred Compensation Plan for Non-Employee Directors (the “Plan”). The Planprovides for an annual stock retainer of 500 shares of Bankshares’ common stockto each non-employee director of Bankshares. The Plan permits non-employeedirectors of Bankshares and its affiliates to elect to defer voluntarily theirannual stock and cash retainers and some or all of their fees. The initialannual stock retainer under the Plan was paid on June 1, 2005 tonon-employee directors. See Current Report on Form 8-K filed with the SECon May 16, 2005 for more details on the Plan. Another form of stock-basedcompensation is phantom stock, which is used for a portion of the Bankshares’Directors’ Deferred Compensation Plan. This plan requires that substantiallyall deferred fees be valued based on Bankshares’ stock and paid out in cashand/or stock at retirement. The compensation cost for the phantom stock isincluded in other expenses.  Employeestock-based compensation amounts, included in salaries expense, for the sixmonths and quarters ended June 30, 2005 and 2004, respectively, aresummarized in the following table:

 
| ** **                          | ** ** | **For the 6  months ended June 30** | ** ** | **For the 3  months ended June 30** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| **(Dollars in thousands)**          | ** ** | **2005**                                 | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Stock options expense               | ** ** | **$**                                    | **1,412**  |                                     | $          | 1,200 | ** ** | **$** | **699** |   | $ | 794 |   |
| Restricted stock awards  expense    | ** ** | **1,280**                                |       | 1,007                                    | ** ** | **638** |   | 519 |   |
| Total included in salaries  expense | ** ** | **$**                                    | **2,692**  |                                     | $          | 2,207 | ** ** | **$** | **1,337** |   | $ | 1,313 |   |

 

15

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# **13.**         Pension & Other Postretirement BenefitPlans

 

Banksharessponsors qualified and nonqualified pension plans and other postretirementbenefit plans for its employees.  Thefollowing table summarizes the components of the net periodic benefit cost forthe pension plans for the six months and quarter ended June 30, 2005 and2004, respectively.

 
| ** **                            | ** ** | **For the 6  months ended June 30, 2005** | ** ** | **For the 6  months ended June 30, 2004** | ** ** |
|---------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **(Dollars in thousands)**            | ** ** | **Qualified**                                  | ** ** | **Nonqualified**                               | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                          | ** ** | **$**                                          | **3,660**  | ** **                                     | **$**      | **304** | ** ** | **$** | **3,964** | ** ** | $ | 3,144 |   | $ | 282 |   | $ | 3,426 |   |
| Interest cost                         | ** ** | **5,638**                                      | ** ** | **80**                                         | ** ** | **5,718** | ** ** | 5,098 |   | 202 |   | 5,300 |   |
| Expected return on plan assets        | ** ** | **(8,287**                                     | **)**      | **—**                                     | ** ** | **(8,287** | **)** | (7,690 | ) | — |   | (7,690 | ) |
| Amortization of prior service  cost   | ** ** | **585**                                        | ** ** | **12**                                         | ** ** | **597** | ** ** | 390 |   | 12 |   | 402 |   |
| Recognized net actuarial (gain)  loss | ** ** | **731**                                        | ** ** | **(93**                                        | **)**      | **638** | ** ** | 354 |   | 58 |   | 412 |   |
| Amortization of transition  asset     | ** ** | **—**                                     | ** ** | **—**                                     | ** ** | **—** | ** ** | — |   | 48 |   | 48 |   |
| Net periodic benefit cost             | ** ** | **$**                                          | **2,327**  | ** **                                     | **$**      | **303** | ** ** | **$** | **2,630** | ** ** | $ | 1,296 |   | $ | 602 |   | $ | 1,898 |   |

 
| ** **                            | ** ** | **For the 3  months ended June 30, 2005** | ** ** | **For the 3  months ended June 30, 2004** | ** ** |
|---------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **(Dollars in thousands)**            | ** ** | **Qualified**                                  | ** ** | **Nonqualified**                               | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                          | ** ** | **$**                                          | **1,882**  | ** **                                     | **$**      | **139** | ** ** | **$** | **2,021** | ** ** | $ | 1,572 |   | $ | 141 |   | $ | 1,713 |   |
| Interest cost                         | ** ** | **2,825**                                      | ** ** | **45**                                         | ** ** | **2,870** | ** ** | 2,549 |   | 101 |   | 2,650 |   |
| Expected return on plan assets        | ** ** | **(4,149**                                     | **)**      | **—**                                     | ** ** | **(4,149** | **)** | (3,845 | ) | — |   | (3,845 | ) |
| Amortization of prior service  cost   | ** ** | **285**                                        | ** ** | **12**                                         | ** ** | **297** | ** ** | 195 |   | 6 |   | 201 |   |
| Recognized net actuarial  (gain) loss | ** ** | **381**                                        | ** ** | **(93**                                        | **)**      | **288** | ** ** | 201 |   | 29 |   | 230 |   |
| Amortization of transition  asset     | ** ** | **—**                                     | ** ** | **—**                                     | ** ** | **—** | ** ** | — |   | 24 |   | 24 |   |
| Net periodic benefit cost             | ** ** | **$**                                          | **1,224**  | ** **                                     | **$**      | **103** | ** ** | **$** | **1,327** | ** ** | $ | 672 |   | $ | 301 |   | $ | 973 |   |

 

The followingtable summarizes the components of the net periodic benefit cost for the otherpostretirement benefit plans for the six months and quarter ended June 30,2005 and 2004, respectively.

 
| ** **                            | ** ** | **For the 6  months ended June 30,** | ** ** | **For the 3  months ended June 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| **(Dollars in thousands)**            | ** ** | **2005**                                  | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service cost                          | ** ** | **$**                                     | **267**    |                                      | $          | 130 | ** ** | **$** | **134** |   | $ | 65 |   |
| Interest cost                         | ** ** | **498**                                   |       | 428                                       | ** ** | **249** |   | 214 |   |
| Expected return on plan assets        | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Amortization of prior service  cost   | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Recognized net actuarial  (gain) loss | ** ** | **176**                                   |       | 81                                        | ** ** | **88** |   | 43 |   |
| Amortization of transition  asset     | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Net periodic benefit cost             | ** ** | **$**                                     | **941**    |                                      | $          | 639 | ** ** | **$** | **471** |   | $ | 322 |   |

 

In May 2004,the FASB issued FSP FAS 106-2, “Accounting and Disclosure Requirements Relatedto the Medicare Prescription Drug, Improvement and Modernization Act of 2003,”which provides guidance on accounting for the impact of the MedicarePrescription Drug, Improvement and Modernization Act of 2003. Bankshares iscurrently reviewing the potential effect of the benefit that is at leastactuarially equivalent to Medicare part D on its postretirement benefit plans.

 

As previouslydisclosed in its financial statements for the year ended December 31,2004, Bankshares generally makes cash contributions to the pension plan inamounts permitted by guidelines established under employee benefit and taxlaws.  Bankshares currently estimates itwill be able to contribute up to approximately $19 million to the pension planfor 2005.  Cash contributions arenormally made after valuations have been finalized for the plan year and priorto the tax return filing date.  As of June 30,2005, no contributions had been made.

 

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# **14.**         Recent Accounting Standards

 

In May 2005, theFinancial Accounting Standards Board (“FASB”) issued Statement No. 154, (“SFASNo. 154”) “Accounting Changes and Error Corrections - A Replacement of APBOpinion No. 20 and FASB Statement No. 3.” This new standard replacesAccounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes”,and FASB Statement No. 3, “Reporting Accounting Changes in InterimFinancial Statements.” Among other changes, SFAS No. 154 requires that avoluntary change in accounting principle be applied retrospectively with allprior period financial statements presented on the new accounting principle,unless it is impracticable to do so. SFAS No. 154 also provides that (1) achange in method of depreciating or amortizing a long-lived nonfinancial assetbe accounted for as a change in estimate (prospectively) that was effected by achange in accounting principle, and (2) correction of errors in previouslyissued financial statements should be termed a “restatement. “ The new standardis effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. Bankshares does not anticipatethis revision will have a material effect on its financial statements.

 

In December 2004,the FASB issued Statement No. 123 (Revised 2004) (“SFAS No. 123R”) “Share-BasedPayment,” which requires that the compensation cost relating to share-basedpayment transactions be recognized in financial statements.  SFAS No. 123R replaces SFAS No. 123,“Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25,“Accounting for Stock Issued to Employees.” Share-based compensationarrangements include share options, restricted share plans, performance-basedawards, share appreciation rights and employee share purchase plans. SFAS No. 123Rrequires all share-based payments to employees be valued using a fair valuedmethod on the date of grant and expensed based on that fair value over theapplicable vesting period. Bankshares adopted the cost recognition provision ofSFAS No. 123 in 1995 and has been expensing compensation cost related tooptions.  SFAS No. 123R also amendsSFAS No. 95 “Statement of Cash Flows,” requiring the benefits of taxdeductions in excess of recognized compensation cost be reported as financinginstead of operating cash flows.  TheSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107,(“SAB No. 107”) which expresses the SEC’s views regarding the interactionbetween SFAS No. 123R and certain SEC rules and regulations.Additionally, SAB No. 107 provides guidance related to share-based paymenttransactions for public companies. Bankshares will be required to apply SFAS No. 123Ras of the annual reporting period that begins after June 15, 2005.Bankshares does not anticipate this revision will have a material effect on itsfinancial statements.

 

In November 2004,the Emerging Issues Task Force (“EITF”) published Issue 03-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”The Task Force discussed the meaning of other-than-temporary impairment and itsapplication to certain investments carried at cost. The Task Force requestedthat the FASB staff consider other impairment models within U.S. GenerallyAccepted Accounting Principles (“GAAP”) when developing its views. The TaskForce also requested that the scope of the impairment issue be expanded toinclude equity investments and investments subject to FASB Statement No. 115,“Accounting for Certain Investments in Debt and Equity Securities,” and thatthe issue be addressed by the Task Force as a separate EITF issue. At the EITFmeeting, the Task Force reached a consensus on one issue that certainquantitative and qualitative disclosures should be required for securitiesaccounted for under Statement 115 that are impaired at the balance sheet datebut for which an other-than-temporary impairment has not been recognized. TheBoard ratified the consensus on that one issue at its November 25, 2004meeting. In September 2004, the Financial Accounting Standards Board (“FASB”)directed the FASB staff to issue two proposed FASB Staff Positions (“FSP”):Proposed FSP EITF Issue 03-1-a, which provides guidance for the application ofparagraph 16 of EITF Issue 03-1 to debt securities that are impaired because ofinterest rate and/or sector spread increases, and Proposed FSP EITF Issue 03-1-b,which delays the effective date of Issue 03-1 for debt securities that areimpaired because of interest rate and/or sector spread increases. In June 2005,the FASB reach a decision whereby they declined to provide additional guidanceon the meaning of other-than-temporary impairment. The Board directed the FASBstaff to issue EITF 03-1a as final and to draft a new FSP that will replaceEITF 03-01. The final FSP (retitled FAS 115-1, “The Meaning ofOther-Than-Temporary Impairment and it Application to Certain Investments”)would be effective for other-than-temporary impairment analysis conducted in periodsbeginning after September 15, 2005. Bankshares does not anticipate thisrevision will have a material effect on its financial statements.

 

17

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

#### ** **

HIGHLIGHTS

 

**ConsolidatedFinancial Results**

 

Net income for thequarter ended June 30, 2005 was $67.9 million, a 20.5% increase over netincome of $56.3 million for the same period in 2004 and an 8.4% increase overthe $62.6 million reported for the first quarter of 2005.  For the quarter ended June 30, 2005,diluted net income per share was $0.84, an increase of 18.3% over the $0.71reported for the same period of last year and a 7.7% increase over the $0.78reported for the first quarter of this year. Adjusted weighted average shares outstanding increased from 79.8 millionfor the quarter ended June 30, 2004, to 81.2 million for the quarter endedJune 30, 2005.  The results ofoperations for the Community Bank of Northern Virginia (“CBNV”) are includedfrom the merger dates forward.

 

Net interest income forthe quarter ended June 30, 2005 increased 14.1% to $152.4 million from$133.5 million for the second quarter of last year. The growth in net interestincome is attributable to a 13.3% growth in average loans and a 17 basis pointimprovement in the net interest margin. Eighteen (18) basis points of the improvement in the net interest marginwas attributable to the effect of noninterest-bearing funds, which consist primarilyof demand deposits and shareholders’ equity.

 

At June 30, 2005,nonperforming assets amounted to $27.7 million, or 0.24% of period-end loansand other real estate owned, a decline from $40.3 million at June 30,2004. Nonperforming assets were $31.4 million at March 31, 2005. Thecomparable nonperforming ratios were 0.41% and 0.30% at June 30, 2004 and March 31,2005, respectively.

 

Noninterest income forthe quarter ended June 30, 2005 increased 17.5% to $60.1 million from$51.1 million for the same period last year, while noninterest expensesincreased 11.3% to $103.9 million from $93.4 million.

 

Bankshares also reportscash operating 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 (such as thoseassociated with integrating acquired entities’ operations into Bankshares)unrelated to Bankshares’ core operations. Cash operating earnings totaled $67.1 million for the second quarter of2005, an increase of 17.1% over the $57.3 million for the same period for 2004and a 6.4% increase over the $63.1 million for the first quarter of 2005.  Diluted cash operating earnings per share forthe second quarter of 2005 and 2004 were $0.83 and $0.72, respectively and$0.79 per share for the first quarter of 2005. A reconciliation of net income (GAAP basis) to cash operating earningscan be found on page 37 of this filing.

 

Management believes thatreporting several key measures based on cash operating earnings and tangibleequity (equity less intangible assets and their related amortization expense)is important, as this is the basis for measuring the adequacy of capital forregulatory purposes.  For the threemonths ended June 30, 2005, return on average assets was 1.79%, return onaverage tangible equity was 19.64% and average tangible equity to averagetangible assets was 9.67%.  Comparableratios for the three months ended June 30, 2004 were 1.62%, 18.14% and9.55%, respectively.  A reconciliation ofthese ratios from their respective GAAP basis ratios can be found on page 37of this filing.

 

For the first six monthsof 2005, net income was $130.5 million, an increase of 16.5% over the $112.0million reported for the comparable period in 2004. Diluted net income pershare was $1.62, an increase of 15.7% from the $1.40 reported for the sameperiod last year. For the six months ended June 30, 2005, compared to thesame period of 2004, cash operating earnings were $130.2 million compared with$114.1 million for the same period last year. Diluted cash operating earnings per share for these periods were $1.62and $1.43, respectively.  The ratios ofreturn on average assets, return on average tangible equity and averagetangible equity to average tangible assets for the year-to-date 2005 were1.77%, 19.11% and 9.83% respectively. These ratios for the same period last year were 1.63%, 18.10% and 9.64%respectively.

 

18

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SEGMENT REPORTING

 

As noted in Footnote No. 10“Segment Reporting”, Bankshares reports two distinct business segments forwhich financial information is segregated for use in assessing performance andallocating resources when reporting to the Board of Directors. Segmentfinancial information is subjective and, unlike financial accounting, is notnecessarily based on GAAP. As a result, the financial information of thereporting segments is not necessarily comparable with similar informationreported by others and may not be comparable with Bankshares’ consolidatedresults.

 

**Banking**

 

The Bankingsegment consists of 11 affiliate banks. Mortgage banking activities are notviewed as a separate business line due to the insignificant impact on the corebusiness of Bankshares and, accordingly, are included in the Banking segment.

 

In the secondquarter of 2005, Bankshares consolidated Fidelity Bank into Farmers &Mechanics. The consolidation of these banks allows the surviving bank, Farmers &Mechanics, to serve its local customers with greater size and expertise. Also,in the second quarter of 2005, Mercantile Potomac Bank merged intoMercantile-Safe Deposit and Trust Company. This combination allows Banksharesto provide the resources necessary for expansion into the Washington, D.C. andNorthern Virginia markets. Further the acquisition of Community Bank ofNorthern Virginia (“CBNV”) as part of the Mercantile Potomac Division ofMercantile-Safe Deposit and Trust Company was completed in the second quarter.Mercantile Potomac Bank and Fidelity Bank will continue to serve theirrespective markets under their own names with local leadership and localdecision-making.

 

Net income for the sixmonths ended June 30, 2005 was $130.9 million. This represented a $20.2million, or 18.2%, increase over the same period last year. The Banking segmentwas the primary beneficiary of the CBNV acquisition. For the first half of 2005compared to the same period last year, net interest income increased by $31.9million, or 12.1%, to $295.7 million. Growth in average earning assets of $1.0billion was largely attributable to growth in average loans of 11.9% of whichthe CBNV acquisition provided 1.7%. Banking had a reduction in the provisionfor loan losses compared to the same period of 2004, as credit quality remainedstrong.

 

Noninterest incomeincreased year-over-year by $6.3 million due to a $3.4 million gain on the saleof an office building, letters of credit fees increasing $0.8 million,insurance fees increasing $1.1 million and electronic banking fees increasing$0.7 million.

 

Noninterest expensesincreased by $11.9 million in the first half of 2005 compared with the sameperiod of 2004. Salaries and benefits grew by $6.0 million, with $1.1 millionof additional personnel expense from CBNV, $3.1 million in increased incentivecompensation linked to improved performance and $1.0 million in higher pensionexpense. Occupancy expense increased by $1.3 million, promotional expensesincreased by $0.8 million and outsourcing expense increased by $2.4 millionover the same period of 2004.

 

**Investment &Wealth Management**

 

Net income increased $1.0million or 16.9% to $6.7 million for the six months ended June 30, 2005 ascompared to the $5.7 million reported in the same period last year.

 

At June 30, 2005,assets under administration by IWM were $48.3 billion, an increase of $2.4billion from the same period last year. IWM had assets under management of$21.7 billion at June 30, 2005, up $0.6 billion from June 30, 2004.

 

Revenues for thefirst half of 2005 increased $2.6 million, or 5.8%, over the same period lastyear.  Noninterest expenses increased by$1.5 million or 4.4% to $35.3 million for the first half of 2005 from $33.8million for the same period last year. The increase in noninterest expense wasdue primarily to salaries and benefits.

 

**Other**

 

The components inthe “Other” column consist of amounts for the nonbanking affiliates,unallocated corporate expenses and intercompany eliminations.

 

For the first halfof 2005 compared to the same period of 2004, noninterest income increased $4.7million related to income from private equity investments. Noninterest expenseincreased $4.0 million. This increase was mostly due to increased audit fees,directors fees and $1.3 million in a previously announced legalsettlement.  The “adjustments” linerepresents corporate allocations from the lead Bank (MSD&T).

 

19

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BANKSHARESEARNINGS PERFORMANCE

 

**Analysisof Interest Rates and Interest Differentials**

 

The following tablepresents the distribution of the average consolidated balance sheet, interestincome/expense and annualized yields earned and rates paid through the sixmonths ended June 30, 2005 and 2004.

 
| ** **                                               | ** ** | **2005**                 | ** **     | **2004**                   | ** **  |
|----------------------------------------------------------|------------|--------------------------|----------------|----------------------------|-------------|
| **(Dollars in thousands)**                               | ** ** | **Average  Balance (2)** | ** **     | **Income  (1)  / Expense** | ** **  | **Yield (1)  / Rate** | ** ** | **Average  Balance (2)** | ** ** | **Income  (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                           |       |                     |           |                       |        |   |   |   |   |   |   |   |   |
| Loans:                                                   |       |                     |           |                       |        |   |   |   |   |   |   |   |   |
| Commercial                                               | ** ** | **$**                    | **2,887,558**  | ** **                 | **$**       | **87,488** | ** ** | **6.11** | **%** | $ | 2,671,562 |   | $ | 68,523 |   | 5.16 | % |
| Commercial real estate                                   | ** ** | **3,249,322**            | ** **     | **103,143**                | ** **  | **6.40** | ** ** | 2,828,463 |   | 82,304 |   | 5.85 |   |
| Construction                                             | ** ** | **1,385,942**            | ** **     | **44,403**                 | ** **  | **6.46** | ** ** | 1,108,601 |   | 28,623 |   | 5.19 |   |
| Residential real estate                                  | ** ** | **1,543,792**            | ** **     | **44,732**                 | ** **  | **5.84** | ** ** | 1,398,153 |   | 41,608 |   | 5.98 |   |
| Consumer                                                 | ** ** | **1,541,814**            | ** **     | **44,892**                 | ** **  | **5.87** | ** ** | 1,474,380 |   | 42,521 |   | 5.80 |   |
| Total loans                                              | ** ** | **10,608,428**           | ** **     | **324,658**                | ** **  | **6.17** | ** ** | 9,481,159 |   | 263,579 |   | 5.59 |   |
| Federal funds sold, et al                                | ** ** | **36,404**               | ** **     | **785**                    | ** **  | **4.35** | ** ** | 71,648 |   | 639 |   | 1.79 |   |
| Securities:                                              | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Taxable securities                                       | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| U.S. Treasury and government  agencies                   | ** ** | **1,404,011**            | ** **     | **23,669**                 | ** **  | **3.40** | ** ** | 1,550,468 |   | 29,462 |   | 3.82 |   |
| Mortgage-backed                                          | ** ** | **1,334,525**            | ** **     | **26,697**                 | ** **  | **4.03** | ** ** | 1,266,028 |   | 24,103 |   | 3.83 |   |
| Other investments (3)                                    | ** ** | **64,500**               | ** **     | **1,237**                  | ** **  | **3.87** | ** ** | 47,767 |   | 697 |   | 2.93 |   |
| Tax-exempt securities  States and political subdivisions | ** ** | **84,750**               | ** **     | **2,495**                  | ** **  | **5.94** | ** ** | 101,171 |   | 2,807 |   | 5.58 |   |
| Total securities                                         | ** ** | **2,887,786**            | ** **     | **54,098**                 | ** **  | **3.78** | ** ** | 2,965,434 |   | 57,069 |   | 3.87 |   |
| Interest-bearing deposits in  other banks                | ** ** | **195**                  | ** **     | **1**                      | ** **  | **1.23** | ** ** | 158 |   | 1 |   | 1.07 |   |
| Total earning assets                                     | ** ** | **13,532,813**           | ** **     | **379,542**                | ** **  | **5.66** | ** ** | 12,518,399 |   | 321,288 |   | 5.16 |   |
| Cash and due from banks                                  | ** ** | **296,227**              | ** **     | ** **                 | ** **  | ** ** | ** ** | 291,982 |   |   |   |   |   |
| Bank premises and equipment,  net                        | ** ** | **142,895**              | ** **     | ** **                 | ** **  | ** ** | ** ** | 141,694 |   |   |   |   |   |
| Other assets                                             | ** ** | **1,052,279**            | ** **     | ** **                 | ** **  | ** ** | ** ** | 982,598 |   |   |   |   |   |
| Less: allowance for loan  losses                         | ** ** | **(151,281**             | **)**          | ** **                 | ** **  | ** ** | ** ** | (157,256 | ) |   |   |   |   |
| Total assets                                             | ** ** | **$**                    | **14,872,933** | ** **                 | ** **  | ** ** | ** ** | ** ** | $ | 13,777,417 |   |   |   |   |   |
| Interest-bearing liabilities                             | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Deposits:                                                | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Savings                                                  | ** ** | **$**                    | **1,461,782**  | ** **                 | **2,464**   | ** ** | **0.34** | ** ** | $ | 1,399,234 |   | 2,027 |   | 0.29 |   |
| Checking plus interest  accounts                         | ** ** | **1,384,616**            | ** **     | **1,093**                  | ** **  | **0.16** | ** ** | 1,269,432 |   | 935 |   | 0.15 |   |
| Money market                                             | ** ** | **1,562,736**            | ** **     | **8,087**                  | ** **  | **1.04** | ** ** | 1,577,378 |   | 4,457 |   | 0.57 |   |
| Time deposits $100,000 and  over                         | ** ** | **1,523,393**            | ** **     | **21,315**                 | ** **  | **2.82** | ** ** | 1,301,407 |   | 12,320 |   | 1.90 |   |
| Other time deposits                                      | ** ** | **1,983,713**            | ** **     | **23,730**                 | ** **  | **2.41** | ** ** | 1,967,533 |   | 20,901 |   | 2.14 |   |
| Total interest-bearing  deposits                         | ** ** | **7,916,240**            | ** **     | **56,689**                 | ** **  | **1.44** | ** ** | 7,514,984 |   | 40,640 |   | 1.09 |   |
| Short-term borrowings                                    | ** ** | **1,011,161**            | ** **     | **9,526**                  | ** **  | **1.90** | ** ** | 915,121 |   | 2,899 |   | 0.64 |   |
| Long-term debt                                           | ** ** | **715,859**              | ** **     | **14,644**                 | ** **  | **4.13** | ** ** | 648,817 |   | 10,460 |   | 3.24 |   |
| Total interest-bearing funds                             | ** ** | **9,643,260**            | ** **     | **80,859**                 | ** **  | **1.69** | ** ** | 9,078,922 |   | 53,999 |   | 1.20 |   |
| Noninterest-bearing deposits                             | ** ** | **3,081,292**            | ** **     | ** **                 | ** **  | ** ** | ** ** | 2,717,467 |   |   |   |   |   |
| Other liabilities and accrued  expenses                  | ** ** | **151,937**              | ** **     | ** **                 | ** **  | ** ** | ** ** | 132,190 |   |   |   |   |   |
| Total liabilities                                        | ** ** | **12,876,489**           | ** **     | ** **                 | ** **  | ** ** | ** ** | 11,928,579 |   |   |   |   |   |
| Shareholders’ equity                                | ** ** | **1,996,444**            | ** **     | ** **                 | ** **  | ** ** | ** ** | 1,848,838 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity  | ** ** | **$**                    | **14,872,933** | ** **                 | ** **  | ** ** | ** ** | ** ** | $ | 13,777,417 |   |   |   |   |   |
| Net interest rate spread                                 |       |                     | ** **     | **$**                      | **298,683** | ** ** | **3.97** | **%** |   |   | $ | 267,289 |   | 3.96 | % |
| Effect of noninterest-bearing  funds                     |       |                     |           |                       | ** **  | **0.48** | ** ** |   |   |   |   | 0.33 |   |
| Net interest margin on earning  assets                   |       |                     |           |                       | ** **  | **4.45** | **%** |   |   |   |   | 4.29 | % |
| Tax-equivalent adjustment  included in:                  |       |                     |           |                       | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Loan income                                              |       |                     | ** **     | **$**                      | **2,237**   | ** ** | ** ** | ** ** |   |   | $ | 2,279 |   |   |   |
| Investment securities income                             |       |                     | ** **     | **996**                    | ** **  | ** ** | ** ** |   |   | 1,121 |   |   |   |
| Total                                                    |       |                     | ** **     | **$**                      | **3,233**   |   |   | ** ** |   |   | $ | 3,400 |   |   |   |

 

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(1)          Presentedon a tax-equivalent basis using the statutory federal corporate income tax rateof 35% (see non-GAAP reconciliation).

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

(3)          Investmentsin hedge funds and other nonmarketable investments were reclassified in theprior period from securities available-for-sale into other assets to conform tothe current presentation.

 

20

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**Analysisof Interest Rates and Interest Differentials**

 

The following tablepresents the distribution of the average consolidated balance sheet, interestincome/expense and annualized yields earned and rates paid for the secondquarters of 2005 and 2004.

 
| ** **                                               | ** ** | **2005**                 | ** **     | **2004**                   | ** **  |
|----------------------------------------------------------|------------|--------------------------|----------------|----------------------------|-------------|
| **(Dollars in thousands)**                               | ** ** | **Average  Balance (2)** | ** **     | **Income  (1)  / Expense** | ** **  | **Yield (1)  / Rate** | ** ** | **Average  Balance (2)** | ** ** | **Income  (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                           |       |                     |           |                       |        |   | ** ** |   |   |   |   |   |   |
| Loans:                                                   |       |                     |           |                       |        |   | ** ** |   |   |   |   |   |   |
| Commercial                                               | ** ** | **$**                    | **2,926,234**  | ** **                 | **$**       | **46,021** | ** ** | **6.31** | **%** | $ | 2,719,232 |   | $ | 34,830 |   | 5.15 | % |
| Commercial real estate                                   | ** ** | **3,363,924**            | ** **     | **54,609**                 | ** **  | **6.51** | ** ** | 2,879,434 |   | 41,648 |   | 5.82 |   |
| Construction                                             | ** ** | **1,442,621**            | ** **     | **23,952**                 | ** **  | **6.66** | ** ** | 1,113,301 |   | 14,414 |   | 5.21 |   |
| Residential real estate                                  | ** ** | **1,570,002**            | ** **     | **22,935**                 | ** **  | **5.86** | ** ** | 1,437,331 |   | 21,120 |   | 5.91 |   |
| Consumer                                                 | ** ** | **1,596,482**            | ** **     | **23,496**                 | ** **  | **5.90** | ** ** | 1,474,586 |   | 21,292 |   | 5.81 |   |
| Total loans                                              | ** ** | **10,899,263**           | ** **     | **171,013**                | ** **  | **6.29** | ** ** | 9,623,884 |   | 133,304 |   | 5.57 |   |
| Federal funds sold, et al                                | ** ** | **40,904**               | ** **     | **442**                    | ** **  | **4.33** | ** ** | 95,504 |   | 533 |   | 2.24 |   |
| Securities:                                              | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Taxable securities                                       | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| U.S. Treasury and government  agencies                   | ** ** | **1,382,037**            | ** **     | **11,600**                 | ** **  | **3.37** | ** ** | 1,543,661 |   | 14,369 |   | 3.74 |   |
| Mortgage-backed                                          | ** ** | **1,365,012**            | ** **     | **13,774**                 | ** **  | **4.05** | ** ** | 1,254,512 |   | 11,796 |   | 3.78 |   |
| Other investments (3)                                    | ** ** | **65,051**               | ** **     | **588**                    | ** **  | **3.63** | ** ** | 52,773 |   | 358 |   | 2.73 |   |
| Tax-exempt securities  States and political subdivisions | ** ** | **88,537**               | ** **     | **1,303**                  | ** **  | **5.90** | ** ** | 98,182 |   | 1,356 |   | 5.55 |   |
| Total securities                                         | ** ** | **2,900,637**            | ** **     | **27,265**                 | ** **  | **3.77** | ** ** | 2,949,128 |   | 27,879 |   | 3.80 |   |
| Interest-bearing deposits in  other banks                | ** ** | **187**                  | ** **     | **1**                      | ** **  | **1.31** | ** ** | 158 |   | 1 |   | 1.06 |   |
| Total earning assets                                     | ** ** | **13,840,991**           | ** **     | **198,720**                | ** **  | **5.76** | ** ** | 12,668,674 |   | 161,717 |   | 5.13 |   |
| Cash and due from banks                                  | ** ** | **301,484**              | ** **     | ** **                 | ** **  | ** ** | ** ** | 298,440 |   |   |   |   |   |
| Bank premises and equipment,  net                        | ** ** | **144,347**              | ** **     | ** **                 | ** **  | ** ** | ** ** | 141,757 |   |   |   |   |   |
| Other assets                                             | ** ** | **1,099,607**            | ** **     | ** **                 | ** **  | ** ** | ** ** | 988,430 |   |   |   |   |   |
| Less: allowance for loan  losses                         | ** ** | **(152,858**             | **)**          | ** **                 | ** **  | ** ** | ** ** | (158,116 | ) |   |   |   |   |
| Total assets                                             | ** ** | **$**                    | **15,233,571** | ** **                 | ** **  | ** ** | ** ** | ** ** | $ | 13,939,185 |   |   |   |   |   |
| Interest-bearing liabilities                             | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Deposits:                                                | ** ** | ** **               | ** **     | ** **                 | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Savings                                                  | ** ** | **$**                    | **1,463,960**  | ** **                 | **1,313**   | ** ** | **0.36** | ** ** | $ | 1,434,288 |   | 1,043 |   | 0.29 |   |
| Checking plus interest accounts                          | ** ** | **1,418,337**            | ** **     | **578**                    | ** **  | **0.16** | ** ** | 1,302,313 |   | 474 |   | 0.15 |   |
| Money market                                             | ** ** | **1,574,422**            | ** **     | **4,498**                  | ** **  | **1.15** | ** ** | 1,564,295 |   | 2,095 |   | 0.54 |   |
| Time deposits $100,000 and  over                         | ** ** | **1,618,161**            | ** **     | **11,968**                 | ** **  | **2.97** | ** ** | 1,315,119 |   | 5,941 |   | 1.82 |   |
| Other time deposits                                      | ** ** | **2,060,974**            | ** **     | **13,027**                 | ** **  | **2.54** | ** ** | 1,955,632 |   | 10,320 |   | 2.12 |   |
| Total interest-bearing  deposits                         | ** ** | **8,135,854**            | ** **     | **31,384**                 | ** **  | **1.55** | ** ** | 7,571,647 |   | 19,873 |   | 1.06 |   |
| Short-term borrowings                                    | ** ** | **1,021,281**            | ** **     | **5,484**                  | ** **  | **2.15** | ** ** | 910,854 |   | 1,480 |   | 0.65 |   |
| Long-term debt                                           | ** ** | **742,056**              | ** **     | **7,829**                  | ** **  | **4.23** | ** ** | 648,576 |   | 5,205 |   | 3.23 |   |
| Total interest-bearing funds                             | ** ** | **9,899,191**            | ** **     | **44,697**                 | ** **  | **1.81** | ** ** | 9,131,077 |   | 26,558 |   | 1.17 |   |
| Noninterest-bearing deposits                             | ** ** | **3,137,366**            | ** **     | ** **                 | ** **  | ** ** | ** ** | 2,826,610 |   |   |   |   |   |
| Other liabilities and accrued  expenses                  | ** ** | **154,910**              | ** **     | ** **                 | ** **  | ** ** | ** ** | 129,737 |   |   |   |   |   |
| Total liabilities                                        | ** ** | **13,191,467**           | ** **     | ** **                 | ** **  | ** ** | ** ** | 12,087,424 |   |   |   |   |   |
| Shareholders’ equity                                | ** ** | **2,042,104**            | ** **     | ** **                 | ** **  | ** ** | ** ** | 1,851,761 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity  | ** ** | **$**                    | **15,233,571** | ** **                 | ** **  | ** ** | ** ** | ** ** | $ | 13,939,185 |   |   |   |   |   |
| Net interest rate spread                                 |       |                     | ** **     | **$**                      | **154,023** | ** ** | **3.95** | **%** |   |   | $ | 135,159 |   | 3.96 | % |
| Effect of noninterest-bearing  funds                     |       |                     |           |                       | ** **  | **0.51** | ** ** |   |   |   |   | 0.33 |   |
| Net interest margin on earning  assets                   |       |                     |           |                       | ** **  | **4.46** | **%** |   |   |   |   | 4.29 | % |
| Tax-equivalent adjustment  included in:                  |       |                     |           |                       | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Loan income                                              |       |                     | ** **     | **$**                      | **1,136**   | ** ** | ** ** | ** ** |   |   | $ | 1,133 |   |   |   |
| Investment securities income                             |       |                     | ** **     | **520**                    | ** **  | ** ** | ** ** |   |   | 542 |   |   |   |
| Total                                                    |       |                     | ** **     | **$**                      | **1,656**   |   |   | ** ** |   |   | $ | 1,675 |   |   |   |

 

----

(1)          Presentedon a tax-equivalent basis using the statutory federal corporate income tax rateof 35% (see non-GAAP reconciliation).

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

(3)          Investmentsin hedge funds and other nonmarketable investments were reclassified in theprior period from securities available-for-sale into other assets to conform tothe current presentation.

 

21

----

 

**Rate /Volume Analysis**

 

A rate/volume analysis,which demonstrates changes in interest income and expense for significantassets and liabilities, appears below.

 
| ** **                                | ** ** | **For the 6  months ended June 30,  2005 vs. 2004** | ** ** | **For the 3  months ended June 30,  2005 vs. 2004** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                | ** ** | **Due to  variances in**                                 | ** ** | **Due to  variances in**                                 | ** ** |
| **(Dollars in thousands)**                | ** ** | **Total**                                                | ** ** | **Rates**                                                | ** ** | **Volumes  (5)** | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes  (5)** | ** ** |
| Interest earned on:                       |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Loans:                                    |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Commercial (1)                            |       | $                                                        | 18,965     |                                                     | $          | 12,610 |   | $ | 6,355 |   | $ | 11,191 |   | $ | 7,754 |   | $ | 3,437 |   |
| Commercial real estate (2)                |       | 20,839                                                   |       | 7,708                                                    |       | 13,131 |   | 12,961 |   | 4,927 |   | 8,034 |   |
| Construction (3)                          |       | 15,780                                                   |       | 6,974                                                    |       | 8,806 |   | 9,538 |   | 3,986 |   | 5,552 |   |
| Residential real estate                   |       | 3,124                                                    |       | (981                                                     | )          | 4,105 |   | 1,815 |   | (179 | ) | 1,994 |   |
| Consumer                                  |       | 2,371                                                    |       | 525                                                      |       | 1,846 |   | 2,204 |   | 348 |   | 1,856 |   |
| Taxable securities (4)                    |       | (2,660                                                   | )          | (1,383                                                   | )          | (1,277 | ) | (561 | ) | (272 | ) | (289 | ) |
| Tax-exempt securities (4)                 |       | (312                                                     | )          | 179                                                      |       | (491 | ) | (53 | ) | 84 |   | (137 | ) |
| Federal funds sold, et al                 |       | 146                                                      |       | 908                                                      |       | (762 | ) | (92 | ) | 492 |   | (584 | ) |
| Interest-bearing deposits in  other banks |       | —                                                   |       | —                                                   |       | — |   | — |   | — |   | — |   |
| Total interest income                     |       | 58,253                                                   |       | 26,540                                                   |       | 31,713 |   | 37,003 |   | 17,140 |   | 19,863 |   |
|                                      |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Interest paid on:                         |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Savings deposits                          |       | 437                                                      |       | 337                                                      |       | 100 |   | 270 |   | 238 |   | 32 |   |
| Checking plus interest  deposits          |       | 158                                                      |       | 70                                                       |       | 88 |   | 104 |   | 55 |   | 49 |   |
| Money market accounts                     |       | 3,630                                                    |       | 3,718                                                    |       | (88 | ) | 2,403 |   | 2,342 |   | 61 |   |
| Time deposit $100,000 and over            |       | 8,995                                                    |       | 5,923                                                    |       | 3,072 |   | 6,027 |   | 3,728 |   | 2,299 |   |
| Other time deposits                       |       | 2,829                                                    |       | 2,693                                                    |       | 136 |   | 2,707 |   | 1,991 |   | 716 |   |
| Short-term borrowings                     |       | 6,626                                                    |       | 5,730                                                    |       | 896 |   | 4,004 |   | 3,370 |   | 634 |   |
| Long-term debt                            |       | 4,184                                                    |       | 2,842                                                    |       | 1,342 |   | 2,624 |   | 1,606 |   | 1,018 |   |
| Total interest expense                    |       | 26,859                                                   |       | 21,313                                                   |       | 5,546 |   | 18,139 |   | 13,330 |   | 4,809 |   |
| Net interest earned                       |       | $                                                        | 31,394     |                                                     | $          | 5,227 |   | $ | 26,167 |   | $ | 18,864 |   | $ | 3,810 |   | $ | 15,054 |   |

 

----

(1)          Interest year-to-date tax-equivalent adjustmentof $1.5 million and $1.6 million for 2005 and 2004, respectively, andquarter-to-date tax-equivalent adjustment of $0.8 million for both 2005 and2004, are included in the commercial loan rate variances.

(2)          Interest year-to-date tax-equivalent adjustmentof $0.3 million for both 2005 and 2004, and quarter-to-date tax-equivalentadjustment of $0.1 million and $0.2 million for 2005 and 2004, respectively,are included in the commercial real estate loan rate variances.

(3)          Interest year-to-date tax-equivalent adjustmentof $0.4 million and $0.5 million for 2005 and 2004, respectively, andquarter-to-date tax-equivalent adjustment of $0.2 million for both 2005 and2004, are included in the construction loan rate variances.

(4)          Interest year-to-date tax-equivalent adjustmentof $1.0 million and $1.1 million for 2005 and 2004, respectively, andquarter-to-date tax-equivalent adjustment of $0.5 million for 2005 and 2004,are included in the investment securities rate variances.

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

 

22

----

 

**NetInterest Income and Net Interest Margin**

 

In the second quarter of2005 net interest income, on a tax-equivalent basis, was $154.0 million,compared with $135.2 million in the second quarter of 2004. This represents an$18.9 million (14.0%) increase from 2004. The increase was due primarily tostrong loan growth and a higher net interest margin. Net interest income isaffected by both changes in the amount and composition of interest-earningassets and interest-bearing liabilities and by changes in the level of interestrates.

 

The net interestmargin increased to 4.46% in the second quarter of 2005 from 4.29% in thesecond quarter of 2004.  The increase wasattributable to the benefit derived from the investment of noninterest-bearingfunds. This benefit increased 18 basis points for the three months ended June 30,2005 from the same period of 2004 to 51 basis points due primarily to a $310.8million increase in noninterest-bearing deposits and the rising rateenvironment. The net interest spread decreased 1 basis point due to the averagecost of interest-bearing liabilities increasing slightly more than earningassets yields due to a decline in the yield on the securities portfolio. Thenet interest margin increased 2 basis points from the first quarter of 2005.

 

Average earningassets for the three months ended June 30, 2005 increased $1.2 billion, or9.3%, from the same period in 2004. The increase in average earning assets wasprimarily driven by increases in average loans partially offset by a slightdecline in investment securities. Loans averaged $10.9 billion in the secondquarter of 2005, compared with $9.6 billion in the second quarter of 2004, anincrease of 13.3% of which CBNV contributed 3.3% on $319.1 million of averageacquired loans. During the second quarter of 2005, total average loan growthwas driven by growth in commercial real estate of $484.5 million (16.8%),construction loan growth of $329.3 million (29.6%), commercial loan growth of$207.0 million (7.6%), residential mortgage loan growth of $132.7 million(9.2%) and consumer loan growth of $121.9 million (8.3%.)

 

Average investmentsecurities for the second quarter of 2005 declined by $48.5 million, or 1.6%,from the same period of 2004, reflecting the reinvestment of proceeds fromsecurity maturities into the funding of loan growth. Bankshares utilizes theinvestment portfolio as part of its overall asset/liability managementpractices to minimize structural interest rate and market valuation risksassociated with changes in interest rates. In connection with changing interestrates and its risk management activities, Bankshares made the decision toadjust the composition of the investment portfolio to include a greaterproportion of short-term mortgage-backed securities, agency and asset-backedsecurities and a lesser proportion of U.S. Treasury securities. As a result,U.S. Treasury securities declined $261.5 million (34.5%), while agency securitiesincreased $99.9 million (12.7%) and mortgage-backed securities increased $110.5million (8.8%). Refer to the “Interest Rate Risk” section for furtherinformation on the sensitivity of net interest income to changes in interestrates.

 

Average core deposits(total deposits less certificates of deposit of $100,000 and over) are animportant contributor to growth in net interest income and in the net interestmargin. This low-cost stable funding source increased 6.3% from a year ago withthe CBNV acquisition contributing 2.5% of that growth on $227.6 million inaverage acquired core deposits. Average core deposits were $9.7 billion and$9.1 billion for the three months ended June 30, 2005 and 2004,respectively. Average noninterest-bearing checking accounts for the secondquarter of 2005 were higher by $310.8 million (11.0%), compared with the sameperiod of 2004. Total average interest-bearing deposits increased by $564.2million (7.5%) for the second quarter of 2005 compared with the same period of2004. The year-over-year increase in average interest-bearing deposits includedincreases in checking plus interest accounts of $116.0 million (8.9%), savingsaccounts of $29.7 million (2.1%), time deposits greater than $100,000 of $303.0million (23.0%), other time deposits of $105.3 million (5.3%) and money marketaccounts of $10.1 million (.6%).

 

Based on currentmarket conditions, with an anticipation of a continued measured increase in theoverall rate environment, management expects the net interest margin tocontinue to expand modestly, as pricing pressure on interest-bearingliabilities will partially offset the improvement in earning asset yields andthe value of noninterest-bearing funds.

 

Netinterest income for the first six months of 2005 increased to $295.5 million or12.0% over the $263.9 million for the first six months of last year dueprincipally to 11.9% growth in average loans offset by a 2.6% decline inaverage securities. The net interest margin increased from 4.29% to 4.45%. Theincrease in the net interest margin was largely attributable to the benefitderived from the investment of noninterest-bearing funds.  This benefit grew from 33 basis points in2004 to 48 basis points in 2005.

 

23

----

 

# **Noninterest Income**

 
| ** **                                  | ** ** | **For the 6  months ended  June 30,** | ** **  | **% Change** |       | **For the 3  months ended  June 30,** | ** ** | **% Change** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|-------------|--------------|------------|--------------------------------------------|------------|--------------|------------|
| **(Dollars in thousands)**                  | ** ** | **2005**                                   | ** **  | **2004**     | ** ** | **2005/2004**                              | ** ** | **2005**     | ** ** | **2004** | ** ** | **2005/2004** | ** ** |
| Investment and wealth  management           | ** ** | **$**                                      | **47,837**  |         | $          | 44,919                                     |       | 6.5          | %          | **$** | **23,780** | ** ** | $ | 22,936 |   | 3.7 | % |
| Service charges on deposit  accounts        | ** ** | **21,514**                                 |        | 21,673       |       | (0.7                                       | )          | **11,088**   | ** ** | 10,981 |   | 1.0 |   |
| Mortgage banking related fees:              |       |                                       |        |         |       |                                       |       |         | ** ** |   |   |   |   |
| Commercial                                  | ** ** | **3,930**                                  |        | 3,483        |       | 12.8                                       |       | **2,092**    | ** ** | 1,563 |   | 33.8 |   |
| Residential                                 | ** ** | **1,248**                                  |        | 1,750        |       | (28.7                                      | )          | **803**      | ** ** | 730 |   | 10.0 |   |
| Total mortgage banking related  fees        | ** ** | **5,178**                                  |        | 5,233        |       | (1.1                                       | )          | **2,895**    | ** ** | 2,293 |   | 26.3 |   |
| Net investment securities  gains / (losses) | ** ** | **513**                                    |        | 535          |       | (4.1                                       | )          | **99**       | ** ** | 590 |   | (83.2 | ) |
| Nonmarketable investments                   |       |                                       |        |         |       |                                       |       |         | ** ** |   |   |   |   |
| Private equity and other  investments       | ** ** | **7,030**                                  |        | 762          |       | 822.6                                      |       | **4,569**    | ** ** | 373 |   | 1,124.9 |   |
| Hedge funds                                 | ** ** | **719**                                    |        | 2,313        |       | (68.9                                      | )          | **(1,245**   | **)**      | (708 | ) | (75.8 | ) |
| Bank-owned life insurance                   | ** ** | **1,744**                                  |        | 1,579        |       | 10.4                                       |       | **898**      | ** ** | 785 |   | 14.4 |   |
| Total nonmarketable  investments            | ** ** | **9,493**                                  |        | 4,654        |       | 104.0                                      |       | **4,222**    | ** ** | 450 |   | 838.2 |   |
| Other income:                               |       |                                       |        |         |       |                                       |       |         | ** ** |   |   |   |   |
| Electronic banking fees                     | ** ** | **11,127**                                 |        | 10,425       |       | 6.7                                        |       | **5,954**    | ** ** | 6,008 |   | (0.9 | ) |
| Charges and fees on loans                   | ** ** | **5,815**                                  |        | 5,293        |       | 9.9                                        |       | **3,020**    | ** ** | 2,835 |   | 6.5 |   |
| Insurance                                   | ** ** | **8,098**                                  |        | 7,095        |       | 14.1                                       |       | **3,558**    | ** ** | 3,267 |   | 8.9 |   |
| All other income                            | ** ** | **8,360**                                  |        | 4,453        |       | 87.7                                       |       | **5,450**    | ** ** | 1,766 |   | 208.6 |   |
| Total other income                          | ** ** | **33,400**                                 |        | 27,266       |       | 22.5                                       |       | **17,982**   | ** ** | 13,876 |   | 29.6 |   |
| Total                                       | ** ** | **$**                                      | **117,935** |         | $          | 104,280                                    |       | 13.1         |       | **$** | **60,066** | ** ** | $ | 51,126 |   | 17.5 |   |

 

Noninterest income forthe quarter ended June 30, 2005 increased by $8.9 million, or 17.5%, to$60.1 million compared with $51.1 million for the same period in 2004.  Noninterest income increased 3.8% from thefirst quarter of 2005. The table above shows the major components of noninterestincome.

 

Investment and wealth managementrevenue, representing the largest source of noninterest income, increased $0.8million, or 3.7%, over the second quarter of 2004. Service charges on depositaccounts increased modestly for the second quarter of 2005 compared to thesecond quarter of 2004.  Service chargeson deposits increased $0.7 million compared with the first quarter of 2005 dueto deposit growth.  Mortgage banking-related fees were $0.6 millionor 26.3% higher than the second quarter of 2004 due to higher volumes in thecommercial business offset partially by lower fees from the residentialbusiness due to lower profit margins.

 

Nonmarketable investment income represents revenues derived frominvesting in private equities, hedge funds-of-funds (“hedge funds”), securitiesacquired to meet various regulatory requirements and bank-owned life insurance(“BOLI”).  Nonmarketable investmentincome increased $3.8 million over the second quarter of 2004.  The increase in nonmarketable investmentincome was primarily due to better performance by private equity investmentsoffset partially by decreased earnings from the hedge funds.

 

Other income was$18.0 million for the second quarter of 2005, a $4.1 million or 29.6% increaseover the $13.9 million for the same quarter last year.  The increase was primarily due to a gain onthe sale of an office building related to the consolidation of administrativeoffices amounting to $3.4 million.  Theremaining increases in other income are due to moderate increases ininsurance-related revenues and charges and fees on loans.

 

For the six months ended June 30, 2005, noninterest income increasedby $13.7 million, or 13.1%, to $117.9 million compared with $104.3 million forthe same period in 2004. This increase was largely due to a $2.9 million or6.5% increase in investment and wealth management revenues, a $6.3 millionincrease in earnings from private equity investments, a $3.6 million increasein gains from the sale of branches and an office building related toconsolidation, and $1.0 million from insurance related revenues partiallyoffset by lower earnings from hedge fund investments of $1.6 million.

 

24

----

 

# **Noninterest Expenses**

 
| ** **                              | ** ** | **For the 6  months ended  June 30,** | ** **  | **% Change** |       | **For the 3  months ended  June 30,** | ** ** | **% Change** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|-------------|--------------|------------|--------------------------------------------|------------|--------------|------------|
| **(Dollars in thousands)**              | ** ** | **2005**                                   | ** **  | **2004**     | ** ** | **2005/2004**                              |       | **2005**     | ** ** | **2004** | ** ** | **2005/2004** | ** ** |
| Salaries                                | ** ** | **$**                                      | **96,734**  |         | $          | 89,477                                     |       | 8.1          | %          | **$** | **50,180** |   | $ | 44,689 |   | 12.3 | % |
| Employee benefits                       | ** ** | **23,853**                                 |        | 23,441       |       | 1.8                                        |       | **11,956**   |       | 10,928 |   | 9.4 |   |
| Net occupancy expense of bank  premises | ** ** | **13,779**                                 |        | 11,879       |       | 16.0                                       |       | **6,857**    |       | 5,819 |   | 17.8 |   |
| Furniture and equipment  expenses       | ** ** | **15,203**                                 |        | 14,937       |       | 1.8                                        |       | **7,924**    |       | 7,573 |   | 4.6 |   |
| Communications and supplies             | ** ** | **8,059**                                  |        | 8,499        |       | (5.2                                       | )          | **4,019**    |       | 4,195 |   | (4.2 | ) |
| Other expenses:                         |       |                                       |        |         |       |                                       |       |         |       |   |   |   |   |
| Professional services                   | ** ** | **10,007**                                 |        | 8,830        |       | 13.3                                       |       | **4,882**    |       | 4,996 |   | (2.3 | ) |
| Advertising and promotional  expenses   | ** ** | **4,388**                                  |        | 3,838        |       | 14.3                                       |       | **2,677**    |       | 2,135 |   | 25.4 |   |
| Electronic banking expense              | ** ** | **6,418**                                  |        | 5,159        |       | 24.4                                       |       | **3,177**    |       | 3,006 |   | 5.7 |   |
| Amortization of intangible  assets      | ** ** | **4,251**                                  |        | 4,088        |       | 4.0                                        |       | **2,179**    |       | 2,057 |   | 5.9 |   |
| Outsourcing expense                     | ** ** | **5,073**                                  |        | 2,686        |       | 88.9                                       |       | **2,383**    |       | 1,227 |   | 94.2 |   |
| All other expenses                      | ** ** | **16,301**                                 |        | 13,919       |       | 17.1                                       |       | **7,679**    |       | 6,742 |   | 13.9 |   |
| Total other expenses                    | ** ** | **46,438**                                 |        | 38,520       |       | 20.6                                       |       | **22,977**   |       | 20,163 |   | 14.0 |   |
| Total                                   | ** ** | **$**                                      | **204,066** |         | $          | 186,753                                    |       | 9.3          |       | **$** | **103,913** |   | $ | 93,367 |   | 11.3 |   |

 

Noninterestexpenses for the three months ended June 30, 2005 increased by $10.5million, or 11.3%, to $103.9 million compared with $93.4 million for the threemonths ended June 30, 2004.  Thetable above shows the major components of noninterest expenses. This increasewas due, in part, to the acquisition of CBNV. CBNV added $2.3 million to noninterest expenses for the second quarterof 2005 of which $1.1 million was salary-related.

 

The efficiencyratio, a key measure of expense management, decreased in the second quarter of2005 compared with the same quarter of 2004. The efficiency ratio is computedby dividing noninterest expenses by the sum of net interest income on atax-equivalent basis and noninterest income. Bankshares’ efficiency ratio was48.54% for the three months ended June 30, 2005 compared with 50.12% forthe three months ended June 30, 2004. On a non-GAAP basis, the cashoperating efficiency ratio excludes the amortization of intangible assetsassociated with purchase accounting for business combinations; securities gainsand losses; and other significant gains, losses or expenses (such as thoseassociated with integrating acquired entities’ operations into Bankshares)unrelated to Bankshares’ core operations. Bankshares’ cash operating efficiency ratio was 48.29% and 49.01% forthe three months ended June 30, 2005 and 2004, respectively. For thereconciliation of GAAP to non-GAAP measures, see page 37 of this filing.

 

Salary expenseincreased $5.5 million or 12.3% from the second quarter of 2004. Theacquisition of CBNV added $1.1 million to this expense category.  Salary expense also increased due to higherincentive compensation of $1.9 million related to improved performance andnormal merit and staff increases of approximately $2.1 million.

 

Employee benefitsincreased $1.0 million, or 9.4%, primarily due to a reduction in the discountrate assumed in the pension expense determination, which was projected at thebeginning of the year.

 

Net occupancyexpense, which includes premises depreciation, rents, maintenance andutilities, increased $1.0 million or 17.8% over the prior year. This increasewas related to the loss of outside tenant income of $1.3 million due to the saleof Bankshares’ headquarters building in December 2004.

 

Total otherexpenses were $2.8 million, 14.0% higher than last year.  This increase was largely due to $1.2 millionin outsourcing fees attributable to the IWM systems and back office conversionto SunGard.  The remaining increase wasdue to higher accruals for external audit fees, charitable giving and statefranchise taxes.

 

Noninterest expense forthe six months ended June 30, 2005 increased to $204.1 million or 9.3%over the $186.8 million for the six months ended June 30, 2004. Theincrease was partially due to the acquisition of CBNV.  CBNV added $2.3 million to noninterestexpenses for the six months ended June 30, 2005.

 

Salary expenses increased$7.3 million or 8.1%. The acquisition of CBNV added $1.1 million to thiscategory.  In addition, higher incentivecompensation accruals of $3.5 million related to better year-over-yearperformance and approximately $2.1 million in normal merit and staff increasescaused the increase over the same period last year.

 

Net occupancy expenseincreased $1.9 million and was related to the loss of outside tenant income of$2.8 million due to the sale of Bankshares’ headquarters building in December 2004.

 

25

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Other expenses were $7.9million or 20.6% higher than the prior year. Outsourcing fees, primarilyrelated to the IWM back office conversion to SunGard, increased $2.4 million.Additionally, there was a $1.3 million settlement, related to a previouslyannounced litigation matter. Management does not expect to incur any furthercharges related to this matter. The remaining increase was attributable to avariety of other expense categories notably advertising and promotion ($0.6million), charitable contributions ($0.7 million) and electronic banking fees($1.3 million).

 

ANALYSIS OFFINANCIAL CONDITION

 

At June 30,2005 compared with June 30, 2004, total assets increased 13.9% or $2.0billion. At June 30, 2005 compared with December 31, 2004, totalassets increased 11.6% or $1.7 billion. The increase was primarily due to the acquisition of CBNV on May 18,2005, which had total assets of approximately $888.2 million, loans of $671.0million, investment securities $168.8 million, deposits of $626.9 million andborrowings of $193.5 million.

 

 A comparative schedule of averagebalances is included in the table on pages 20 and 21.

 

**SecuritiesAvailable-for-Sale**

 

The securitiesavailable-for-sale portfolio includes both debt and marketable equitysecurities. Bankshares holds debt securities available-for-sale primarily forliquidity, interest rate risk management and yield enhancement purposes.Accordingly, this portfolio primarily includes very liquid, high qualityfederal agency-backed debt securities. At June 30, 2005, the portfoliototaled $3.0 billion of debt securities available-for-sale, compared with $2.9billion at December 31, 2004. The increase in the investment portfolio wasprimarily due to additional investment securities from the CBNV acquisition,which at acquisition approximated $168.9 million. There were 20 securities in acontinuous loss position for 12 months or more at June 30, 2005, whichconsisted primarily of mortgage-backed securities. Because the declines in fairvalue were due to changes in market interest rates, not in estimated cashflows, no other-than-temporary impairment was recorded at June 30, 2005.There was a net unrealized loss on debt securities available-for-sale of $17.1million and $4.1 million at June 30, 2005 and December 31, 2004, respectively.

 

Theweighted-average expected maturity of debt securities available-for-sale was2.1 years at June 30, 2005. Since approximately 48% of this portfolio ismortgage-backed securities, the expected remaining maturity may differ fromcontractual maturity because borrowers may have the right to prepay obligationsbefore the underlying mortgages mature. See Note No. 4 “InvestmentSecurities” to the FinancialStatements for securities available-for-sale by security type.

 

**LoanPortfolio**

 

Total loans at June 30,2005 were $11.4 billion, compared with $10.2 billion at December 31, 2004,an increase of 11.1%. The increase in total loans was driven by the CBNVacquisition and strong organic growth in commercial real estate andconstruction lending. The CBNV acquisition added $671.3 million in additionalloans and contributed approximately 6.6% of the loan growth. Construction loanstotaled $1.56 billion at June 30, 2005, compared with $1.27 billion at December 31,2004, an increase of $291.8 million ($142.0 million from CBNV) or 23.0%.Commercial real estate loans increased $462.9 million ($274.7 million fromCBNV) or 14.8% from the beginning of the year. Commercial loans increased $54.0million ($61.4 million from CBNV) or 1.9% from December 31, 2004. Residentialloans increased $95.4 million ($9.8 million from CBNV) or 6.4% from thebeginning of the year. Consumer loans increased $229.1 million ($183.3 millionfrom CBNV of primarily indirect automobile loans) or 15.4% from December 31,2004. Total loans at June 30, 2005 increased $1.6 billion or 16.4% over June 30,2004.

 

The table belowpresents the composition of the loan portfolio at June 30, 2005, December 31,2004 and June 30, 2004.

 
| **(Dollars in thousands)**   | ** ** | **June 30,  2005** | ** **     | **% of  Total  Loans** | ** ** | **December 31,  2004** | ** ** | **% of  Total  Loans** | ** ** | **June 30,  2004** | ** ** | **% of  Total  Loans** | ** ** |
|------------------------------|------------|-------------------------|----------------|------------------------|------------|-----------------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|
| Commercial                   | ** ** | **$**                   | **2,867,315**  | ** **             | **25.2**   | **%**                       | $          | 2,813,325              |       | 27.5                    | %          | $                      | 2,715,173  |   | 27.8 | % |
| Commercial real estate       | ** ** | **3,585,592**           | ** **     | **31.6**               |       | 3,122,701                   |       | 30.6                   |       | 2,918,642               |       | 29.9                   |       |
| Construction                 | ** ** | **1,560,149**           | ** **     | **13.7**               |       | 1,268,350                   |       | 12.4                   |       | 1,129,208               |       | 11.6                   |       |
| Residential real estate      | ** ** | **1,581,472**           | ** **     | **13.9**               |       | 1,486,106                   |       | 14.5                   |       | 1,468,804               |       | 15.0                   |       |
| Consumer                     | ** ** | **1,713,674**           | ** **     | **15.1**               |       | 1,484,583                   |       | 14.5                   |       | 1,472,300               |       | 15.1                   |       |
| Lease financing              | ** ** | **56,104**              | ** **     | **0.5**                |       | 53,368                      |       | 0.5                    |       | 57,983                  |       | 0.6                    |       |
| Total loans at end of period | ** ** | **$**                   | **11,364,306** | ** **             | **100.0**  |                        | $          | 10,228,433             |       | 100.0                   |       | $                      | 9,762,110  |   | 100.0 |   |

 

26

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**Deposits**

 

Deposits, whichrepresent Bankshares’ primary source of funds, are offered through 239 branchesprimarily in Maryland, Virginia, Delaware, and Washington, D.C.  At June 30, 2005, total depositsincreased 11.2% or $1.2 billion compared to the year-earlier period of whichthe CBNV acquisition contributed 5.9% based on $626.9 million in acquireddeposits. Organic growth in deposits was in core deposits from customers in thelocal markets. The affiliate banking model positions Bankshares to compete notonly with the large national and regional banking companies in the gathering ofthese funds, but also with local community banks. Based on historicalexperience, Bankshares expects to retain these deposits in a rising interestrate environment although pricing pressure is expected to intensify.

 

The table belowpresents the composition of deposits at June 30, 2005, December 31,2004 and June 30, 2004.

 
| ** **                       | ** ** | ** **        | ** **     | ** **            | ** ** | ** **        | ** ** | **% change**                | ** ** |
|----------------------------------|------------|-------------------|----------------|-----------------------|------------|-------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **June 30,** | ** **     | **December 31,** | ** ** | **June 30,** | ** ** | **June 30  2005 /**    | ** ** | **June 30  2005 /** | ** ** |
| **(Dollars in thousands)**       | ** ** | **2005**          | ** **     | **2004**              | ** ** | **2004**          | ** ** | **December 31,  2004** | ** ** | **June 30,  2004** | ** ** |
| Noninterest bearing deposits     | ** ** | **$**             | **3,293,344**  |                  | $          | 3,049,031         |       | $                           | 3,043,242  |   | 8.0 | % | 8.2 | % |
| Savings                          | ** ** | **1,447,105**     |           | 1,449,313             |       | 1,455,418         |       | (0.2                        | )          | (0.6 | ) |
| Checking plus interest           | ** ** | **1,482,850**     |           | 1,377,981             |       | 1,312,978         |       | 7.6                         |       | 12.9 |   |
| Money market                     | ** ** | **1,673,044**     |           | 1,588,445             |       | 1,618,411         |       | 5.3                         |       | 3.4 |   |
| Time deposits $100,000 and  over | ** ** | **1,683,378**     |           | 1,393,907             |       | 1,285,091         |       | 20.8                        |       | 31.0 |   |
| Other time deposits              | ** ** | **2,251,030**     |           | 1,940,522             |       | 1,928,554         |       | 16.0                        |       | 16.7 |   |
| Total deposits at end of  period | ** ** | **$**             | **11,830,751** |                  | $          | 10,799,199        |       | $                           | 10,643,694 |   | 9.6 |   | 11.2 |   |

 

Total deposits at June 30,2005, were $11.8 billion, an increase of $1.0 billion, or 9.6%, over December 31,2004. The increase in total deposits was primarily the result of the $641.4million of acquired deposits from the CBNV acquisition with the main accountconcentration being in time certificates of deposit.  Non-interest bearing checking accounts grewto $3.3 billion at June 30, 2005, an increase of $244.3 million, or 8.0%,of which CBNV contributed $127.9 million. Interest-bearing deposits, which represent approximately 72% of totaldeposits were $8.5 billion at June 30, 2005, compared to $7.8 billion at December 31,2004, an increase of $787.2 million, or 10.2%. Checking plus interest accounts increased $104.9 million, or 7.6%, ofwhich CBNV contributed $27.9 million. Savings accounts declined by $2.2 million, or 0.2%, as the $12.3 millionin additional savings accounts from CBNV were offset by a $14.5 million declinein existing deposits as customers seek the higher rates offered by premiummoney market accounts and certificate of deposit accounts.  Money market accounts increased $84.6 million(5.3%) of which CBNV contributed $57.9 million. Time deposits greater than $100,000 increased by $289.5 million, or20.8%, of which CBNV contributed $146.3 million.  Other time deposits increased by $310.5million, or 16.0%, primarily from the $269.1 million acquired from CBNV.

 

**Borrowings**

 

Banksharesutilizes both short-term and long-term borrowings to fund growth of earningassets in excess of deposit growth. Short-term borrowings, which includefederal funds purchased, securities sold under agreements to repurchase andother short-term borrowings, were $1.19 billion at June 30, 2005, comparedwith $887.9 million at December 31, 2004. Short-term funding is managed to levels deemed appropriate givenalternative funding sources.  Theincrease of $304.9 million, or 34.3%, in short-term borrowings reflected anincrease in customer securities sold under agreements to repurchase as well asincreased usage of the overnight funding markets to support loan growth andfund the $82.9 million cash portion of the CBNV acquisition.  Long-term debt was $808.0 million at June 30,2005, an increase of $117.0 million, or 16.9%, compared with $691.0 million at December 31,2004.  The increase in long-term debt wasprimarily the result of $116.2 million of additional FHLB advances andsubordinated debt assumed in the CBNV acquisition.

 

**Capital**

 

Shareholders’equity at June 30, 2005 was $2.1 billion an increase of $203.4 millionfrom December 31, 2004. This increase reflected the shares issued in theCBNV acquisition that were valued at $124.3 million.  Effective at the May 2005 Board meeting,the quarterly dividend rate was increased by 8.6% to $0.38 from $0.35 pershare. Bankshares has authorization enabling it to repurchase up toapproximately 0.5 million additional shares.

 

At the AnnualShareholders’ Meeting held on May 10, 2005, Bankshares’ stockholdersapproved the Mercantile Bankshares Corporation Stock Retainer and DeferredCompensation Plan for Non-Employee Directors (the “Plan”). The Plan providesfor an annual stock retainer of 500 shares of Bankshares common stock to eachnon-employee director of Bankshares. The Plan permits non-employee directors ofBankshares and its affiliates to elect to defer voluntarily their annual stockand cash retainers and some or all of their fees. The initial annual stockretainer under the Plan was paid on June 1, 2005 to non-employeedirectors. See Current Report on Form 8-K filed with the SEC on May 16,2005 for more details on the Plan.

 

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RISK MANAGEMENT

 

**CreditRisk Analysis**

 

Bankshares’ loans andcommitments are substantially to borrowers located within our immediate region.Bankshares has set an internal limit for each affiliate bank, that is wellbelow the regulatory limit, on the maximum amount of credit that may beextended to a single borrower. For more information on credit risk see “RiskManagement – Credit Risk Analysis” in the Mercantile Bankshares Corporation’s2004 Annual Report on Form 10-K.

 

**NonperformingAssets**

 

Nonperforming assetsconsist of nonaccrual loans, renegotiated loans and other real estate owned(i.e., real estate acquired in foreclosure or in lieu of foreclosure).  With respect to nonaccrual loans, Bankshares’policy 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.  If aloan is impaired and has a specific loss allocation based on an analysis underSFAS No. 114, “**Accounting by Creditors for Impairmentof a Loan**– **An Amendment ofFASB Statements No. 5 and 15,**” all payments are thenapplied against the loan’s principal.  Aloan may be put on nonaccrual status sooner than this standard if, inmanagement’s judgment, such action is warranted.

 

During the six monthsended June 30, 2005, nonperforming assets decreased $3.4 million to $27.7million from $31.1 million at December 31, 2004.  Nonaccrual loans were $26.9 million at June 30,2005 and other real estate owned, the other component of nonperforming assets,was $0.8 million.  Nonperforming assetsas a percent of period-end loans and other real estate owned were 0.24% at June 30,2005 and 0.30% at December 31, 2004, respectively.  The decrease in nonperforming loans was dueprimarily to improvement in credit quality at the lead bank, MSD&T.

 

At June 30, 2005 andDecember 31, 2004, monitored loans, or loans with characteristicssuggesting that they could be classified as nonperforming in the near future,were $0.5 million and $6.4 million, respectively.  Contributing to this decrease was theelimination of the one remaining loan secured by a commercial aircraft. Theamount of loans past due 30-89 days decreased from $51.5 million at December 31,2004 to $43.7 million at June 30, 2005. At the acquisition date, Bankshares determined that two loans at CBNVcame under the scope of SOP 03-3, “Accounting for Certain Loans or DebtSecurities Acquired in a Transfer.” These loans have a $4.9 million contractual balance and a $3.5 millioncarrying value at June 30, 2005. The accretable yield on these loans at that date was $63 thousand.   For additional information on these loanssee Note No.5 “Impaired Loans”

 

The table below presentsa comparison of nonperforming assets at June 30, 2005, December 31,2004 and June 30, 2004.

 
| **(Dollars in thousands)**                                                         | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** | **June 30,  2004** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|-------------------------|------------|
| Nonaccrual loans *(1)*                                                             |       |                    |       |                        |       |                    |       |
| Commercial                                                                         | ** ** | **$**                   | **21,770** |                        | $          | 25,030                  |       | $ | 34,002 |   |
| Commercial real estate                                                             | ** ** | **2,848**               |       | 1,959                       |       | 2,197                   |       |
| Construction                                                                       | ** ** | **378**                 |       | 9                           |       | 155                     |       |
| Residential real estate                                                            | ** ** | **1,238**               |       | 2,748                       |       | 2,518                   |       |
| Consumer                                                                           | ** ** | **465**                 |       | 672                         |       | 346                     |       |
| Lease financing                                                                    | ** ** | **210**                 |       | 480                         |       | 670                     |       |
| Total                                                                              | ** ** | **26,909**              |       | 30,898                      |       | 39,888                  |       |
| Renegotiated loans*(1)*                                                            | ** ** | **—**              |       | —                      |       | —                  |       |
| Loans contractually past due  90 days or more and still accruing interest          | ** ** | **—**              |       | —                      |       | —                  |       |
| Total nonperforming loans                                                          | ** ** | **26,909**              |       | 30,898                      |       | 39,888                  |       |
| Other real estate owned                                                            | ** ** | **777**                 |       | 212                         |       | 402                     |       |
| Total nonperforming assets                                                         | ** ** | **$**                   | **27,686** |                        | $          | 31,110                  |       | $ | 40,290 |   |
| Nonperforming loans as a  percent of period-end loans                              | ** ** | **0.24**                | **%**      | 0.30                        | %          | 0.41                    | %          |
| Nonperforming assets as a  percent of period-end loans and other real estate owned | ** ** | **0.24**                | **%**      | 0.30                        | %          | 0.41                    | %          |

 

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(1)          Aggregategross interest income of $1.2 million, $2.5 million and $1.4 million for thefirst half of 2005, the year 2004 and the first half of 2004, 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 $0.3 million, $0.8 million and $0.5 million for thefirst six months of 2005, the year 2004 and the first six months of 2004,respectively.

 

28

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**Allowanceand Provision for Loan Losses**

 

Each Bankshares affiliateis required to maintain an allowance for loan losses adequate to absorb lossesinherent in the loan portfolio. Each affiliate’s reserve is dedicated to thataffiliate only and is not available to absorb losses from anotheraffiliate.   Management at eachaffiliate, along with Bankshares’ management, conducts a regular review toassure that adequacy.  On a periodicbasis, significant credit exposures, nonperforming loans, impaired loans,historical losses by loan type and various statistical measurements of assetquality are examined to assure the adequacy of the allowance for loan losses.Management believes that the allowance for loan losses is adequate to absorblosses inherent in the portfolio.

 

The allowance for loanlosses has been established through provisions for loan losses charged againstincome. Loans deemed uncollectible are charged against the allowance for loanlosses and any subsequent recoveries are credited to the allowance.  Intensive collection efforts continue aftercharge-off in order to maximize recovery amounts.  No provision for possible loan losses wastaken for the quarter ended June 30, 2005 as recoveries exceededcharge-offs. This compares with provisions of $0.8 million and $2.4 million forthe quarters ended March 31, 2005 and June 30, 2004, respectively.The decline in the provision reflects a continued improvement in the economyand improved credit quality within Bankshares’ Affiliate Banks. Net recoverieswere $1.0 million for the second quarter of 2005, compared with net charge-offsof $0.7 million and $0.6 million for the first quarter of 2005 and the secondquarter of 2004, respectively. The allowance for loan losses increased between December 31,2004 and June 30, 2005 primarily as a result of the acquired allowance ofCBNV, which after the application of SOP 03-3, was approximately $7.1 million.The allowance for loan losses as a percent of period-end loans decreased to1.38% at June 30, 2005 from 1.46% at December 31, 2004 and 1.62% at June 30,2004. The reduction in the allowance as a percent of total loans isattributable to improved credit quality as well as the acquired loan portfoliowhich resulted in a lower required allowance as a percent of loans.

 

The following tablepresents a summary of the activity in the Allowance for Loan Losses.

 
| ** **                                                | ** ** | **For the 6  months ended June 30,** |           | **For the 3  months ended June 30,** |   |
|-----------------------------------------------------------|------------|-------------------------------------------|----------------|-------------------------------------------|--------|
| **(Dollars  in thousands)**                               | ** ** | **2005**                                  | ** **     | **2004**                                  |   | **2005** | ** ** | **2004** |   |
| Allowance balance - beginning                             | ** ** | **$**                                     | **149,002**    | ** **                                | $      | 155,337 |   | **$** | **149,017** | ** ** | $ | 156,635 |   |
| Allowance of acquired bank                                | ** ** | **7,086**                                 | ** **     | ** **                                |   | **7,086** | ** ** |   |   |
| Charge-offs:                                              |       |                                      | ** **     |                                      |   |   | ** ** |   |   |
| Commercial                                                | ** ** | **(1,682**                                | **)**          | (945                                      | )      | **(383** | **)** | (255 | ) |
| Commercial real estate                                    | ** ** | **(32**                                   | **)**          | (28                                       | )      | **—** | ** ** | — |   |
| Construction                                              | ** ** | **—**                                | ** **     | —                                    |   | **—** | ** ** | — |   |
| Residential real estate                                   | ** ** | **(14**                                   | **)**          | (129                                      | )      | **(3** | **)** | (28 | ) |
| Consumer                                                  | ** ** | **(1,387**                                | **)**          | (2,377                                    | )      | **(787** | **)** | (1,260 | ) |
| Lease financing                                           | ** ** | **—**                                | ** **     | —                                    |   | **—** | ** ** | — |   |
| Total                                                     | ** ** | **(3,115**                                | **)**          | (3,479                                    | )      | **(1,173** | **)** | (1,543 | ) |
| Recoveries:                                               |       |                                      | ** **     |                                      |   |   | ** ** |   |   |
| Commercial                                                | ** ** | **934**                                   | ** **     | 337                                       |   | **465** | ** ** | 237 |   |
| Commercial real estate                                    | ** ** | **124**                                   | ** **     | 26                                        |   | **118** | ** ** | 8 |   |
| Construction                                              | ** ** | **1**                                     | ** **     | 4                                         |   | **1** | ** ** | — |   |
| Residential real estate                                   | ** ** | **65**                                    | ** **     | 191                                       |   | **30** | ** ** | 139 |   |
| Consumer                                                  | ** ** | **1,602**                                 | ** **     | 1,236                                     |   | **1,037** | ** ** | 602 |   |
| Lease financing                                           | ** ** | **646**                                   | ** **     | —                                    |   | **520** | ** ** | — |   |
| Total                                                     | ** ** | **3,372**                                 | ** **     | 1,794                                     |   | **2,171** | ** ** | 986 |   |
| Net (charge-offs) / recoveries                            | ** ** | **257**                                   | ** **     | (1,685                                    | )      | **998** | ** ** | (557 | ) |
| Provision for loan losses                                 | ** ** | **756**                                   | ** **     | 4,779                                     |   | **—** | ** ** | 2,353 |   |
| Allowance balance - ending                                | ** ** | **$**                                     | **157,101**    | ** **                                | $      | 158,431 |   | **$** | **157,101** | ** ** | $ | 158,431 |   |
| Average loans                                             | ** ** | **$**                                     | **10,608,428** | ** **                                | $      | 9,481,159 |   | **$** | **10,899,263** | ** ** | $ | 9,623,884 |   |
| Percent of net charge-offs  (annualized) to average loans | ** ** | **—**                                | **%**          | 0.04                                      | %      | **(0.04** | **)%** | 0.02 | % |
| Period-end loans                                          | ** ** | **$**                                     | **11,364,306** | ** **                                | $      | 9,762,110 |   |   | ** ** |   |   |
| Percent of allowance for loan  losses to period-end loans | ** ** | **1.38**                                  | **%**          | 1.62                                      | %      |   | ** ** |   |   |

 

29

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**InterestRate Risk**

 

The objective ofinterest rate risk management is to contain the risks associated with interestrate fluctuations. The process involves identification and management of thesensitivity of net interest income to changing interest rates and other marketfactors. Interest rate risk, one of the more prominent risks in terms ofpotential earnings impact, is an inevitable part of being a financialintermediary. For more information see “Risk Management – Interest Rate Risk”in the Mercantile Bankshares Corporation’s 2004 Annual Report on Form 10-K.

 

EARNINGS SIMULATION MODELPROJECTIONS

 

Banksharesassesses interest rate risk by comparing projected net interest income in thecurrent rate environment with various interest rate scenarios that differ inthe direction of interest rate changes, the degree of change over time, thespeed of the change and the projected shape of the yield curve.  This analysis incorporates substantially allof Bankshares’ assets and liabilities and off-balance sheet instruments,however it does not include CBNV loans and deposits as of June 30,2005.  The inclusion of CBNV balancesheet is not anticipated to have a material effect on Bankshares’ interest raterisk position Through these simulations, management estimates the impact on netinterest income of a 200 basis point upward and 100 basis point downward changein interest rates. The following table summarizes the effect a positive 100 and200 basis point parallel change and a negative 100 basis point parallel changein interest rates would have on Bankshares’ net interest income over the next12 months.

 
| ** **                    | ** ** | **Calculated  increase / (decrease) in** | ** ** |
|-------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | **projected  net interest income**       | ** ** |
| **Change in  interest rates** | ** ** | **June 30,**                        | ** ** | **December 31,** | ** ** |
| **(basis  points)**           | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| +200                          | ** ** | **4.5**                                  | **%**      | 5.5 | % |
| +100                          | ** ** | **2.2**                                  | **%**      | 2.8 | % |
| -100                          | ** ** | **(2.4**                                 | **)%**     | (2.9 | )% |

 

At June 30,2005, Bankshares’ interest sensitivity position remained asset sensitive.  Based on its most recent simulation model,Bankshares’ net interest income would increase by $13.6 million or 2.2% and$27.5 million or 4.5% if interest rates were to move up gradually over the nextsix months by 100 basis points or 200 basis points, respectively.  A downward movement of 100 basis points wouldreduce net interest income by $14.5 million or 2.4%.  Bankshares manages the interest rate risk profilewithin policy limits.  Given the lowlevel of interest rates, Bankshares’ Asset/Liability Management Committee “ALCO”has measured the risk for decrease in interest rat at 100 basis points.  At June 30, 2005, and December 31,2004, Bankshares was within its policy guidelines.  In response to action by the Federal Reserveto increase short-term interest rates, Bankshares’ prime interest ratecontinues to rise.  Bankshares hasapproximately $4.6 billion in loans that will reprice within the next quarter.  The effects of a rising rate environment oninterest expense are less predictable due to customer behavior that shifts themix of deposit products.  Approximately$1.6 billion in short and long-term debt will also be subject to rate increaseswithin the next quarter.  As ratescontinue to rise, management expects, based on Bankshares’ interest sensitivityposition, that the net interest margin and net interest income will expandmodestly.

 

Bankshares alsoutilizes interest rate derivatives to hedge interest rate risk exposures. Thecredit risk amount and estimated net fair values of these derivatives as of June 30,2005 and December 31, 2004 are presented in Note No. 11 (DerivativeInstruments and Hedging Activities) to the Financial Statements. Derivativesare used for asset/liability management in three ways:

 

•                  To convert long-term fixed-rate debtto floating-rate payments by entering into receive-fixed swaps at issuance;

•                  To convert the cash flows fromselected asset and/or liability instruments/portfolios from fixed to floatingpayments or vice versa; and

•                  To hedge the mortgage originationpipeline by utilizing forward rate commitments for loans held-for-sale.

 

MARKET VALUE OFEQUITY MODELING

 

Bankshares alsoutilizes the market value of equity as a measurement tool in managing interestrate sensitivity.  The market value ofequity measures the degree to which the market values of Bankshares’ assets andliabilities and off-balance sheet instruments will change given a change ininterest rates.  ALCO guidelines limitthe change in market value of equity in a 200 basis point parallel rate shockto 25% of the market value of equity assuming interest rates at June 30,2005.  The up 200 basis point scenarioresulted in a 2.7% increase at June 30, 2005 and a 2.2% increase at December 31,2004.  The down 200 basis point scenarioresulted in an 8.3% decrease at June 30, 2005 and an 8.6% decrease at December 31,2004.  At June 30, 2005 and December 31,2004, Bankshares was within its policy guidelines.

 

30

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

 

**MarketRisk – Trading Activities**

 

Banksharesprovides capital market products to its customers. From a market riskperspective, Bankshares’ net income is exposed to changes in interest rates,credit spreads, and equities and their implied volatilities.  The primary purpose of Bankshares’ tradingbusiness is to accommodate customers in the management of their market pricerisks.  Derivative transactions executedwith customers are simultaneously hedged in the capital markets. Allderivatives transacted with customers used to hedge capital market transactionswith customers are carried at fair value. The ALCO establishes and monitors counterparty risk limits.  The notional amount, exposure amount andestimated net fair value of all customer accommodation derivatives at June 30,2005 are included in Note No. 11 (Derivative Instruments and HedgingActivities) to the Financial Statements.

 

**MarketRisk – Equity Markets**

 

Bankshares isdirectly and indirectly affected by changes in the equity markets.  Bankshares has made investments in privateequities. These investments are made within capital allocations approved bymanagement.  Management reviews theseinvestments at least quarterly and assesses them for possibleother-than-temporary impairment.  Privateequity investments totaled $29.4 million at June 30, 2005 and $21.3million at June 30, 2004.

 

Changes in equitymarket prices may also indirectly affect Bankshares’ net income:   (1) by affecting the value of thirdparty assets under management or administration within IWM and, hence, feeincome; (2) by affecting particular borrowers, whose ability to repay principaland/or interest may be affected by the stock market; or (3) by affectingbrokerage activity, related commission income and other business activities.

 

**LiquidityRisk**

 

Liquidity risk isthe possibility that Bankshares will not be able to fund present and futurefinancial obligations.  The objective ofliquidity management is to maintain the ability to meet commitments to fundloans, purchase securities and repay deposits and other liabilities inaccordance with their terms.  To achievethis objective, the ALCO establishes and monitors liquidity guidelines thatrequire sufficient asset-based liquidity to cover potential fundingrequirements and to avoid over-reliance on volatile, less reliable fundingmarkets.  Debt securities in theavailable-for-sale portfolio provide liquidity, in addition to the immediatelyliquid resources of cash and due from banks and federal funds sold andsecurities purchased under resale agreements. By limiting the maturity of securities and maintaining a conservativeinvestment posture, management can rely on the investment portfolio to helpmeet any short-term funding needs. U.S. Treasury and agency securities, whichprovide the greatest liquidity, averaged $1.4 billion for both the secondquarter of 2005 and the first quarter of 2005, a 3.1% decrease for this periodand a 10.5% decrease from the average of $1.5 billion for the second quarter of2004.

 

Core customerdeposits have historically provided a sizable source of relatively stable andlow-cost funds.  For the three monthsended June 30, 2005, core deposits (total deposits less certificates ofdeposit of $100,000 and over) averaged $9.7 billion compared with $9.3 billionfor the first quarter of 2005 and $9.1 billion for the second quarter of2004.  Although not viewed as coredeposits, a substantial portion of short-term borrowings comprised ofsecurities sold under agreements to repurchase and commercial paper originatefrom core deposit relationships tied to the overnight cash management programoffered to customers.  Long-term debt andshort-term borrowings funded the remaining assets.

 

In addition tothese sources, Bankshares has access to national markets for certificates ofdeposit, commercial paper and debt financing. Should it need to further supplement its liquidity, Bankshares has $1.8billion in lines with the FHLB Atlanta and back-up commercial paper lines of$40 million with commercial banks. Bankshares is required to obtain approvalfrom holders of Bankshares’ 6.72% and 6.80% unsecured senior notes if it incrementallyborrows in excess of $150 million under these FHLB lines.

 

Liquidity is alsoavailable through Bankshares’ ability to raise funds in the capitalmarkets.  Bankshares accesses capitalmarkets for long-term funding by issuing registered debt and privateplacements.  As of June 2005, Moody’sInvestors Service published their Mercantile Bankshares Corporation’scommercial paper rating of “P-1” and the Corporation’s subordinated debt ratingof “A2.”  Also in June 2005,Standard & Poor’s Ratings Service published their Bankshares’ ratingof “A+/Stable/A-1” and counterparty rating of “A+/Stable/A-1.”  Rating agencies base their ratings on manyquantitative and qualitative factors, including capital adequacy, liquidity,asset quality, quality of the management team, business mix and level andquality of earnings.  For additionalinformation see “Risk Management – Liquidity Risk” in the Mercantile BanksharesCorporation’s 2004 Annual Report on Form 10-K.

 

31

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**ContractualObligations and Commitments**

 

In the normalcourse of business, Bankshares enters into certain contractual obligations andother commitments. Such obligations generally relate to funding operationsthrough debt arrangements as well as leases of premises and equipment.  As a financial services provider, Banksharesroutinely enters into commitments to extend credit, including loan commitments,standby letters of credit and financial guarantees. For a discussion of thesecommitments see Note No. 6 “Commitments” above. For a discussion ofcontractual commitments see “Off-Balance Sheet Arrangements and ContractualObligations” in the Mercantile Bankshares Corporation’s 2004 Annual Report on Form 10-K.  Items disclosed in the Annual Report on Form 10-Khave not changed materially since the report was filed.

 

**CautionaryStatement**

 

This reportcontains financial information determined by methods other than in accordancewith Generally Accepted Accounting Principles (“GAAP”).  Bankshares’ management uses these non-GAAPmeasures in their analysis of the Company’s performance. In particular, netinterest income, net interest margin and the cash operating efficiency ratioare calculated on a fully tax-equivalent basis (“FTE”).  The FTE basis is determined by adjusting netinterest income to reflect tax-exempt interest income on a before-taxequivalent basis. These measures typically adjust GAAP performance measures toexclude intangible assets and the amortization of intangible assets related tothe consummation of mergers. These operating earnings measures may also excludeother significant gains, losses or expenses that are not considered componentsof core earnings. Since these items and their impact on Bankshares’ performanceare difficult to predict, management believes presentations of financialmeasures excluding the impact of these items provide useful supplementalinformation that is essential to a proper understanding of the operatingresults and financial position of Bankshares’ core businesses. Thesedisclosures should not be viewed as a substitute for results determined inaccordance with GAAP, nor are they necessarily comparable to operating earningsperformance measures that may be presented by other companies.

 

This reportcontains forward-looking statements within the meaning of and pursuant to thesafe harbor provisions of the Private Securities Litigation Reform Act of1995.  A forward-looking statementencompasses any estimate, prediction, opinion or statement of belief containedin this report, and the underlying management assumptions.  Such statements in this report include:identification of trends; loan growth; deposit retention; comments on adequacyof the allowance for loan losses; credit quality; changes in leasingactivities; effects of asset sensitivity and interest rate changes; informationconcerning market risk referenced in Item 3; expected pro forma assets, loansand deposits of the banks resulting from the planned reorganization; and theanticipated effect of the proposed reorganization on operations, regulatorycompliance and service to banking customers. 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.  Inaddition, the following factors, among others, could cause actual results todiffer materially from the anticipated results or expectations expressed in theforward-looking statements: administrative and operational efficiencies may notimprove to the degree projected; and competitive pressures and regulatorycomplexities that affect our banks may be stronger than expected.

 

32

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**SupplementalInformation by Quarter**

**SelectFinancial Data**

(in thousands, except per share data)

 
| ** **                                                                            | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2Q 05** | ** ** | **2Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                                                                            | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| ** **                                                                            | ** ** | **2Q 05**      | ** **     | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 05** | ** ** | **2Q 04** | ** ** |
| **OPERATING RESULTS**                                                                 | ** ** | ** **     |           |       |       |       |       |       |       |       |       |      |       |      |       |
| Net interest income (1)                                                               | ** ** | **$**          | **152,367**    | ** ** | $          | 143,083    |       | $          | 143,710    |       | $          | 138,182   |       | $         | 133,484    |   | 6.5 | % | 14.1 | % |
| Net interest income - taxable  equivalent (1)                                         | ** ** | **154,023**    | ** **     | 144,660    |       | 145,370    |       | 139,866    |       | 135,159    |       | 6.5       |       | 14.0      |       |
| Provision for loan losses                                                             | ** ** | **—**     | ** **     | 756        |       | —     |       | 2,442      |       | 2,353      |       | (100.0    | )          | (100.0    | )          |
| Net income                                                                            | ** ** | **67,873**     | ** **     | 62,627     |       | 60,612     |       | 56,785     |       | 56,313     |       | 8.4       |       | 20.5      |       |
| **PER COMMON SHARE DATA**                                                             |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| Basic net income                                                                      | ** ** | **$**          | **.84**        | ** ** | $          | .79        |       | $          | .77        |       | $          | .72       |       | $         | .71        |   | 6.3 | % | 18.3 | % |
| Diluted net income                                                                    | ** ** | **.84**        | ** **     | .78        |       | .76        |       | .71        |       | .71        |       | 7.7       |       | 18.3      |       |
| Dividends paid                                                                        | ** ** | **.38**        | ** **     | .35        |       | .35        |       | .35        |       | .35        |       | 8.6       |       | 8.6       |       |
| Book value at period end                                                              | ** ** | **25.87**      | ** **     | 24.39      |       | 24.18      |       | 23.85      |       | 23.28      |       | 6.1       |       | 11.1      |       |
| Market value at period end                                                            | ** ** | **51.53**      | ** **     | 50.86      |       | 52.20      |       | 47.96      |       | 46.82      |       | 1.3       |       | 10.1      |       |
| Market range:                                                                         |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| High                                                                                  | ** ** | **52.80**      | ** **     | 52.35      |       | 53.09      |       | 49.34      |       | 47.93      |       | 0.9       |       | 10.2      |       |
| Low                                                                                   | ** ** | **48.58**      | ** **     | 48.40      |       | 47.07      |       | 44.18      |       | 40.31      |       | 0.4       |       | 20.5      |       |
| **AVERAGE BALANCE SHEET DATA**                                                        |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| Total loans                                                                           | ** ** | **$**          | **10,899,263** | ** ** | $          | 10,314,361 |       | $          | 10,084,344 |       | $          | 9,825,793 |       | $         | 9,623,884  |   | 5.7 | % | 13.3 | % |
| Total earning assets                                                                  | ** ** | **13,840,991** | ** **     | 13,221,167 |       | 13,056,972 |       | 12,831,612 |       | 12,668,674 |       | 4.7       |       | 9.3       |       |
| Total assets                                                                          | ** ** | **15,233,571** | ** **     | 14,508,344 |       | 14,310,894 |       | 14,099,488 |       | 13,939,185 |       | 5.0       |       | 9.3       |       |
| Total deposits                                                                        | ** ** | **11,273,220** | ** **     | 10,718,734 |       | 10,675,933 |       | 10,507,716 |       | 10,398,257 |       | 5.2       |       | 8.4       |       |
| Shareholders’ equity                                                             | ** ** | **2,042,104**  | ** **     | 1,950,276  |       | 1,911,151  |       | 1,877,844  |       | 1,851,761  |       | 4.7       |       | 10.3      |       |
| **STATISTICS AND RATIOS (Net  income annualized)**                                    |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| Return on average assets                                                              | ** ** | **1.79**       | **%**          | 1.75       | %          | 1.68       | %          | 1.60       | %          | 1.62       | %          |      |       |      |       |
| Return on average equity (2)                                                          | ** ** | **13.33**      | ** **     | 13.02      |       | 12.62      |       | 12.03      |       | 12.23      |       |      |       |      |       |
| Return on average tangible  equity (2)                                                | ** ** | **19.64**      | ** **     | 18.57      |       | 18.16      |       | 17.63      |       | 18.14      |       |      |       |      |       |
| Average equity to average  assets (2)                                                 | ** ** | **13.41**      | ** **     | 13.44      |       | 13.35      |       | 13.32      |       | 13.28      |       |      |       |      |       |
| Average tangible equity to  average tangible assets (2)                               | ** ** | **9.67**       | ** **     | 10.00      |       | 9.84       |       | 9.67       |       | 9.55       |       |      |       |      |       |
| Net interest rate spread -  taxable equivalent                                        | ** ** | **3.95**       | ** **     | 3.99       |       | 4.02       |       | 3.99       |       | 3.96       |       |      |       |      |       |
| Net interest margin on earning  assets - taxable equivalent                           | ** ** | **4.46**       | ** **     | 4.44       |       | 4.43       |       | 4.34       |       | 4.29       |       |      |       |      |       |
| Efficiency ratio (1),(3)                                                              | ** ** | **48.54**      | ** **     | 49.45      |       | 52.70      |       | 51.20      |       | 50.12      |       |      |       |      |       |
| Operating efficiency ratio  (1),(3)                                                   | ** ** | **48.29**      | ** **     | 48.68      |       | 51.20      |       | 48.96      |       | 49.01      |       |      |       |      |       |
| Dividend payout ratio                                                                 | ** ** | **45.24**      | ** **     | 44.30      |       | 45.45      |       | 48.61      |       | 49.30      |       |      |       |      |       |
|                                                                                  |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| Bank offices                                                                          | ** ** | **239**        | ** **     | 225        |       | 226        |       | 229        |       | 229        |       | 14        |       | 10        |       |
| Employees                                                                             | ** ** | **3,630**      | ** **     | 3,423      |       | 3,479      |       | 3,418      |       | 3,508      |       | 207       |       | 122       |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| Net charge-offs / (recoveries)                                                        | ** ** | **$**          | **(998**       | **)**      | $          | 741        |       | $          | 12,439     |       | $          | (568      | )          | $         | 557        |   | (234.7 | )% | (279.2 | )% |
| Nonaccrual loans                                                                      | ** ** | **26,909**     | ** **     | 31,234     |       | 30,898     |       | 38,902     |       | 39,888     |       | (13.8     | )          | (32.5     | )          |
| Restructured loans                                                                    |       | —         | ** **     | —     |       | —     |       | —     |       | —     |       | —    |       | —    |       |
| Total nonperforming loans                                                             | ** ** | **26,909**     | ** **     | 31,234     |       | 30,898     |       | 38,902     |       | 39,888     |       | (13.8     | )          | (32.5     | )          |
| Other real estate owned, net                                                          | ** ** | **777**        | ** **     | 145        |       | 212        |       | 388        |       | 402        |       | 435.9     |       | 93.3      |       |
| Total nonperforming assets                                                            | ** ** | **27,686**     | ** **     | 31,379     |       | 31,110     |       | 39,290     |       | 40,290     |       | (11.8     | )          | (31.3     | )          |
| **CREDIT QUALITY RATIOS**                                                             |       |           | ** **     |       |       |       |       |       |       |       |       |      |       |      |       |
| Provision for loan losses  (annualized) as a percent of period-end loans              |       | **—**     | **%**          | .03        | %          | —     | %          | .10        | %          | .10        | %          |      |       |      |       |
| Net charge-offs / (recoveries)  - annualized as a percent of period-end loans         | ** ** | **(.04**       | **)**          | .03        |       | .48        |       | (.02       | )          | .02        |       |      |       |      |       |
| Nonperforming loans as a  percent of period-end loans                                 | ** ** | **.24**        | ** **     | .30        |       | .30        |       | .39        |       | .41        |       |      |       |      |       |
| Allowance for loan losses as a  percent of period-end loans                           | ** ** | **1.38**       | ** **     | 1.43       |       | 1.46       |       | 1.61       |       | 1.62       |       |      |       |      |       |
| Allowance for loan losses as a  percent of nonperforming loans                        | ** ** | **583.82**     | ** **     | 477.10     |       | 482.24     |       | 414.99     |       | 397.19     |       |      |       |      |       |
| Other real estate owned as a  percent of period-end loans and other real estate owned | ** ** | **.01**        | ** **     | —     |       | —     |       | —     |       | —     |       |      |       |      |       |
| Nonperforming assets as a  percent of period-end loans and other real estate owned    | ** ** | **.24**        | ** **     | .30        |       | .30        |       | .39        |       | .41        |       |      |       |      |       |
| Nonperforming assets as a  percent of total assets                                    | ** ** | **.17**        | ** **     | .21        |       | .22        |       | .27        |       | .29        |       |      |       |      |       |

 

----

(1),(2),(3) See Reconciliation of Non-GAAP measures on page 37 for additionalinformation.

 

33

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**Statementsof Consolidated Income**

(in thousands, except per share data)

 
| ** **                                               | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2Q 05**  | ** ** | **2Q 05**  | ** ** |
|----------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                               | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**     | ** ** | **vs**     | ** ** |
| ** **                                               | ** ** | **2Q 05**   | ** **  | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 05**  | ** ** | **2Q 04**  | ** ** |
| **INTEREST INCOME**                                      | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and fees on loans                               | ** ** | **$**       | **169,877** |       | $          | 152,544    |       | $          | 147,114    |       | $          | 138,117    |       | $          | 132,171    |   | 11.4 | % | 28.5 | % |
| Interest and dividends on  investment securities:        |       |        |        |       |       |       |       |       |       |       |       |       |       |       |       |
| Taxable interest income                                  | ** ** | **25,374**  |        | 24,992     |       | 25,809     |       | 26,048     |       | 26,165     |       | 1.5        |       | (3.0       | )          |
| Tax-exempt interest income                               | ** ** | **788**     |        | 721        |       | 766        |       | 803        |       | 820        |       | 9.3        |       | (3.9       | )          |
| Other investment income                                  | ** ** | **583**     |        | 644        |       | 1,157      |       | 472        |       | 352        |       | (9.5       | )          | 65.6       |       |
| ** **                                               |       | **26,745**  |        | 26,357     |       | 27,732     |       | 27,323     |       | 27,337     |       | 1.5        |       | (2.2       | )          |
| Other interest income                                    | ** ** | **442**     |        | 344        |       | 414        |       | 449        |       | 534        |       | 28.5       |       | (17.2      | )          |
| Total interest income                                    | ** ** | **197,064** |        | 179,245    |       | 175,260    |       | 165,889    |       | 160,042    |       | 9.9        |       | 23.1       |       |
| **INTEREST EXPENSE**                                     | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest on deposits                                     | ** ** | **31,384**  |        | 25,305     |       | 22,621     |       | 20,142     |       | 19,873     |       | 24.0       |       | 57.9       |       |
| Interest on short-term  borrowings                       | ** ** | **5,484**   |        | 4,042      |       | 2,955      |       | 1,990      |       | 1,480      |       | 35.7       |       | 270.5      |       |
| Interest on long-term debt                               | ** ** | **7,829**   |        | 6,815      |       | 5,974      |       | 5,575      |       | 5,205      |       | 14.9       |       | 50.4       |       |
| Total interest expense                                   | ** ** | **44,697**  |        | 36,162     |       | 31,550     |       | 27,707     |       | 26,558     |       | 23.6       |       | 68.3       |       |
|                                                     |       |        |        |       |       |       |       |       |       |       |       |       |       |       |       |
| **NET INTEREST INCOME**                                  | ** ** | **152,367** |        | 143,083    |       | 143,710    |       | 138,182    |       | 133,484    |       | 6.5        |       | 14.1       |       |
| Provision for loan losses                                | ** ** | **—**  |        | 756        |       | —     |       | 2,442      |       | 2,353      |       | (100.0     | )          | (100.0     | )          |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES** | ** ** | **152,367** |        | 142,327    |       | 143,710    |       | 135,740    |       | 131,131    |       | 7.1        |       | 16.2       |       |
| **NONINTEREST INCOME**                                   | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investment and wealth  management                        | ** ** | **23,780**  |        | 24,057     |       | 22,735     |       | 22,396     |       | 22,936     |       | (1.2       | )          | 3.7        |       |
| Service charges on deposit  accounts                     | ** ** | **11,088**  |        | 10,426     |       | 11,312     |       | 11,278     |       | 10,981     |       | 6.3        |       | 1.0        |       |
| Mortgage banking related fees                            | ** ** | **2,895**   |        | 2,283      |       | 3,199      |       | 3,063      |       | 2,293      |       | 26.8       |       | 26.3       |       |
| Investment securities gains and  (losses)                | ** ** | **99**      |        | 414        |       | 705        |       | (1         | )          | 590        |       | (76.1      | )          | (83.2      | )          |
| Nonmarketable investments                                | ** ** | **4,222**   |        | 5,271      |       | 4,001      |       | 2,767      |       | 450        |       | (19.9      | )          | 838.2      |       |
| Other income                                             | ** ** | **17,982**  |        | 15,418     |       | 13,776     |       | 14,418     |       | 13,876     |       | 16.6       |       | 29.6       |       |
| Total noninterest income                                 | ** ** | **60,066**  |        | 57,869     |       | 55,728     |       | 53,921     |       | 51,126     |       | 3.8        |       | 17.5       |       |
| **NONINTEREST EXPENSES**                                 | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries                                                 | ** ** | **50,180**  |        | 46,554     |       | 49,448     |       | 48,696     |       | 44,689     |       | 7.8        |       | 12.3       |       |
| Employee benefits                                        | ** ** | **11,956**  |        | 11,897     |       | 10,678     |       | 10,557     |       | 10,928     |       | 0.5        |       | 9.4        |       |
| Net occupancy expense of bank  premises                  | ** ** | **6,857**   |        | 6,922      |       | 6,300      |       | 6,128      |       | 5,819      |       | (0.9       | )          | 17.8       |       |
| Furniture and equipment  expenses                        | ** ** | **7,924**   |        | 7,279      |       | 8,566      |       | 7,936      |       | 7,573      |       | 8.9        |       | 4.6        |       |
| Communications and supplies                              | ** ** | **4,019**   |        | 4,040      |       | 4,294      |       | 4,111      |       | 4,195      |       | (0.5       | )          | (4.2       | )          |
| Other expenses                                           | ** ** | **22,977**  |        | 23,461     |       | 26,702     |       | 21,789     |       | 20,163     |       | (2.1       | )          | 14.0       |       |
| Total noninterest expenses                               | ** ** | **103,913** |        | 100,153    |       | 105,988    |       | 99,217     |       | 93,367     |       | 3.8        |       | 11.3       |       |
| Income before income taxes                               | ** ** | **108,520** |        | 100,043    |       | 93,450     |       | 90,444     |       | 88,890     |       | 8.5        |       | 22.1       |       |
| Applicable income taxes                                  | ** ** | **40,647**  |        | 37,416     |       | 32,838     |       | 33,659     |       | 32,577     |       | 8.6        |       | 24.8       |       |
| **NET INCOME**                                           | ** ** | **$**       | **67,873**  |       | $          | 62,627     |       | $          | 60,612     |       | $          | 56,785     |       | $          | 56,313     |   | 8.4 |   | 20.5 |   |
|                                                     |       |        |        |       |       |       |       |       |       |       |       |       |       |       |       |
| Weighted average shares  outstanding                     | ** ** | **80,514**  |        | 79,228     |       | 79,075     |       | 78,965     |       | 79,119     |       | 1.6        |       | 1.8        |       |
| Adjusted weighted average  shares outstanding            | ** ** | **81,161**  |        | 79,875     |       | 79,800     |       | 79,611     |       | 79,751     |       | 1.6        |       | 1.8        |       |
| **NET INCOME PER COMMON SHARE:**                         | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                    | ** ** | **$**       | **.84**     |       | $          | .79        |       | $          | .77        |       | $          | .72        |       | $          | .71        |   | 6.3 |   | 18.3 |   |
| Diluted                                                  | ** ** | **$**       | **.84**     |       | $          | .78        |       | $          | .76        |       | $          | .71        |       | $          | .71        |   | 7.7 |   | 18.3 |   |

 

34

----

 

**Statementsof Consolidated Noninterest Income and Noninterest Expenses**

(in thousands)

 
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2Q 05** | ** ** | **2Q 05** | ** ** |
|-------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| **Noninterest Income**                    | ** ** | **2Q 05**  | ** ** | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 05** | ** ** | **2Q 04** | ** ** |
| Investment and wealth  management         | ** ** | **$**      | **23,780** |       | $          | 24,057     |       | $          | 22,735     |       | $          | 22,396    |       | $         | 22,936     |   | (1.2 | )% | 3.7 | % |
| Service charges on deposit  accounts      | ** ** | **11,088** |       | 10,426     |       | 11,312     |       | 11,278     |       | 10,981     |       | 6.3       |       | 1.0       |       |
| Mortgage banking related fees:            |       |       |       |       |       |       |       |       |       |       |       |      |       |      |       |
| Commercial                                | ** ** | **2,092**  |       | 1,837      |       | 2,600      |       | 2,395      |       | 1,563      |       | 13.9      |       | 33.8      |       |
| Residential                               | ** ** | **803**    |       | 446        |       | 599        |       | 668        |       | 730        |       | 80.0      |       | 10.0      |       |
| Total mortgage banking related  fees      | ** ** | **2,895**  |       | 2,283      |       | 3,199      |       | 3,063      |       | 2,293      |       | 26.8      |       | 26.3      |       |
| Investment securities gains and  (losses) | ** ** | **99**     |       | 414        |       | 705        |       | (1         | )          | 590        |       | (76.1     | )          | (83.2     | )          |
| Nonmarketable investments                 |       |       |       |       |       |       |       |       |       |       |       |      |       |      |       |
| Private equity and other  investments     | ** ** | **4,569**  |       | 2,461      |       | 179        |       | 1,628      |       | 373        |       | 85.7      |       | 1,124.9   |       |
| Hedge funds                               | ** ** | **(1,245** | )          | 1,964      |       | 2,875      |       | 341        |       | (708       | )          | (163.4    | )          | (75.8     | )          |
| Bank-owned life insurance                 | ** ** | **898**    |       | 846        |       | 947        |       | 798        |       | 785        |       | 6.1       |       | 14.4      |       |
| Total nonmarketable investments           | ** ** | **4,222**  |       | 5,271      |       | 4,001      |       | 2,767      |       | 450        |       | (19.9     | )          | 838.2     |       |
| Other income:                             |       |       |       |       |       |       |       |       |       |       |       |      |       |      |       |
| Electronic banking fees                   | ** ** | **5,954**  |       | 5,173      |       | 5,312      |       | 6,029      |       | 6,008      |       | 15.1      |       | (0.9      | )          |
| Charges and fees on loans                 | ** ** | **3,020**  |       | 2,795      |       | 2,892      |       | 2,647      |       | 2,835      |       | 8.1       |       | 6.5       |       |
| Insurance                                 | ** ** | **3,558**  |       | 4,540      |       | 3,046      |       | 3,218      |       | 3,267      |       | (21.6     | )          | 8.9       |       |
| All other income                          | ** ** | **5,450**  |       | 2,910      |       | 2,526      |       | 2,524      |       | 1,766      |       | 87.3      |       | 208.6     |       |
| Total other income                        | ** ** | **17,982** |       | 15,418     |       | 13,776     |       | 14,418     |       | 13,876     |       | 16.6      |       | 29.6      |       |
| Total                                     | ** ** | **$**      | **60,066** |       | $          | 57,869     |       | $          | 55,728     |       | $          | 53,921    |       | $         | 51,126     |   | 3.8 |   | 17.5 |   |

 
| ** **                             | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2Q 05** | ** ** | **2Q 05** | ** ** |
|----------------------------------------|------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                             | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| **Noninterest Expenses**               | ** ** | **2Q 05**  | ** **  | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 05** | ** ** | **2Q 04** | ** ** |
| Salaries                               | ** ** | **$**      | **50,180**  |       | $          | 46,554     |       | $          | 49,448     |       | $          | 48,696    |       | $         | 44,689     |   | 7.8 | % | 12.3 | % |
| Employee benefits                      | ** ** | **11,956** |        | 11,897     |       | 10,678     |       | 10,557     |       | 10,928     |       | 0.5       |       | 9.4       |       |
| Net occupancy expense of bank premises | ** ** | **6,857**  |        | 6,922      |       | 6,300      |       | 6,128      |       | 5,819      |       | (0.9      | )          | 17.8      |       |
| Furniture and equipment  expenses      | ** ** | **7,924**  |        | 7,279      |       | 8,566      |       | 7,936      |       | 7,573      |       | 8.9       |       | 4.6       |       |
| Communications and supplies            | ** ** | **4,019**  |        | 4,040      |       | 4,294      |       | 4,111      |       | 4,195      |       | (0.5      | )          | (4.2      | )          |
| Other expenses:                        |       |       |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Professional services                  | ** ** | **4,882**  |        | 5,125      |       | 9,315      |       | 7,157      |       | 4,996      |       | (4.7      | )          | (2.3      | )          |
| Advertising and promotional  expenses  | ** ** | **2,677**  |        | 1,711      |       | 2,833      |       | 1,747      |       | 2,135      |       | 56.5      |       | 25.4      |       |
| Electronic banking expenses            | ** ** | **3,177**  |        | 3,241      |       | 3,051      |       | 3,299      |       | 3,006      |       | (2.0      | )          | 5.7       |       |
| Amortization of intangible  assets     | ** ** | **2,179**  |        | 2,072      |       | 2,009      |       | 2,044      |       | 2,057      |       | 5.2       |       | 5.9       |       |
| Outsourcing expenses                   | ** ** | **2,383**  |        | 2,690      |       | 1,305      |       | 1,351      |       | 1,227      |       | (11.4     | )          | 94.2      |       |
| All other expenses                     | ** ** | **7,679**  |        | 8,622      |       | 8,189      |       | 6,191      |       | 6,742      |       | (10.9     | )          | 13.9      |       |
| Total other expenses                   | ** ** | **22,977** |        | 23,461     |       | 26,702     |       | 21,789     |       | 20,163     |       | (2.1      | )          | 14.0      |       |
| Total                                  | ** ** | **$**      | **103,913** |       | $          | 100,153    |       | $          | 105,988    |       | $          | 99,217    |       | $         | 93,367     |   | 3.8 |   | 11.3 |   |

 

35

----

 

**ConsolidatedAverage Balance Sheets**

(in thousands)

 
|                                                    | ** ** | ** **     | ** **     | ** **   |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   | **Average Balance** |       |
|---------------------------------------------------------|------------|----------------|----------------|--------------|------------|-------------|------------|--------------|------------|-------------|------------|--------------|------------|-------------|------------|--------------|------------|-------------|------------|--------------|--------|---------------------|------------|
|                                                    | ** ** | **2Q 05**      |           | **1Q 05**    |       | **4Q 04**   |       | **3Q 04**    |       | **2Q 04**   |       | **2Q 05**    | ** ** | **2Q 05**   |       |
|                                                    | ** ** | **Average**    | ** **     | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** |   | **vs**              | ** ** | **vs** |   |
|                                                    | ** ** | **Balance**    | ** **     | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   |   | **1Q 05**           | ** ** | **2Q 04** |   |
| Earning assets                                          | ** ** | ** **     | ** **     | ** **   |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Loans:                                                  | ** ** | ** **     | ** **     | ** **   |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Commercial                                              | ** ** | **$**          | **2,926,234**  | ** **   | **6.31**   | %           | $          | 2,848,452    |       | 5.90        | %          | $            | 2,813,318  |        | 5.63       | %            | $          | 2,744,195   |       | 5.34         | %      | $                   | 2,719,232  |   | 5.15 | % | 2.7 | % | 7.6 | % |
| Commercial real estate                                  | ** ** | **3,363,924**  | ** **     | **6.51**     |       | 3,133,446   |       | 6.28         |       | 3,083,266   |       | 6.09         |       | 2,969,515   |       | 5.91         |       | 2,879,434   |       | 5.82         |   | 7.4                 |       | 16.8 |   |
| Construction                                            | ** ** | **1,442,621**  | ** **     | **6.66**     |       | 1,328,633   |       | 6.24         |       | 1,215,282   |       | 5.93         |       | 1,142,921   |       | 5.49         |       | 1,113,301   |       | 5.21         |   | 8.6                 |       | 29.6 |   |
| Residential real estate                                 | ** ** | **1,570,002**  | ** **     | **5.86**     |       | 1,517,291   |       | 5.83         |       | 1,488,523   |       | 5.84         |       | 1,490,763   |       | 5.80         |       | 1,437,331   |       | 5.91         |   | 3.5                 |       | 9.2 |   |
| Consumer                                                | ** ** | **1,596,482**  | ** **     | **5.90**     |       | 1,486,539   |       | 5.84         |       | 1,483,955   |       | 5.70         |       | 1,478,399   |       | 5.60         |       | 1,474,586   |       | 5.81         |   | 7.4                 |       | 8.3 |   |
| Total loans                                             | ** ** | **10,899,263** | ** **     | **6.29**     |       | 10,314,361  |       | 6.04         |       | 10,084,344  |       | 5.85         |       | 9,825,793   |       | 5.64         |       | 9,623,884   |       | 5.57         |   | 5.7                 |       | 13.3 |   |
| Federal funds sold, et al                               | ** ** | **40,904**     | ** **     | **4.33**     |       | 31,854      |       | 4.37         |       | 44,113      |       | 3.72         |       | 50,035      |       | 3.57         |       | 95,504      |       | 2.24         |   | 28.4                |       | (57.2 | ) |
| Securities: (2)                                         |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Taxable securities                                      |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| U.S. Treasury and gov. agencies                         | ** ** | **1,382,037**  | ** **     | **3.37**     |       | 1,426,230   |       | 3.43         |       | 1,532,514   |       | 3.53         |       | 1,571,102   |       | 3.59         |       | 1,543,661   |       | 3.74         |   | (3.1                | )          | (10.5 | ) |
| Mortgage-backed                                         | ** ** | **1,365,012**  | ** **     | **4.05**     |       | 1,303,700   |       | 4.02         |       | 1,243,520   |       | 3.90         |       | 1,228,539   |       | 3.84         |       | 1,254,512   |       | 3.78         |   | 4.7                 |       | 8.8 |   |
| Other investments                                       | ** ** | **65,051**     | ** **     | **3.63**     |       | 63,943      |       | 4.12         |       | 68,004      |       | 7.12         |       | 65,264      |       | 2.90         |       | 52,773      |       | 2.73         |   | 1.7                 |       | 23.3 |   |
| Tax-exempt securities                                   |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| States and political  subdivisions                      | ** ** | **88,537**     | ** **     | **5.90**     |       | 80,921      |       | 5.97         |       | 84,319      |       | 5.99         |       | 90,721      |       | 5.82         |       | 98,182      |       | 5.55         |   | 9.4                 |       | (9.8 | ) |
| Total securities                                        | ** ** | **2,900,637**  | ** **     | **3.77**     |       | 2,874,794   |       | 3.79         |       | 2,928,357   |       | 3.84         |       | 2,955,626   |       | 3.75         |       | 2,949,128   |       | 3.80         |   | 0.9                 |       | (1.6 | ) |
| Interest-bearing deposits in  other banks               | ** ** | **187**        | ** **     | **1.31**     |       | 158         |       | 1.47         |       | 158         |       | 1.45         |       | 158         |       | 1.08         |       | 158         |       | 1.06         |   | 18.4                |       | 18.4 |   |
| Total earning assets                                    | ** ** | **13,840,991** | ** **     | **5.76**     |       | 13,221,167  |       | 5.55         |       | 13,056,972  |       | 5.39         |       | 12,831,612  |       | 5.20         |       | 12,668,674  |       | 5.13         |   | 4.7                 |       | 9.3 |   |
| Cash and due from banks                                 | ** ** | **301,484**    |           |         |       | 290,911     |       |         |       | 285,742     |       |         |       | 296,203     |       |         |       | 298,440     |       |         |   | 3.6                 |       | 1.0 |   |
| Bank premises and equipment,  net                       | ** ** | **144,347**    |           |         |       | 141,426     |       |         |       | 140,556     |       |         |       | 141,536     |       |         |       | 141,757     |       |         |   | 2.1                 |       | 1.8 |   |
| Other assets                                            | ** ** | **1,099,607**  |           |         |       | 1,004,526   |       |         |       | 985,411     |       |         |       | 990,468     |       |         |       | 988,430     |       |         |   | 9.5                 |       | 11.2 |   |
| Less: allowance for loan losses                         | ** ** | **(152,858**   | )              |         |       | (149,686    | )          |         |       | (157,787    | )          |         |       | (160,331    | )          |         |       | (158,116    | )          |         |   | 2.1                 |       | (3.3 | ) |
| Total assets                                            | ** ** | **$**          | **15,233,571** |         |       |        | $          | 14,508,344   |       |        |       | $            | 14,310,894 |        |       |         | $          | 14,099,488  |       |         |   | $                   | 13,939,185 |   |   |   | 5.0 |   | 9.3 |   |
|                                                    |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Interest-bearing liabilities                            |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Deposits:                                               |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Savings                                                 | ** ** | **$**          | **1,463,960**  | ** **   | **.36**    |        | $          | 1,459,580    |       | .32         |       | $            | 1,445,223  |        | .30        |         | $          | 1,457,432   |       | .29          |   | $                   | 1,434,288  |   | .29 |   | 0.3 |   | 2.1 |   |
| Checking plus interest                                  | ** ** | **1,418,337**  | ** **     | **.16**      |       | 1,350,521   |       | .15          |       | 1,326,074   |       | .15          |       | 1,291,808   |       | .15          |       | 1,302,313   |       | .15          |   | 5.0                 |       | 8.9 |   |
| Money market                                            | ** ** | **1,574,422**  | ** **     | **1.15**     |       | 1,550,919   |       | .94          |       | 1,572,997   |       | .75          |       | 1,556,212   |       | .55          |       | 1,564,295   |       | .54          |   | 1.5                 |       | 0.6 |   |
| Time deposits $100,000 and over                         | ** ** | **1,618,161**  | ** **     | **2.97**     |       | 1,427,571   |       | 2.66         |       | 1,354,677   |       | 2.22         |       | 1,299,918   |       | 1.90         |       | 1,315,119   |       | 1.82         |   | 13.4                |       | 23.0 |   |
| Other time deposits                                     | ** ** | **2,060,974**  | ** **     | **2.54**     |       | 1,905,548   |       | 2.28         |       | 1,882,646   |       | 2.22         |       | 1,918,216   |       | 2.12         |       | 1,955,632   |       | 2.12         |   | 8.2                 |       | 5.4 |   |
| Total interest-bearing deposits                         | ** ** | **8,135,854**  | ** **     | **1.55**     |       | 7,694,139   |       | 1.33         |       | 7,581,617   |       | 1.19         |       | 7,523,586   |       | 1.07         |       | 7,571,647   |       | 1.06         |   | 5.7                 |       | 7.5 |   |
| Short-term borrowings                                   | ** ** | **1,021,281**  | ** **     | **2.15**     |       | 1,000,929   |       | 1.64         |       | 956,368     |       | 1.23         |       | 942,789     |       | .84          |       | 910,854     |       | .65          |   | 2.0                 |       | 12.1 |   |
| Long-term debt                                          | ** ** | **742,056**    | ** **     | **4.23**     |       | 689,372     |       | 4.01         |       | 642,675     |       | 3.70         |       | 641,264     |       | 3.46         |       | 648,576     |       | 3.23         |   | 7.6                 |       | 14.4 |   |
| Total interest-bearing funds                            | ** ** | **9,899,191**  | ** **     | **1.81**     |       | 9,384,440   |       | 1.56         |       | 9,180,660   |       | 1.37         |       | 9,107,639   |       | 1.21         |       | 9,131,077   |       | 1.17         |   | 5.5                 |       | 8.4 |   |
| Noninterest-bearing deposits                            | ** ** | **3,137,366**  |           |         |       | 3,024,595   |       |         |       | 3,094,316   |       |         |       | 2,984,130   |       |         |       | 2,826,610   |       |         |   | 3.7                 |       | 11.0 |   |
| Other liabilities and accrued  expenses                 | ** ** | **154,910**    |           |         |       | 149,033     |       |         |       | 124,767     |       |         |       | 129,875     |       |         |       | 129,737     |       |         |   | 3.9                 |       | 19.4 |   |
| Total liabilities                                       | ** ** | **13,191,467** |           |         |       | 12,558,068  |       |         |       | 12,399,743  |       |         |       | 12,221,644  |       |         |       | 12,087,424  |       |         |   | 5.0                 |       | 9.1 |   |
| Shareholders’ equity                               | ** ** | **2,042,104**  |           |         |       | 1,950,276   |       |         |       | 1,911,151   |       |         |       | 1,877,844   |       |         |       | 1,851,761   |       |         |   | 4.7                 |       | 10.3 |   |
| Total liabilities &  shareholders’ equity | ** ** | **$**          | **15,233,571** |         |       |        | $          | 14,508,344   |       |        |       | $            | 14,310,894 |        |       |         | $          | 14,099,488  |       |         |   | $                   | 13,939,185 |   |   |   | 5.0 |   | 9.3 |   |
|                                                    |       |           |           |         |       |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |   |                |       |   |   |
| Net interest rate spread                                | ** ** | ** **     |           | **3.95**     | %          |        |       | 3.99         | %          |        |       | 4.02         | %          |        |       | 3.99         | %          |        |       | 3.96         | %      |                |       |   |   |
| Effect of noninterest-bearing  funds                    | ** ** | ** **     |           | **.51**      |       |        |       | .45          |       |        |       | .41          |       |        |       | .35          |       |        |       | .33          |   |                |       |   |   |
| Net interest margin on earning  assets                  | ** ** | ** **     |           | **4.46**     | %          |        |       | 4.44         | %          |        |       | 4.43         | %          |        |       | 4.34         | %          |        |       | 4.29         | %      |                |       |   |   |

 

----

(1)          Presentedon a tax-equivalent basis using the statutory federal corporate income tax rateof 35% (see reconciliation of non-GAAP measures on page 37)

(2)          Nonaccrualloans are included in average loans

(3)          Balancesreported at amortized cost; excludes pretax unrealized gains (losses) onsecurities available-for-sale

 

36

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**Reconciliationof Non-GAAP Measures (unaudited)**

 
| ** **                                 | ** ** | **YTD**  | ** ** | **YTD**  |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|--------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(in thousands, except per share  data)** | ** ** | **2005** | ** ** | **2004** |   | **2Q 05**  | ** ** | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** |

 

(1)          Thenet interest margin and efficiency ratios are presented on a fullytax-equivalent (“FTE”) and annualized basis. The FTE basis adjusts for thetax-favored status of income from certain loans and investments.  Management believes this measure to be thepreferred industry measurement of the net interest income and provides arelevant comparison between taxable and non-taxable investments.

 
| Net interest income (GAAP  basis)         | ** ** | **$**     | **295,450** | ** ** | $      | 263,889   |       | **$** | **152,367** | ** ** | $      | 143,083 |   | $     | 143,710 |   | $ | 138,182 |   | $ | 133,484 |   |
|-------------------------------------------|------------|-----------|-------------|------------|--------|-----------|------------|-------|-------------|------------|--------|---------|--------|-------|---------|--------|---|---------|--------|---|---------|--------|
| Taxable-equivalent adjustment             | ** ** | **3,233** | ** **  | 3,400      |   | **1,656** | ** ** | 1,577 |        | 1,660      |   | 1,684   |   | 1,675 |    |
| Net interest income - taxable  equivalent | ** ** | **$**     | **298,683** | ** ** | $      | 267,289   |       | **$** | **154,023** | ** ** | $      | 144,660 |   | $     | 145,370 |   | $ | 139,866 |   | $ | 135,159 |   |

 

(2)          Managementexcludes the balance of intangible assets and their related amortizationexpense from its calculation of return on average tangible equity and averagetangible equity to average tangible assets. This adjustment allows managementto review the core operating results and core capital position of Bankshares.This is consistent with the treatment by bank regulatory agencies which excludegoodwill and other intangible assets from their calculation of risk-basedcapital ratios.

 
| Return on average equity (GAAP  basis)                          | ** ** | **13.18** | **%**      | 12.18  | %      | **13.33** | **%**      | 13.02  | %      | 12.62  | %      | 12.03  | %      | 12.23  | %      |
|-----------------------------------------------------------------|------------|-----------|------------|--------|--------|-----------|------------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding average  intangible assets and amortization | ** ** | **5.93**  | ** ** | 5.92   |   | **6.31**  | ** ** | 5.55   |   | 5.54   |   | 5.60   |   | 5.91   |   |
| Return on average tangible  equity                              | ** ** | **19.11** | **%**      | 18.10  | %      | **19.64** | **%**      | 18.57  | %      | 18.16  | %      | 17.63  | %      | 18.14  | %      |
|                                                            |       |      | ** ** |   |   |      | ** ** |   |   |   |   |   |   |   |   |
| Average equity to average  assets (GAAP basis)                  | ** ** | **13.42** | **%**      | 13.42  | %      | **13.41** | **%**      | 13.44  | %      | 13.35  | %      | 13.32  | %      | 13.28  | %      |
| Impact of excluding average  intangible assets and amortization | ** ** | **(3.59** | **)**      | (3.78  | )      | **(3.74** | **)**      | (3.44  | )      | (3.51  | )      | (3.65  | )      | (3.73  | )      |
| Average tangible equity to  average tangible assets             | ** ** | **9.83**  | **%**      | 9.64   | %      | **9.67**  | **%**      | 10.00  | %      | 9.84   | %      | 9.67   | %      | 9.55   | %      |

 

When computing the cashoperating efficiency ratio and cash operating earnings, management excludes theamortization of intangible assets, restructuring charges, merger-relatedexpenses, gains on sales of premises and gains and losses from sales ofinvestment securities in order to assess the core operating results ofBankshares and because of the uncertainty as to timing and amount of gain orlosses to be recognized.

 

(3)          Theefficiency ratio is measured by dividing noninterest expenses by the sum of netinterest income on a FTE basis and noninterest income.

 
| Efficiency ratio (GAAP basis)   | ** **                           | **48.98**  | **%**      | 50.26      | %     | **48.54** | **%**      | 49.45      | %      | 52.70  | %      | 51.20  | %      | 50.12  | %      |
|---------------------------------|--------------------------------------|------------|------------|------------|-------|-----------|------------|------------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding:            | Securities gains and (losses)        | ** ** | **0.06**   | ** ** | 0.07  |      | **0.02**   | ** ** | 0.10   |   | 0.18   |   | — |   | 0.16   |   |
|                            | Gains on sales of premises           | ** ** | **0.54**   | ** ** | 0.12  |      | **0.78**   | ** ** | 0.27   |   | 0.01   |   | 0.20   |   | 0.06   |   |
|                            | Amortization of deposit  intangibles | ** ** | **(0.68**  | **)**      | (0.74 | )         | **(0.69**  | **)**      | (0.67  | )      | (0.68  | )      | (0.71  | )      | (0.73  | ) |
|                            | Amortization of other  intangibles   | ** ** | **(0.35**  | **)**      | (0.36 | )         | **(0.34**  | **)**      | (0.35  | )      | (0.31  | )      | (0.35  | )      | (0.37  | ) |
|                            | Restructuring charges                |       | **—** | ** ** | (0.11 | )         | **—** | ** ** | — |   | (0.70  | )      | (1.38  | )      | (0.23  | ) |
|                            | Merger-related expenses              | ** ** | **(0.07**  | **)**      | (0.11 | )         | **(0.02**  | **)**      | (0.12  | )      | — |   | — |   | — |   |
| Cash operating efficiency ratio | ** **                           | **48.48**  | **%**      | 49.13      | %     | **48.29** | **%**      | 48.68      | %      | 51.20  | %      | 48.96  | %      | 49.01  | %      |

 

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

 
| Net income (GAAP basis)                    | ** **                                       | **$**      | **130,500** | ** ** | $      | 112,010 |       | **$**      | **67,873** | ** ** | $      | 62,627 |   | $      | 60,612 |   | $      | 56,785 |   | $      | 56,313 |   |
|--------------------------------------------|--------------------------------------------------|------------|-------------|------------|--------|---------|------------|------------|------------|------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Less:                                      | Securities (gains) and losses,  net of tax       | ** ** | **(310**    | **)**      | (323   | )       | **(60**    | **)**      | (250       | )          | (426   | )      | 1      |   | (357   | )      |
|                                       | Gains on sales of premises, net  of tax          | ** ** | **(2,741**  | **)**      | (583   | )       | **(2,048** | **)**      | (693       | )          | (26    | )      | (442   | )      | (144   | )      |
| Plus:                                      | Amortization of deposit  intangibles, net of tax | ** ** | **1,701**   | ** ** | 1,653  |    | **875**    | ** ** | 826        |       | 826    |   | 826    |   | 826    |   |
|                                       | Amortization of other  intangibles, net of tax   | ** ** | **868**     | ** ** | 819    |    | **442**    | ** ** | 426        |       | 388    |   | 409    |   | 417    |   |
|                                       | Restructuring charges, net of  tax               | ** ** | **—**  | ** ** | 251    |    | **—** | ** ** | —     |       | 850    |   | 1,610  |   | 251    |   |
|                                       | Merger-related expenses, net of  tax             | ** ** | **183**     | ** ** | 248    |    | **27**     | ** ** | 156        |       | — |   | — |   | — |   |
| Cash operating earnings                    | ** **                                       | **$**      | **130,201** | ** ** | $      | 114,075 |       | **$**      | **67,109** | ** ** | $      | 63,092 |   | $      | 62,224 |   | $      | 59,189 |   | $      | 57,306 |   |
|                                       |                                             |       | ** **  |       |   |    | ** ** |       |       |       |   |   |   |   |   |
| Diluted net income per share  (GAAP basis) | ** **                                       | **$**      | **1.62**    | ** ** | $      | 1.40    |       | **$**      | **0.84**   | ** ** | $      | 0.78   |   | $      | 0.76   |   | $      | 0.71   |   | $      | 0.71   |   |
| Less:                                      | Securities (gains) and losses,  net of tax       | ** ** | **—**  | ** ** | — |    | **—** | ** ** | —     |       | (0.01  | )      | — |   | — |   |
|                                       | Gains on sales of premises, net  of tax          | ** ** | **(0.03**   | **)**      | — |    | **(0.03**  | **)**      | (0.01      | )          | — |   | (0.01  | )      | — |   |
| Plus:                                      | Amortization of deposit intangibles,  net of tax | ** ** | **0.02**    | ** ** | 0.02   |    | **0.01**   | ** ** | 0.01       |       | 0.01   |   | 0.01   |   | 0.01   |   |
|                                       | Amortization of other  intangibles, net of tax   | ** ** | **0.01**    | ** ** | 0.01   |    | **0.01**   | ** ** | 0.01       |       | 0.01   |   | 0.01   |   | — |   |
|                                       | Restructuring charges, net of  tax               | ** ** | **—**  | ** ** | — |    | **—** | ** ** | —     |       | 0.01   |   | 0.02   |   | — |   |
|                                       | Merger-related expenses, net of  tax             |       | **—**  | ** ** | — |    | **—** | ** ** | —     |       | — |   | — |   | — |   |
| Diluted cash operating earnings  per share | ** **                                       | **1.62**   | ** **  | 1.43       |   | **$**   | **0.83**   | ** ** | $          | 0.79       |   | $      | 0.78   |   | $      | 0.74   |   | $      | 0.72   |   |

 

37

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# **Item 3. Quantitative andQualitative Disclosures About Market Risk**

 

Informationresponsive to this item as of December 31, 2005 appears under the captions“*Risk Management”, “Interest Rate SensitivityAnalysis (Static Gap)”* and*“Earnings SimulationModel Projections”* of the registrant’s Form 10-K for the yearended December 31, 2005. There was no material change in such informationas of June 30, 2005.

 

# **Item 4. Controls andProcedures**

 

Bankshares’management, under the supervision and with the participation of Bankshares’principal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures, (as that term is defined in Rules 13a-15(e) and 15d-15(e))under the Securities and Exchange Act of 1934, as amended)) Based on theevaluation, the principal executive officer and principal financial officerconcluded that Bankshares’ disclosure controls and procedures are effective asof the end of the period covered by this report.

 

There have notbeen any changes in Bankshares’ internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f)) under the Securities andExchange Act of 1934, as amended)) during the fiscal quarter to which thisreport relates that have materially affected, or are reasonably likely tomaterially affect, Bankshares’ internal control over financial reporting.

 

# **PART II – OTHERINFORMATION**

 

# **Item 1. LegalProceedings**

 

Between 2001 and2003, on behalf of either individual plaintiffs or a putative class ofplaintiffs, eight separate actions were filed in state and federal courtagainst Community Bank of Northern Virginia (“CBNV”) and other defendantschallenging the validity of second mortgage loans the defendants made to theplaintiffs.  All of the cases were eitherfiled in or removed to the federal district court for the Western District ofPennsylvania.  In June 2003, theparties to the various actions informed the court that they had reached anagreement in principle to settle the various actions.  On July 17, 2003, the court conditionallycertified a class for settlement purposes, preliminarily approved the classsettlement, and directed the issuance of notice to the class.

 

Thereafter,certain plaintiffs opted out of the proposed settlement and challenged thevalidity of the settlement in the district court.  The district court denied their arguments andapproved the settlement.  These “opt out”plaintiffs appealed the district court’s approval of the settlement to theThird Circuit Court of Appeals.  TheThird Circuit heard oral argument on February 17, 2005 and has not yetissued its decision. Certain individuals who were excluded from the settlementclass have filed two actions on behalf of a putative class of plaintiffsalleging claims similar to those raised in the initial filing.  These actions recently were consolidated inthe Western District of Pennsylvania. Bankshares believes these actions are without merit and intends todefend the actions vigorously.

 

**Item 4.****                       Submission of Matters to a Vote of SecurityHolders**

 

Matters voted upon andconsidered at the Annual Meeting of Shareholders held on May 10, 2005.There were 79,449,126 shares of Common Stock entitled to vote at the meetingand a total of 65,060,284 shares, or 81.9%, were represented at the meeting.

 

Elect thefollowing individuals as directors of Bankshares to serve until the 2008 AnnualMeeting of Stockholders and until successors are duly elected and qualify. Theresults of voting for election of directors were:

 
| ** **                     | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|--------------------------------|------------|------------|------------|--------------|------------|
| Eddie C. Brown                 |       | 64,425,523 |       | 634,759      |       |
| Anthony W. Deering             |       | 64,194,508 |       | 865,773      |       |
| Freeman A. Hrabowski, III |       | 62,175,695 |       | 2,884,587    |       |
| Jenny G. Morgan                |       | 64,353,623 |       | 706,658      |       |
| Clayton S. Rose                |       | 64,131,858 |       | 928,423      |       |
| Donald J. Shepard              |       | 63,887,579 |       | 1,172,702    |       |
| Jay M. Wilson                  |       | 64,316,546 |       | 743,735      |       |

 

38

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The following directors’terms of office continued after the meeting and they did not stand forreelection:

 

Cynthia A. Archer

R. Carl Benna

Richard O. Berndt

Howard B. Bowen

William R. Brody, M.D.

GeorgeL. Bunting, Jr.

DarrellD. Friedman

EdwardJ. Kelly, III

RobertA. Kinsley

AlexanderT. Mason

MortonB. Plant

ChristianH. Poindexter

JamesL. Shea

 

Ratified the appointmentof PricewaterhouseCoopers LLP as Bankshares’ Independent Public Accountant for2005. The voting results of shares represented by proxy were:

 
| **For**    | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker  nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|----------------------|------------|
| 64,062,859 |       | 789,644     |       | 207,275       |       | 505                  |       |

 

Approve the Mercantile Bankshares Corporation Stock Retainer and DeferredCompensation Plan for Non-Employee Directors were:

 

| **For**    | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker  nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|----------------------|------------|
| 48,668,962 |       | 3,693,648   |       | 1,070,062     |       | 11,627,611           |       |

 

 

**Item 6.****                       Exhibits**

 

Exhibits

 

31.1 Section 302Certification of Chief Executive Officer. Filed as an exhibit hereto andincorporated herein by reference

 

31.2 Section 302Certification of Chief Financial Officer. Filed as an exhibit hereto andincorporated herein by reference

 

32.1 Section 906Certification of Chief Executive Officer. Filed as an exhibit hereto andincorporated herein by reference

 

32.2 Section 906Certification of Chief Financial Officer. Filed as an exhibit hereto andincorporated herein by reference

 

**Signatures**

 

Pursuant to therequirements of the Securities Exchange Act of 1934 the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                     |   | **Mercantile Bankshares Corporation** |   |
|--------------------------|--------|---------------------------------------|--------|
|                     |   | (Registrant)                          |   |
|                     |   |                                  |   |
| July 29,  2005      |   | /s/ Edward J. Kelly, III         |   |
| Date                     |   | By: Edward J. Kelly, III         |   |
|                     |   | Chairman of the Board,                |   |
|                     |   | President and                         |   |
|                     |   | Chief Executive Officer               |   |
|                     |   |                                  |   |
|                     |   |                                  |   |
|  July 29, 2005 |   | /s/ Terry L. Troupe                   |   |
| Date                     |   | By: Terry L. Troupe                   |   |
|                     |   | Executive Vice President and          |   |
|                     |   | Chief Financial Officer               |   |
|                     |   |                                  |   |
|                     |   |                                  |   |
|  July 29, 2005 |   | /s/ William T. Skinner, Jr.      |   |
| Date                     |   | By: William T. Skinner, Jr.      |   |
|                     |   | Controller                            |   |

 

39

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