**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

** **

**FORM 10-Q**
| **(Mark One)** | ** ** | ** **                                                                                    |
|----------------|------------|-----------------------------------------------------------------------------------------------|
| **x**          | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  | ** ** | ** ** |
| ** **     | ** ** | ** **                                                                                    | ** ** | ** ** |
| ** **     | ** ** | **For the quarterly period ended****September 30, 2006**                                      | ** ** | ** ** |
| ** **     | ** ** | ** **                                                                                    | ** ** | ** ** |
| ** **     | ** ** | **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 |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**2 Hopkins Plaza**

**Baltimore, Maryland 21201**

(Address of principal executive offices) (Zip Code)

 

 

**(410) 237-5900**

(Registrant’s telephone number, including area code)

 

 

**NONE**

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

 

 

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

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

Large accelerated filer x                               Acceleratedfiler o                               Non-acceleratedfiler o

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

As of October 20, 2006, therewere 125,490,121 shares of registrant’s Common Stock, $2 par value per share,outstanding.

 

 

----

 

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

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

 

2

----

 

**PART I — FINANCIALINFORMATION**

**Item 1. FinancialStatements (Unaudited)**

**MERCANTILEBANKSHARES CORPORATIONCONSOLIDATED BALANCE SHEETS**

 
| **(Dollars in thousands, except per share data)**                                                                                       | ** ** | ** **     | ** **     | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------|----------------|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                            | ** ** | ** **     | ** **     | ** **                   | ** ** | ** **                  | ** ** |
| Cash and due from banks                                                                                                                                               | ** ** | **$**          | **318,184**    |                         | $          | 369,536                     |       | $                            | 328,964    |   |
| Interest-bearing  deposits in other banks                                                                                                                             | ** ** | **200**        |           | 200                          |       | 200                         |       |
| Federal funds sold                                                                                                                                                    | ** ** | **133,608**    |           | 25,104                       |       | 232,129                     |       |
| Total cash and  cash equivalents                                                                                                                                      | ** ** | **451,992**    |           | 394,840                      |       | 561,293                     |       |
| Investment securities  available-for-sale (Note 4)                                                                                                                    | ** ** | **3,126,770**  |           | 3,089,628                    |       | 3,048,846                   |       |
| Investment securities  held-to-maturity (Note 4) - fair value of $14,766 (September 2006), $17,181  (December 2005) and $17,380 (September 2005)                      | ** ** | **14,361**     |           | 16,659                       |       | 16,804                      |       |
| Total investment  securities                                                                                                                                          | ** ** | **3,141,131**  |           | 3,106,287                    |       | 3,065,650                   |       |
| Loans held-for-sale                                                                                                                                                   | ** ** | **1,930**      |           | 26,263                       |       | 42,307                      |       |
| Loans:                                                                                                                                                                |       |           |           |                         |       |                        |       |
| Commercial                                                                                                                                                            | ** ** | **2,925,300**  |           | 2,957,301                    |       | 2,925,445                   |       |
| Commercial real  estate                                                                                                                                               | ** ** | **4,148,895**  |           | 3,703,297                    |       | 3,638,238                   |       |
| Construction                                                                                                                                                          | ** ** | **1,952,013**  |           | 1,607,095                    |       | 1,543,633                   |       |
| Residential real  estate                                                                                                                                              | ** ** | **1,988,336**  |           | 1,802,373                    |       | 1,778,684                   |       |
| Home equity  lines                                                                                                                                                    | ** ** | **476,746**    |           | 505,508                      |       | 520,214                     |       |
| Consumer                                                                                                                                                              | ** ** | **1,043,048**  |           | 1,032,271                    |       | 1,039,845                   |       |
| Total loans                                                                                                                                                           | ** ** | **12,534,338** |           | 11,607,845                   |       | 11,446,059                  |       |
| Less: allowance for  loan losses                                                                                                                                      | ** ** | **(143,853**   | **)**          | (156,673                     | )          | (157,176                    | )          |
| Loans, net                                                                                                                                                            | ** ** | **12,390,485** |           | 11,451,172                   |       | 11,288,883                  |       |
| Bank premises and  equipment, less accumulated depreciation of $152,829 (September 2006),  $146,585 (December 2005) and $147,395 (September 2005)                     | ** ** | **142,664**    |           | 137,419                      |       | 146,615                     |       |
| Other real estate  owned, net                                                                                                                                         | ** ** | **67**         |           | 667                          |       | 777                         |       |
| Goodwill, net                                                                                                                                                         | ** ** | **760,347**    |           | 670,028                      |       | 670,306                     |       |
| Other intangible  assets, net (Note 8)                                                                                                                                | ** ** | **47,818**     |           | 46,653                       |       | 47,485                      |       |
| Other assets                                                                                                                                                          | ** ** | **638,813**    |           | 588,400                      |       | 580,138                     |       |
| Total assets                                                                                                                                                          | ** ** | **$**          | **17,575,247** |                         | $          | 16,421,729                  |       | $                            | 16,403,454 |   |
| **COMMITMENTS and CONTINGENCIES  (Note 7)**                                                                                                                           | ** ** | ** **     | ** **     | ** **                   | ** ** | ** **                  | ** ** |
| **LIABILITIES**                                                                                                                                                       | ** ** | ** **     | ** **     | ** **                   | ** ** | ** **                  | ** ** |
| Deposits:                                                                                                                                                             |       |           |           |                         |       |                        |       |
| Noninterest-bearing  deposits                                                                                                                                         | ** ** | **$**          | **3,301,554**  |                         | $          | 3,324,650                   |       | $                            | 3,329,331  |   |
| Interest-bearing  deposits                                                                                                                                            | ** ** | **9,473,557**  |           | 8,752,700                    |       | 8,710,575                   |       |
| Total deposits                                                                                                                                                        | ** ** | **12,775,111** |           | 12,077,350                   |       | 12,039,906                  |       |
| Short-term borrowings                                                                                                                                                 | ** ** | **1,558,710**  |           | 1,237,714                    |       | 1,266,672                   |       |
| Accrued expenses and  other liabilities                                                                                                                               | ** ** | **188,331**    |           | 169,780                      |       | 165,398                     |       |
| Long-term debt                                                                                                                                                        | ** ** | **659,688**    |           | 742,163                      |       | 780,087                     |       |
| Total  liabilities                                                                                                                                                    | ** ** | **15,181,840** |           | 14,227,007                   |       | 14,252,063                  |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                         | ** ** | ** **     | ** **     | ** **                   | ** ** | ** **                  | ** ** |
| Preferred stock, no par  value; authorized 2,000,000 shares; issued and outstanding - None                                                                            |       |           |           |                         |       |                        |       |
| Common stock, $2 par  value; authorized 200,000,000 shares; issued shares - 125,476,310 (September  2006), 82,165,414 (December 2005) and 82,078,721 (September 2005) |       | **250,953**    |           | 164,331                      |       | 164,157                     |       |
| Capital surplus                                                                                                                                                       | ** ** | **667,307**    |           | 676,830                      |       | 669,185                     |       |
| Retained earnings                                                                                                                                                     | ** ** | **1,503,226**  |           | 1,386,405                    |       | 1,343,076                   |       |
| Accumulated other  comprehensive loss                                                                                                                                 | ** ** | **(28,079**    | **)**          | (32,844                      | )          | (25,027                     | )          |
| Total  shareholders’ equity                                                                                                                                      | ** ** | **2,393,407**  |           | 2,194,722                    |       | 2,151,391                   |       |
| Total liabilities and  shareholders’ equity                                                                                                                      | ** ** | **$**          | **17,575,247** |                         | $          | 16,421,729                  |       | $                            | 16,403,454 |   |

 

See Notes to ConsolidatedFinancial Statements.

3

----

**MERCANTILEBANKSHARES CORPORATIONSTATEMENTS OF CONSOLIDATED INCOME**

 
| ** **                                                                      | ** ** | **For the 9 months ended  September 30,** | ** **  | **For the 3 months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|-------------|--------------------------------------------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | ** **                                                         | ** **  | **2006**                                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                      | ** ** | ** **                                                         | ** **  | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| **INTEREST  INCOME**                                                            |       |                                                               |        |                                                               |       |   |   |   |   |
| Interest and  fees on loans                                                     | ** ** | **$**                                                              | **628,369** |                                                               | $          | 508,135 | ** ** | **$** | **224,218** |   | $ | 185,714 |   |
| Interest and  dividends on investment securities:                               | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| Taxable interest income                                                         | ** ** | **93,323**                                                         |        | 77,052                                                             | ** ** | **32,393** |   | 26,686 |   |
| Tax-exempt interest income                                                      | ** ** | **2,273**                                                          |        | 2,348                                                              | ** ** | **730** |   | 839 |   |
| Other investment income                                                         | ** ** | **1,986**                                                          |        | 1,753                                                              | ** ** | **660** |   | 526 |   |
| Total interest and dividends on investment  securities                          | ** ** | **97,582**                                                         |        | 81,153                                                             | ** ** | **33,783** |   | 28,051 |   |
| Other interest  income                                                          | ** ** | **2,611**                                                          |        | 1,546                                                              | ** ** | **855** |   | 760 |   |
| Total interest income                                                           | ** ** | **728,562**                                                        |        | 590,834                                                            | ** ** | **258,856** |   | 214,525 |   |
|                                                                            | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| **INTEREST  EXPENSE**                                                           | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| Interest on  deposits                                                           | ** ** | **175,638**                                                        |        | 95,280                                                             | ** ** | **68,792** |   | 38,591 |   |
| Interest on  short-term borrowings                                              | ** ** | **39,738**                                                         |        | 17,228                                                             | ** ** | **15,215** |   | 7,702 |   |
| Interest on  long-term debt                                                     | ** ** | **27,394**                                                         |        | 23,634                                                             | ** ** | **8,780** |   | 8,990 |   |
| Total interest expense                                                          | ** ** | **242,770**                                                        |        | 136,142                                                            | ** ** | **92,787** |   | 55,283 |   |
|                                                                            | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| **NET  INTEREST INCOME**                                                        | ** ** | **485,792**                                                        |        | 454,692                                                            | ** ** | **166,069** |   | 159,242 |   |
| Provision for  credit losses                                                    | ** ** | **—**                                                         |        | 1,576                                                              | ** ** | **—** |   | 820 |   |
|                                                                            | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| **NET INTEREST  INCOME AFTER PROVISION FOR CREDIT LOSSES**                      | ** ** | **485,792**                                                        |        | 453,116                                                            | ** ** | **166,069** |   | 158,422 |   |
| ** **                                                                      |       |                                                               |        |                                                               |       |   |   |   |   |
| **NONINTEREST  INCOME**                                                         | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| Investment and  wealth management                                               | ** ** | **82,582**                                                         |        | 71,505                                                             | ** ** | **27,596** |   | 23,668 |   |
| Service charges  on deposit accounts                                            | ** ** | **33,936**                                                         |        | 32,992                                                             | ** ** | **12,776** |   | 11,478 |   |
| Mortgage banking  related fees                                                  | ** ** | **5,042**                                                          |        | 10,329                                                             | ** ** | **497** |   | 5,151 |   |
| Investment  securities gains (losses)                                           | ** ** | **205**                                                            |        | 458                                                                | ** ** | **218** |   | (32 | ) |
| Nonmarketable  investments                                                      | ** ** | **13,383**                                                         |        | 13,683                                                             | ** ** | **1,150** |   | 4,190 |   |
| Other income                                                                    | ** ** | **49,693**                                                         |        | 52,042                                                             | ** ** | **17,530** |   | 18,619 |   |
| Total noninterest income                                                        | ** ** | **184,841**                                                        |        | 181,009                                                            | ** ** | **59,767** |   | 63,074 |   |
|                                                                            | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| **NONINTEREST  EXPENSES**                                                       | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| Salaries                                                                        | ** ** | **147,755**                                                        |        | 148,482                                                            | ** ** | **51,424** |   | 51,748 |   |
| Employee  benefits                                                              | ** ** | **42,538**                                                         |        | 35,490                                                             | ** ** | **13,511** |   | 11,637 |   |
| Net occupancy  expense of bank premises                                         | ** ** | **23,991**                                                         |        | 20,918                                                             | ** ** | **8,289** |   | 7,139 |   |
| Furniture and  equipment expenses                                               | ** ** | **24,752**                                                         |        | 23,168                                                             | ** ** | **8,353** |   | 7,965 |   |
| Communications  and supplies                                                    | ** ** | **12,083**                                                         |        | 11,992                                                             | ** ** | **3,796** |   | 3,933 |   |
| Other expenses                                                                  | ** ** | **77,447**                                                         |        | 72,398                                                             | ** ** | **27,056** |   | 25,960 |   |
| Total noninterest expenses                                                      | ** ** | **328,566**                                                        |        | 312,448                                                            | ** ** | **112,429** |   | 108,382 |   |
| Income before  income taxes                                                     | ** ** | **342,067**                                                        |        | 321,677                                                            | ** ** | **113,407** |   | 113,114 |   |
| Applicable  income taxes                                                        | ** ** | **126,643**                                                        |        | 120,221                                                            | ** ** | **41,834** |   | 42,158 |   |
|                                                                            | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| **NET  INCOME**                                                                 | ** ** | **$**                                                              | **215,424** |                                                               | $          | 201,456 | ** ** | **$** | **71,573** |   | $ | 70,956 |   |
| ** **                                                                      | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| **NET  INCOME PER SHARE OF COMMON STOCK (Note 3):**                             | ** ** | ** **                                                         |        |                                                               | ** ** | ** ** |   |   |   |
| Basic                                                                           | ** ** | **$**                                                              | **1.74**    |                                                               | $          | 1.67 | ** ** | **$** | **0.57** |   | $ | 0.58 |   |
| Diluted                                                                         | ** ** | **$**                                                              | **1.73**    |                                                               | $          | 1.65 | ** ** | **$** | **0.57** |   | $ | 0.57 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                                             | ** ** | **$**                                                              | **0.82**    |                                                               | $          | 0.74 | ** ** | **$** | **0.28** |   | $ | 0.25 |   |
|                                                                                 |            |                                                                    |             |                                                                    |            |  |  |  |  |  |  |  |  |  |  |

 

See Notes to ConsolidatedFinancial Statements.

4

----

**MERCANTILEBANKSHARES CORPORATIONSTATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**
| ** **                                                                                             | ** ** | ** ** | **For  the 9 months ended September 30, 2006 and 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------|---------------------------------------------------------|------------|
| **(Dollars in thousands, except per share data)**                        | ** ** | ** ** | ** **                                              | **Total**  | ** ** | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** ** | **Accumulated   Other  Comprehensive  Income (Loss)** | ** ** |
|                                                                                                   |       |       |                                                    |       |   |   |   |   |   |   |   |
| BALANCE, DECEMBER 31,  2004                                                                            |       | $          | 1,917,683                                               |       | $ | 158,601 |   | $ | 530,705 |   | $ | 1,231,102 |   | $ | (2,725 | ) |
| Net income                                                                                             |       | 201,456    |                                                    |       |   |   |   | 201,456 |   |   |   |
| Unrealized losses on  securities available-for-sale, net of reclassification adjustment, net of  taxes |       | (22,302    | )                                                       |       |   |   |   |   |   | (22,302 | ) |
| Comprehensive income (Note  9)                                                                         |       | 179,154    |                                                    |       |   |   |   |   |   |   |   |
| Cash dividends paid:                                                                                   |       |       |                                                    |       |   |   |   |   |   |   |   |
| Common stock  ($0.74 per share)                                                                        |       | (89,017    | )                                                       |       |   |   |   | (89,017 | ) |   |   |
| 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 82,444  shares for dividend reinvestment and stock purchase plan                           |       | 4,098      |                                                    | 165        |   | 3,933 |   |   |   |   |   |
| Issuance of 17,550  shares for employee stock purchase dividend reinvestment plan                      |       | 873        |                                                    | 35         |   | 838 |   |   |   |   |   |
| Stock options                                                                                          |       |       |                                                    |       |   |   |   |   |   |   |   |
| Issuance of  181,808 shares                                                                            |       | 3,664      |                                                    | 364        |   | 3,300 |   |   |   |   |   |
| Expense                                                                                                |       | 2,519      |                                                    |       |   | 2,519 |   |   |   |   |   |
| Stock awards                                                                                           |       |       |                                                    |       |   |   |   |   |   |   |   |
| Issuance of  41,823 shares                                                                             |       | 2,211      |                                                    | 84         |   | 2,127 |   |   |   |   |   |
| Deferred  compensation                                                                                 |       | (2,242     | )                                                       |       |   |   |   | (2,242 | ) |   |   |
| Expense                                                                                                |       | 1,972      |                                                    |       |   |   |   | 1,972 |   |   |   |
| Directors’ deferred  compensation plan                                                            |       |       |                                                    |       |   |   |   |   |   |   |   |
| Issuance of  10,182 shares                                                                             |       | 439        |                                                    | 19         |   | 420 |   |   |   |   |   |
| Contribution                                                                                           |       | 520        |                                                    |       |   | 520 |   |   |   |   |   |
| Dividend                                                                                               |       | —     |                                                    |       |   | 195 |   | (195 | ) |   |   |
| BALANCE, SEPTEMBER 30,  2005                                                                           |       | $          | 2,151,391                                               |       | $ | 164,157 |   | $ | 669,185 |   | $ | 1,343,076 |   | $ | (25,027 | ) |
| BALANCE, DECEMBER 31,  2005                                                                            |       | $          | 2,194,722                                               |       | $ | 164,331 |   | $ | 676,830 |   | $ | 1,386,405 |   | $ | (32,844 | ) |
| Net income                                                                                             |       | 215,424    |                                                    |       |   |   |   | 215,424 |   |   |   |
| Unrealized gains on  securities available-for-sale, net of reclassification adjustment, net of  taxes  |       | 4,765      |                                                    |       |   |   |   |   |   | 4,765 |   |
| Comprehensive income  (Note 9)                                                                         |       | 220,189    |                                                    |       |   |   |   |   |   |   |   |
| Cash dividends paid                                                                                    |       |       |                                                    |       |   |   |   |   |   |   |   |
| Common stock  ($0.82 per share)                                                                        |       | (101,556   | )                                                       |       |   |   |   | (101,556 | ) |   |   |
| Issuance of 1,833,757  shares in connection with bank acquisition                                      |       | 63,140     |                                                    | 3,668      |   | 59,472 |   |   |   |   |   |
| Fair value of 138,066  converted options related to employee stock option plan of acquired bank        |       | 1,605      |                                                    |       |   | 1,605 |   |   |   |   |   |
| Issuance of 134,274  shares for dividend reinvestment and stock purchase plan                          |       | 4,706      |                                                    | 268        |   | 4,438 |   |   |   |   |   |
| Issuance of 26,505  shares for employee stock purchase dividend reinvestment plan                      |       | 996        |                                                    | 53         |   | 943 |   |   |   |   |   |
| Stock options                                                                                          |       |       |                                                    |       |   |   |   |   |   |   |   |
| Issuance of  107,767 shares                                                                            |       | 1,975      |                                                    | 216        |   | 1,759 |   |   |   |   |   |
| Expense                                                                                                |       | 2,219      |                                                    |       |   | 2,219 |   |   |   |   |   |
| Stock awards and units                                                                                 |       |       |                                                    |       |   |   |   |   |   |   |   |
| Issuance of  157,243 shares                                                                            |       | 189        |                                                    | 314        |   | (125 | ) |   |   |   |   |
| Repurchase of  38,471 shares for tax settlement                                                        |       | (1,477     | )                                                       | (77        | ) | (1,400 | ) |   |   |   |   |
| Expense                                                                                                |       | 5,748      |                                                    |       |   | 5,748 |   |   |   |   |   |
| Directors’ deferred  compensation plan                                                            |       |       |                                                    |       |   |   |   |   |   |   |   |
| Issuance of  4,995 shares                                                                              |       | 192        |                                                    | 10         |   | 182 |   |   |   |   |   |
| Contribution                                                                                           |       | 841        |                                                    |       |   | 841 |   |   |   |   |   |
| Dividend                                                                                               |       | —     |                                                    |       |   | 253 |   | (253 | ) |   |   |
| Adjustment for adoption  of SFAS No. 123R                                                              |       | —     |                                                    |       |   | (3,206 | ) | 3,206 |   |   |   |
| Issuance of 41,084,826  shares for a 3-for-2 stock split                                               |       | (82        | )                                                       | 82,170     |   | (82,252 | ) |   |   |   |   |
| **BALANCE, SEPTEMBER 30, 2006**                                                                        | ** ** | **$**      | **2,393,407**                                           | ** ** | **$** | **250,953** | ** ** | **$** | **667,307** | ** ** | **$** | **1,503,226** | ** ** | **$** | **(28,079** | **)** |

See Notes to ConsolidatedFinancial Statements.

5

----

**MERCANTILEBANKSHARES CORPORATIONSTATEMENTS OF CONSOLIDATED CASH FLOWS**

 
| ** **                                                                                                           | ** ** | **For the 9 months ended September 30,** | ** **  |
|----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|-------------|
| **Increase (decrease) in cash and cash equivalents  (Dollars in thousands)** | ** ** | ** **                                                             | ** **  | **2006** | ** ** | **2005** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                                           |       |                                                                   |        |   |   |
| Net income                                                                                                           | ** ** | **$**                                                                  | **215,424** |   | $ | 201,456 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                   |       |                                                                   |        |   |   |
| Provision for credit losses                                                                                          | ** ** | **—**                                                             |        | 1,576 |   |
| Depreciation                                                                                                         | ** ** | **11,857**                                                             |        | 11,581 |   |
| Amortization of other intangible assets                                                                              | ** ** | **7,064**                                                              |        | 6,482 |   |
| Tax benefit from the issuance of stock-based awards                                                                  | ** ** | **115**                                                                |        | 83 |   |
| Write-downs of other real estate owned                                                                               | ** ** | **—**                                                             |        | 1 |   |
| Gains on sales of other real estate owned                                                                            | ** ** | **(7**                                                                 | **)**       | (153 | ) |
| Gains on sales of investments securities                                                                             | ** ** | **(205**                                                               | **)**       | (458 | ) |
| Gains on sales of premises                                                                                           | ** ** | **(103**                                                               | **)**       | (4,341 | ) |
| Net (increase) decrease in assets:                                                                                   |       |                                                                   |        |   |   |
| Loans held-for-sale                                                                                                  | ** ** | **25,568**                                                             |        | (31,307 | ) |
| Interest receivable                                                                                                  | ** ** | **(11,975**                                                            | **)**       | (9,332 | ) |
| Nonmarketable investments                                                                                            | ** ** | **(8,964**                                                             | **)**       | 11,912 |   |
| Other assets                                                                                                         | ** ** | **(13,246**                                                            | )           | (80 | ) |
| Net increase (decrease) in liabilities:                                                                              |       |                                                                   |        |   |   |
| Interest payable                                                                                                     | ** ** | **19,359**                                                             |        | 13,710 |   |
| Other liabilities                                                                                                    | ** ** | **(15,502**                                                            | **)**       | (11,871 | ) |
| Net cash provided by operating activities                                                                            | ** ** | **229,385**                                                            |        | 189,259 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                           |       |                                                                   |        |   |   |
| Proceeds from  maturities of investment securities held-to-maturity                                                  | ** ** | **2,298**                                                              |        | 3,372 |   |
| Proceeds from  maturities of investment securities available-for-sale                                                | ** ** | **705,128**                                                            |        | 655,641 |   |
| Proceeds from  sales of investment securities available-for-sale                                                     | ** ** | **101,670**                                                            |        | 121,207 |   |
| Purchases of  investment securities available-for-sale                                                               | ** ** | **(723,014**                                                           | **)**       | (782,084 | ) |
| Net increase in  customer loans                                                                                      | ** ** | **(511,661**                                                           | **)**       | (551,290 | ) |
| Proceeds from  sales of other real estate owned                                                                      | ** ** | **2,241**                                                              |        | 273 |   |
| Capital  expenditures                                                                                                | ** ** | **(16,117**                                                            | **)**       | (12,878 | ) |
| Proceeds from  sales of premises                                                                                     | ** ** | **536**                                                                |        | 7,981 |   |
| Proceeds from sale  of interest in Ltd Partnership                                                                   | ** ** | **6,705**                                                              |        | — |   |
| Business  acquisitions (net of cash received)                                                                        | ** ** | **(61,251**                                                            | **)**       | (78,655 | ) |
| Business  acquisitions contingent consideration                                                                      | ** ** | **(8,806**                                                             | **)**       | — |   |
| Purchase of  nonmarketable investments                                                                               | ** ** | **(12,112**                                                            | **)**       | (57,105 | ) |
| Net cash used in investing activities                                                                                | ** ** | **(514,383**                                                           | **)**       | (693,538 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                           |       |                                                                   |        |   |   |
| Net (decrease)  increase in noninterest-bearing deposits                                                             | ** ** | **(118,812**                                                           | **)**       | 172,450 |   |
| Net increase in  interest-bearing deposits                                                                           | ** ** | **383,457**                                                            |        | 442,943 |   |
| Net increase in  short-term borrowings                                                                               | ** ** | **266,837**                                                            |        | 369,109 |   |
| Repayment of  long-term debt                                                                                         | ** ** | **(95,362**                                                            | **)**       | (84,659 | ) |
| Tax benefit from  the issuance of stock-based awards                                                                 | ** ** | **1,040**                                                              |        | 530 |   |
| Excess tax  benefit related to stock-based awards                                                                    | ** ** | **346**                                                                |        | 447 |   |
| Proceeds from  issuance of shares                                                                                    | ** ** | **7,677**                                                              |        | 8,635 |   |
| Repurchase of  common shares                                                                                         | ** ** | **(1,477**                                                             | **)**       | — |   |
| Dividends paid                                                                                                       | ** ** | **(101,556**                                                           | **)**       | (89,017 | ) |
| Net cash provided by financing activities                                                                            | ** ** | **342,150**                                                            |        | 820,438 |   |
| Net increase in  cash and cash equivalents                                                                           | ** ** | **57,152**                                                             |        | 316,159 |   |
| Cash and cash  equivalents at beginning of period                                                                    | ** ** | **394,840**                                                            |        | 245,134 |   |
| Cash and cash  equivalents at end of period                                                                          | ** ** | **$**                                                                  | **451,992** |   | $ | 561,293 |   |
| **SUPPLEMENTAL  INFORMATION**                                                                                        |       |                                                                   |        |   |   |
| Cash payments  for interest                                                                                          | ** ** | **$**                                                                  | **222,237** |   | $ | 121,081 |   |
| Cash payments for  income taxes                                                                                      | ** ** | **135,974**                                                            |        | 133,745 |   |
|                                                                                                                      |            |                                                                        |             |  |  |  |  |  |  |

 

See Notes to ConsolidatedFinancial Statements.

 

6

----

 

**MERCANTILEBANKSHARES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

1.  Basis of Presentation

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

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimates and assumptions that affect thereported amounts of assets and liabilities and contingent assets andliabilities in the financial statements, and the disclosure of revenue andexpenses during the reporting period. These assumptions are based on information available as of the date ofthe financial statements and could differ from actual results.  See Bankshares’ Annual Report on Form 10-Kfor more detail.

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

2.  Business Combinations / Restructuring

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

OnJuly 17, 2006, Bankshares completed its acquisition of James Monroe Bancorp,Inc. (“James Monroe”), an Arlington, Virginia-based commercial bank.  James Monroe was merged into Mercantile-SafeDeposit & Trust Company (“MSD&T”). At the time of the acquisition, James Monroe operated six full-servicebranches and a loan production office located in Northern Virginia and suburbanWashington, D.C.  The total considerationpaid to James Monroe shareholders in connection with the acquisition was $71.4million in cash and 1.8 million shares of Bankshares’ common stock.  The results of James Monroe’s operations havebeen included in Bankshares’ financial results subsequent to July 17,2006.  The assets and liabilities ofJames Monroe were recorded on the Consolidated Balance Sheet at theirrespective fair values.  The fair valueshave been determined as of July 17, 2006 and are subject to refinement, asfurther information becomes available. The transaction resulted in total assets acquired of $552 million,including $414 million in gross loans; and liabilities assumed of $507 million,including $434 million in total deposits. Additionally, Bankshares preliminarily recorded $87.0 million ofgoodwill.  Intangible assets subject to amortizationare being amortized on an accelerated basis.

Bankshares’exit costs, referred to herein as “merger-related” costs, are defined toinclude those costs for branch closings and related severance, combiningoperations such as systems conversions, and printing and mailing costs incurredby Bankshares prior to and after the merger date and are included in Bankshares’results of operations.  Banksharesexpensed merger-related costs totaling $0.7 million for the three month periodended September 30, 2006.  The costsassociated with these activities are included in noninterest expense.  Merger-related expenses incurred to dateconsisted largely of expenses for systems conversion costs.  Bankshares will incur additionalmerger-related expenses of $1.5 million during the fourth quarter of 2006 andthe first quarter of 2007 as systems conversions, branch closings andintegration of operations continue and these expenses will be recorded whenincurred.

7

----

3.  Earnings per Share

Basicearnings per share (“EPS”) are computed by dividing income available to commonshareholders by weighted average common shares outstanding.  Diluted EPS are computed using the samecomponents as basic EPS with the denominator adjusted for the dilutive effectof weighted average common shares from the various share-based compensationplans.  The following tables providereconciliations between the computation of basic EPS and diluted EPS for thenine and three months ended September 30, 2006 and 2005, respectively.

 
| ** **                                                         | ** ** | **For the 9 months ended September 30,** | ** **  |
|--------------------------------------------------------------------|------------|------------------------------------------------------------------------|-------------|
| ** **                                                         | ** ** | **2006**                                                               | ** **  | **2005** | ** ** |
| **(In thousands, except per share data)** | ** ** | ** **                                                             | ** **  | **Net  Income** | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                          | ** ** | **$**                                                                  | **215,424** | ** ** | **123,678** | ** ** | **$** | **1.74** |   | $ | 201,456 |   | 120,818 |   | $ | 1.67 |   |
| Dilutive effect  of :                                              |       |                                                                   |        |   |   |   |   |   |   |   |   |   |   |
| Stock options                                                      | ** ** | ** **                                                             |        | **760** |   |   |   |   |   | 635 |   |   |   |
| Restricted stock awards and units                                  | ** ** | ** **                                                             |        | **109** |   |   |   |   |   | 113 |   |   |   |
| Vested directors’ deferred compensation plan shares           | ** ** | ** **                                                             |        | **295** |   |   |   |   |   | 258 |   |   |   |
| Diluted EPS                                                        | ** ** | **$**                                                                  | **215,424** | ** ** | **124,842** | ** ** | **$** | **1.73** |   | $ | 201,456 |   | 121,824 |   | $ | 1.65 |   |
|                                                                    |            |                                                                        |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                         | ** ** | **For the 3 months ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| **(In thousands, except per share data)** | ** ** | ** **                                                             | ** ** | **Net  Income** | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Common  Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                          | ** ** | **$**                                                                  | **71,573** | ** ** | **124,750** | ** ** | **$** | **0.57** |   | $ | 70,956 |   | 122,797 |   | $ | 0.58 |   |
| Dilutive effect  of :                                              |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Stock options                                                      | ** ** | ** **                                                             |       | **742** |   |   |   |   |   | 776 |   |   |   |
| Restricted stock awards and units                                  | ** ** | ** **                                                             |       | **100** |   |   |   |   |   | 116 |   |   |   |
| Vested directors’ deferred compensation plan shares           | ** ** | ** **                                                             |       | **301** |   |   |   |   |   | 264 |   |   |   |
| Diluted EPS                                                        | ** ** | **$**                                                                  | **71,573** | ** ** | **125,893** | ** ** | **$** | **$0.57** |   | $ | 70,956 |   | 123,953 |   | $ | 0.57 |   |
|                                                                    |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Antidilutiveweighted average common shares from the various share-based compensation plansexcluded from the computation of diluted earnings per share were 430,857 and666,503 for the nine months and three months ended September 30, 2006.  There were no antidilutive weighted averagecommon shares excluded from the computation of diluted earnings per share forthe nine months and three months ended September 30, 2005.

8

----

4.  Investment Securities

AtSeptember 30, 2006 and December 31, 2005, securities with an amortized cost of$1.5 billion and $1.3 billion, respectively, were pledged as collateral forrepurchase transactions and certain deposits as required by regulatoryguidelines.  The following table showsthe amortized cost and fair value of investment securities at September 30,2006 and December 31, 2005.

 
| ** **                                | ** ** | **September 30, 2006** | ** **    | **December 31, 2005** | ** ** |
|-------------------------------------------|------------|----------------------------------|---------------|---------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | ** **                       | ** **    | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Investment  securities held-to-maturity   | ** ** | ** **                       | ** **    | ** **                      | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| States and political subdivisions         | ** ** | **$**                            | **14,361**    | ** **                      | **$**      | **425** | ** ** | **$** | **20** | ** ** | **$** | **14,766** |   | $ | 16,659 |   | $ | 541 |   | $ | 19 |   | $ | 17,181 |   |
|                                      |       |                             |          |                            |       |   | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Investment  securities available-for-sale |       |                             |          |                            |       |   | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                             | ** ** | **$**                            | **409,137**   | ** **                      | **$**      | **512** | ** ** | **$** | **2,041** | ** ** | **$** | **407,608** |   | $ | 434,893 |   | $ | 223 |   | $ | 3,080 |   | $ | 432,036 |   |
| U.S. Government agencies                  | ** ** | **928,550**                      | ** **    | **240**                         | ** ** | **7,996** | ** ** | **920,794** |   | 992,040 |   | 29 |   | 12,761 |   | 979,308 |   |
| Mortgage-backed securities                | ** ** | **1,710,596**                    | ** **    | **2,116**                       | ** ** | **37,791** | ** ** | **1,674,921** |   | 1,581,845 |   | 685 |   | 38,269 |   | 1,544,261 |   |
| States and political subdivisions         | ** ** | **61,542**                       | ** **    | **255**                         | ** ** | **127** | ** ** | **61,670** |   | 70,017 |   | 306 |   | 188 |   | 70,135 |   |
| Other bonds, notes and debentures         | ** ** | **11,678**                       | ** **    | **—**                      | ** ** | **129** | ** ** | **11,549** |   | 19,083 |   | — |   | 215 |   | 18,868 |   |
| Total bonds                               | ** ** | **3,121,503**                    | ** **    | **3,123**                       | ** ** | **48,084** | ** ** | **3,076,542** |   | 3,097,878 |   | 1,243 |   | 54,513 |   | 3,044,608 |   |
| Other  investments                        | ** ** | **49,597**                       | ** **    | **1,118**                       | ** ** | **487** | ** ** | **50,228** |   | 43,980 |   | 1,236 |   | 196 |   | 45,020 |   |
| Total                                     | ** ** | **$**                            | **3,171,100** | ** **                      | **$**      | **4,241** | ** ** | **$** | **48,571** | ** ** | **$** | **3,126,770** |   | $ | 3,141,858 |   | $ | 2,479 |   | $ | 54,709 |   | $ | 3,089,628 |   |
|                                           |            |                                  |               |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table shows the unrealized gross losses and fair value of securitiesin the securities available-for-sale portfolio at September 30, 2006, by lengthof time that individual securities in each category have been in a continuousloss position.

 
| ** **                           | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**       | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                             | ** ** | **Gross  Unrealized  Losses**        | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| U.S. Treasury                        |       | $                                      | 94         |                                 | $          | 229,867         |       | $ | 1,947 |   | $ | 177,741 |   | $ | 2,041 |   | $ | 407,608 |   |
| U.S. Government  agencies            |       | 709                                    |       | 331,626                              |       | 7,287           |       | 589,168 |   | 7,996 |   | 920,794 |   |
| Mortgage-backed  securities          |       | 2,632                                  |       | 610,473                              |       | 35,159          |       | 1,064,448 |   | 37,791 |   | 1,674,921 |   |
| States and political  subdivisions   |       | 29                                     |       | 45,862                               |       | 98              |       | 15,808 |   | 127 |   | 61,670 |   |
| Other bonds, notes and  debentures   |       | 29                                     |       | 5,497                                |       | 100             |       | 6,052 |   | 129 |   | 11,549 |   |
| Total bonds                          |       | 3,493                                  |       | 1,223,325                            |       | 44,591          |       | 1,853,217 |   | 48,084 |   | 3,076,542 |   |
| Other investments                    |       | 181                                    |       | 35,934                               |       | 306             |       | 14,294 |   | 487 |   | 50,228 |   |
| Total                                |       | $                                      | 3,674      |                                 | $          | 1,259,259       |       | $ | 44,897 |   | $ | 1,867,511 |   | $ | 48,571 |   | $ | 3,126,770 |   |
|                                      |            |                                        |            |                                      |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

AtSeptember 30, 2006, there were $1.9 billion of individual securities that hadunrealized losses for a period greater than 12 months.  At September 30, 2006, these securities hadan unrealized loss of $44.9 million of which approximately 57% weremortgage-backed securities. Management has assessed the impairment of thesesecurities and determined that the impairment is temporary.  All principal and interest payments onavailable-for-sale debt securities in an unrealized loss position for greaterthan 12 months are expected to be collected given the high credit quality ofthe U.S. government agency debt securities and Bankshares’ ability and intentto hold the securities until the value recovers or they mature.

9

----

# 5.  Allowance for Loan Losses and Reserve forUnfunded Commitments

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

Banksharesreclassified $14.0 million and $1.9 million in the first and third quarters of2006, respectively, of the allowance for loan losses to the reserve forunfunded commitments.  The third quarterreclassification resulted from a refinement in the manner in which the requiredreserves for unfunded commitments were calculated.  The acquired allowance from James Monroe wasapproximately $4.0 million.

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

| ** **                                    | ** ** | **For the 9 months ended September 30,** | ** **  | **For the 3 months ended September 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------------------|-------------|------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**          | ** ** | ** **                                                             | ** **  | **2006**                                                               | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Allowance  for Loan Losses**                | ** ** | ** **                                                             |        |                                                                   | ** ** | ** ** |   |   |   |
| Balance,  beginning of period                 | ** ** | **$**                                                                  | **156,673** |                                                                   | $          | 149,002 | ** ** | **$** | **142,860** |   | $ | 157,101 |   |
| Allowance of  acquired bank                   | ** ** | **3,985**                                                              |        | 7,086                                                                  | ** ** | **3,985** |   | — |   |
| Provision for  credit losses                  | ** ** | **(990**                                                               | **)**       | 1,576                                                                  | ** ** | **—** |   | 820 |   |
| Transfer to  reserve for unfunded commitments | ** ** | **(15,824**                                                            | **)**       | —                                                                 | ** ** | **(1,856** | **)** | — |   |
| Total                                         | ** ** | **143,844**                                                            |        | 157,664                                                                | ** ** | **144,989** |   | 157,921 |   |
| Charge-offs                                   | ** ** | **(4,137**                                                             | **)**       | (4,825                                                                 | )          | **(1,909** | **)** | (1,710 | ) |
| Recoveries                                    | ** ** | **4,146**                                                              |        | 4,337                                                                  | ** ** | **773** |   | 965 |   |
| Net recoveries (charge-offs)                  | ** ** | **9**                                                                  |        | (488                                                                   | )          | **(1,136** | **)** | (745 | ) |
| Balance, end of  period                       | ** ** | **$**                                                                  | **143,853** |                                                                   | $          | 157,176 | ** ** | **$** | **143,853** |   | $ | 157,176 |   |
|                                          |       |                                                                   |        |                                                                   |       |   |   |   |   |
| **Reserve  for Unfunded Commitments**         |       |                                                                   |        |                                                                   |       |   |   |   |   |
| Balance,  beginning of period                 | ** ** | **$**                                                                  | **—**  |                                                                   | $          | — | ** ** | **$** | **14,958** |   | $ | — |   |
| Provision for  credit losses                  | ** ** | **990**                                                                |        | —                                                                 | ** ** | **—** |   | — |   |
| Transfer from  allowance for loan losses      | ** ** | **15,824**                                                             |        | —                                                                 | ** ** | **1,856** |   | — |   |
| Balance, end of period                        | ** ** | **$**                                                                  | **16,814**  |                                                                   | $          | — | ** ** | **$** | **16,814** |   | $ | — |   |
|                                               |            |                                                                        |             |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

#  

# 6.  Impaired Loans

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

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

10

----

 
| **(Dollars in thousands)**                                             | ** ** | ** **  | ** **  | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------|-------------|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Impaired loans  with a specific valuation allowance                              | ** ** | **$**       | **2,488**   |                         | $          | 11,512                      |       | $                            | 15,579     |   |
| All other  impaired loans                                                        | ** ** | **30,293**  |        | 9,086                        |       | 9,103                       |       |
| Total impaired loans                                                             | ** ** | **$**       | **32,781**  |                         | $          | 20,598                      |       | $                            | 24,682     |   |
|                                                                             | ** ** | ** **  |        |                         |       |                        |       |
| Specific  allowance for loan losses applicable to impaired loans                 | ** ** | **$**       | **1,755**   |                         | $          | 4,150                       |       | $                            | 8,671      |   |
| General  allowance for loan losses applicable to other than impaired loans       | ** ** | **142,098** |        | 152,523                      |       | 148,505                     |       |
| Total allowance for loan losses                                                  | ** ** | **$**       | **143,853** |                         | $          | 156,673                     |       | $                            | 157,176    |   |
|                                                                             | ** ** | ** **  |        |                         |       |                        |       |
| Year-to-date  interest income on impaired loans recorded on the cash basis       | ** ** | **$**       | **106**     |                         | $          | 128                         |       | $                            | 114        |   |
| Year-to-date  average recorded investment in impaired loans during the period    | ** ** | **$**       | **23,970**  |                         | $          | 26,703                      |       | $                            | 27,332     |   |
| Quarter-to-date  interest income on impaired loans recorded on the cash basis    | ** ** | **$**       | **30**      |                         | $          | 14                          |       | $                            | 61         |   |
| Quarter-to-date average  recorded investment in impaired loans during the period | ** ** | **$**       | **27,016**  |                         | $          | 24,817                      |       | $                            | 26,223     |   |

 

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

Therewere no loans associated with the James Monroe acquisition that were within thescope of the American Institute of Certified Public Accountants issuedStatement of Position (“SOP”) 03-3, “Accounting for Certain Loans or DebtSecurities Acquired in a Transfer.”  Aspart of the Community Bank of Northern Virginia (“CBNV”) acquisition, twocommercial real estate loans totaling $4.9 million were within the scope of SOP03-3.  One of the loans was subsequentlypaid in full and the remaining loan is deemed to be immaterial for purposes ofthe required disclosures.

7.  Commitments and Contingencies 

Banksharesis a party to financial instruments that are not recorded in the balance sheet,which include commitments to extend credit and standby letters of credit.  Various commitments to extend credit (linesof credit) are made in the normal course of banking business.  Letters of credit are issued for the benefitof customers by affiliated banks.  Thesecommitments are subject to loan underwriting standards and geographicboundaries consistent with Bankshares’ loans outstanding. Bankshares’ lendingactivities are concentrated in Maryland, Delaware and Virginia.

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected toexpire without being drawn upon, the total commitment amounts do not necessarilyrepresent future cash requirements.  Totalcommitments to extend credit were $5.1 billion at September 30, 2006, $4.8billion at December 31, 2005, and $4.6 billion at September 30, 2005.

Lettersof credit are commitments issued to guarantee the performance of a customer toa third party.  Outstanding letters ofcredit were $575.8 million at September 30, 2006, $540.6 million at December31, 2005 and $506.8 million at September 30, 2005.  Fees received for issuing letters of creditare deferred and amortized over the life of the commitment.  The unamortized fees on letters of credit atSeptember 30, 2006, December 31, 2005, and September 30, 2005 had a carryingvalue of $2.5 million, $2.7 million and $2.5 million, respectively.

11

----

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 $278.7 million,$249.8 million and $237.2 million at September 30, 2006, December 31, 2005 andSeptember 30, 2005, respectively.  Theloss reserve for potential losses on loans originated and sold in the secondarymarket was $100.2 thousand and $60.7 thousand at September 30, 2006 andDecember 31, 2005, respectively.  Themortgage subsidiary also has originated and sold loans with recourse in theevent of foreclosure on the underlying real estate.

Bankshareshas committed to invest funds in third-party private equity investments.  At September 30, 2006, December 31, 2005 andSeptember 30, 2005, $31.1 million, $26.6 million and $28.1 million,respectively, remained unfunded.

Inthe ordinary course of business, Bankshares and its subsidiaries are involvedin a number of pending and threatened legal actions and proceedings.  In certain of these actions and proceedings,claims for substantial monetary damages are asserted against Bankshares and itssubsidiaries.  In view of the inherentdifficulty of predicting the outcome of such matters, Bankshares cannot statewhat the eventual outcome of pending matters will be.  However, based on current knowledge,management does not believe that liabilities, if any, arising from pendinglitigation matters, will have a material adverse effect on the consolidatedfinancial position, earnings or liquidity of Bankshares.  If payment associated with a claim becomesprobable and the cost can be reasonably estimated, a contingent liability wouldbe established based on information currently available, advice of counsel andavailable insurance coverage.

8.  Goodwill and Other Intangible Assets

Goodwill,net, totaled $760.3 million at September 30, 2006 and $670.0 million atDecember 31, 2005.  In the third quarterof 2006, Bankshares preliminarily recorded $87.0 million in goodwill inconnection with the James Monroe acquisition. In the first quarter of 2006, there was an increase in goodwill of $8.8million related to a contingent payment made to the management of BoydWatterson Asset Management as they met the performance conditions outlined inthe merger agreement.

Thefollowing table discloses the gross carrying amount and accumulatedamortization of intangible assets subject to amortization at September 30, 2006and December 31, 2005.
| ** **                           | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                       | ** ** | **Gross  carrying  amount**     | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Core deposits                        | ** ** | **$**                            | **62,842** | ** **                      | **$**      | **(25,444** | **)** | **$** | **37,398** |   | $ | 54,509 |   | $ | (20,790 | ) | $ | 33,719 |   |
| Mortgage  servicing                  | ** ** | **2,848**                        | ** ** | **(1,461**                      | **)**      | **1,387** |   | 2,902 |   | (1,145 | ) | 1,757 |   |
| Customer lists  and other            | ** ** | **17,795**                       | ** ** | **(8,762**                      | **)**      | **9,033** |   | 17,845 |   | (6,668 | ) | 11,177 |   |
| Total                                | ** ** | **$**                            | **83,485** | ** **                      | **$**      | **(35,667** | **)** | **$** | **47,818** |   | $ | 75,256 |   | $ | (28,603 | ) | $ | 46,653 |   |
|                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Inconnection with the James Monroe acquisition, Bankshares preliminarily recorded$8.3 million in core deposit intangibles. The core deposit intangible from James Monroe is being amortized on anaccelerated basis.

Identifiableintangible assets are amortized based on estimated lives of up to 15years.  Management reviews other intangibleassets for impairment yearly or whenever events or changes in circumstancesindicate that their carrying amounts may not be recoverable.  For those intangible assets subject toamortization, impairment is indicated if the sum of undiscounted estimatedfuture net cash flows is less than the carrying amount of the asset.  Impairment is recognized by writing down thecarrying value or adjusting the estimated life of the asset.  Any impairment recognized in a valuationaccount is reflected in the income statement in the corresponding period.

 

12

----

 

Thefollowing table shows the current period and estimated future amortizationexpense for amortized intangible assets. The projections of amortization expense shown for mortgage servicingrights are based on asset balances and the interest rate environment as ofSeptember 30, 2006.  Future amortizationexpense may be significantly different depending upon changes in themortgage-servicing portfolio, mortgage interest rates and market conditions.

 
| **(Dollars in thousands)**               | ** ** | ** ** | ** ** | ** ** | ** ** | **Core  Deposits** | ** ** | **Mortgage  Servicing** | ** ** | **Customer   Lists  and Other** | ** ** | **Total**  | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|--------------------|------------|-------------------------|------------|-------------------------------------------|------------|------------|------------|
| Nine months ended  September 30, 2006 (actual)     | ** ** | ** ** | ** ** | **$**      | **4,654**  | ** **         | **$**      | **251**                 | ** ** | **$**                                     | **2,159**  | ** ** | **$**      | **7,064** | ** ** |
| Three months ended  December 31, 2006 (estimated)  |       |       |       | 1,680      |       | 59                 |       | 562                     |       | 2,301                                     |       |
| Twelve months ended  December 31, 2006 (estimated) |       |       |       | $          | 6,334      |               | $          | 310                     |       | $                                         | 2,721      |       | $          | 9,365 |   |
|                                               |       |       |       |       |       |               |       |                    |       |                                      |       |
| Estimate for years  ended December 31,             |       |       |       |       |       |               |       |                    |       |                                      |       |
|                                               |       | 2007       |       | $          | 6,517      |               | $          | 232                     |       | $                                         | 2,454      |       | $          | 9,203 |   |
|                                               |       | 2008       |       | 5,423      |       | 215                |       | 1,617                   |       | 7,255                                     |       |
|                                               |       | 2009       |       | 5,272      |       | 215                |       | 641                     |       | 6,128                                     |       |
|                                               |       | 2010       |       | 5,272      |       | 215                |       | 505                     |       | 5,992                                     |       |

 

9.  Comprehensive Income

Thefollowing table summarizes the market value change and related tax effect ofunrealized gains (losses) on securities available-for-sale for the nine monthsand three months ended September 30, 2006 and 2005, respectively.  Total comprehensive income is included in theStatements of Changes in Consolidated Shareholders’ Equity.

 
| ** **                                                             | ** ** | **For the 9 months ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| **(Dollars in thousands)**                                   | ** ** | ** **                                                             | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Net Income                                                             |       |                                                                   | ** ** | ** ** |   | **$** | **215,424** |   |   |   |   |   | $ | 201,456 |   |
| Other comprehensive  income                                            |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  holding gains (losses) arising                             | ** ** | ** **                                                             |       |   |   |   |   |   |   |   |   |   |   |
| during the  period                                                     | ** ** | **8,105**                                                              | ** ** | **(3,216** | **)** | **4,889** |   | (35,258 | ) | 13,234 |   | (22,024 | ) |
| Reclassification  adjustment for (gains) losses included in net income | ** ** | **(205**                                                               | **)**      | **81** | ** ** | **(124** | **)** | (458 | ) | 180 |   | (278 | ) |
| Total other  comprehensive income                                      | ** ** | **7,900**                                                              | ** ** | **(3,135** | **)** | **4,765** |   | (35,716 | ) | 13,414 |   | (22,302 | ) |
| Total comprehensive income                                             |       |                                                                   | ** ** | ** ** |   | **$** | **220,189** |   |   |   |   |   | $ | 179,154 |   |
|                                                                        |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 
| ** **                                                             | ** ** | **For the 3 months ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| **(Dollars in thousands)**                                   | ** ** | ** **                                                             | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Net Income                                                             |       |                                                                   |       | ** ** | ** ** | **$** | **71,573** |   |   |   |   |   | $ | 70,956 |   |
| Other  comprehensive income                                            |       |                                                                   |       | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |
| Unrealized holding gains (losses) arising during the  period           |       | **34,202**                                                             |       | **(12,947** | **)** | **21,255** |   | (22,781 | ) | 8,459 |   | (14,322 | ) |
| Reclassification adjustment for (gains) losses  included in net income |       | **(218**                                                               | )          | **86** | ** ** | **(132** | ) | 32 |   | (13 | ) | 19 |   |
| Total other comprehensive income                                       |       | **33,984**                                                             |       | **(12,861** | **)** | **21,123** |   | (22,749 | ) | 8,446 |   | (14,303 | ) |
| Total comprehensive  income                                            |       | ** **                                                             |       | ** ** | ** ** | **$** | **92,696** |   |   |   |   |   | $ | 56,653 |   |
|                                                                        |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

13

----

 

10.  Capital Adequacy

Banksharesand its bank affiliates are subject to various regulatory capital adequacyrequirements administered by federal and state banking agencies.  These requirements include maintainingcertain capital ratios above minimum levels. These capital ratios include Tier I Capital and Total Risk-Based Capitalas percentages of net risk-weighted assets and Tier I Capital as a percentageof adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacypurposes are 4.00%, 8.00% and 4.00%, for the Tier I Capital, Total Capital andLeverage Ratios, respectively.  To becategorized as *well capitalized,* a bank mustmaintain minimum ratios of 6.00%, 10.00% and 5.00%, for its Tier I Capital,Total Capital and Leverage Ratios, respectively.  As of September 30, 2006, Bankshares and eachof its bank affiliates exceeded all capital adequacy requirements to beconsidered well capitalized.

Actualcapital amounts and ratios are presented in the following table for Banksharesand its affiliates.  The September 30,2006 MSD&T capital ratios reflect the James Monroe acquisition.

 
| **September 30, 2006  (Dollars in thousands)** | ** ** | ** ** | ** **    | **Tier I  Capital** | ** ** | **Total  Risk-Based  Capital** | ** ** | **Net  Risk-Weighted  Assets** | ** **     | **Adjusted  Average  Total Assets** | ** ** | **Tier I  Capital  Ratio** | ** ** | **Total  Capital  Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|--------------------------------------------------------------------|------------|------------|---------------|--------------------------|------------|--------------------------------|------------|--------------------------------|----------------|------------------------------------------|------------|---------------------------------|------------|---------------------------|------------|---------------------|------------|
| **Bankshares**                                                     | ** ** | **$**      | **1,639,229** | ** **               | **$**      | **2,099,107**                  | ** ** | **$**                          | **13,713,845** | ** **                               | **$**      | **16,413,550**                  | ** ** | **11.95**                 | **%**      | **15.31**           | **%**      | **9.99** | **%** |
| Annapolis  Banking & Trust                                     |       | 44,251     |          | 51,524                   |       | 347,132                        |       | 483,250                        |           | 12.75                                    |       | 14.84                           |       | 9.16                      |       |
| Citizens  National Bank                                            |       | 108,741    |          | 156,454                  |       | 1,213,369                      |       | 1,338,333                      |           | 8.96                                     |       | 12.89                           |       | 8.13                      |       |
| Farmers  & Mechanics Bank                                      |       | 168,335    |          | 229,463                  |       | 1,370,064                      |       | 1,687,145                      |           | 12.29                                    |       | 16.75                           |       | 9.98                      |       |
| Marshall  National Bank & Trust                                |       | 13,957     |          | 20,423                   |       | 144,576                        |       | 185,805                        |           | 9.65                                     |       | 14.13                           |       | 7.51                      |       |
| Mercantile  County Bank                                            |       | 82,794     |          | 119,526                  |       | 753,143                        |       | 955,397                        |           | 10.99                                    |       | 15.87                           |       | 8.67                      |       |
| Mercantile  Eastern Shore Bank                                     |       | 55,070     |          | 86,472                   |       | 479,466                        |       | 614,010                        |           | 11.49                                    |       | 18.04                           |       | 8.97                      |       |
| Mercantile  Peninsula Bank                                         |       | 150,847    |          | 222,454                  |       | 1,405,887                      |       | 1,783,333                      |           | 10.73                                    |       | 15.82                           |       | 8.46                      |       |
| Mercantile-Safe  Deposit & Trust Company                       |       | 617,697    |          | 738,896                  |       | 6,302,877                      |       | 7,583,480                      |           | 9.80                                     |       | 11.72                           |       | 8.15                      |       |
| Mercantile  Southern Maryland Bank                                 |       | 95,858     |          | 132,791                  |       | 697,608                        |       | 1,000,486                      |           | 13.74                                    |       | 19.04                           |       | 9.58                      |       |
| National  Bank of Fredericksburg                                   |       | 39,402     |          | 50,261                   |       | 395,730                        |       | 477,679                        |           | 9.96                                     |       | 12.70                           |       | 8.25                      |       |
| Westminster Union Bank                                             |       | 70,671     |          | 101,193                  |       | 524,157                        |       | 822,105                        |           | 13.48                                    |       | 19.31                           |       | 8.60                      |       |
|                                                                    |            |            |               |                          |            |                                |            |                                |                |                                          |            |                                 |            |                           |            |                     |            |  |  |  |  |

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

 

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 areretired.  During the nine months endedSeptember 30, 2006, Bankshares purchased 38,471 shares in net settlement of theminimum tax liability for vested restricted stock.  On June 13, 2006, Bankshares’ Board ofDirectors authorized the repurchase of two million shares in addition to 676thousand shares remaining from a previously announced program.  At September 30, 2006, there wereapproximately 2.7 million shares available for repurchase under the program.

14

----

11.  Segment Reporting

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

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

 
| ** **                           | ** ** | **For the 9 months ended September 30, 2006** | ** **     | **For the 9 months ended September 30, 2005** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------|----------------|----------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                                                                       | ** **     | **Banking**                                                                      | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net  interest income                 | ** ** | **$**                                                                            | **476,760**    | ** **                                                                       | **$**      | **9,324** | ** ** | **$** | **(292** | **)** | **$** | **485,792** |   | $ | 448,467 |   | $ | 6,546 |   | $ | (321 | ) | $ | 454,692 |   |
| Provision  for credit losses         | ** ** | **—**                                                                       | ** **     | **—**                                                                       | ** ** | **—** | ** ** | **—** |   | (1,576 | ) | — |   | — |   | (1,576 | ) |
| Noninterest  income                  | ** ** | **89,868**                                                                       | ** **     | **82,981**                                                                       | ** ** | **11,992** | ** ** | **184,841** |   | 98,733 |   | 71,635 |   | 10,641 |   | 181,009 |   |
| Noninterest  expenses                | ** ** | **(258,397**                                                                     | **)**          | **(64,820**                                                                      | **)**      | **(5,349** | **)** | **(328,566** | **)** | (256,337 | ) | (53,644 | ) | (2,467 | ) | (312,448 | ) |
| Adjustments                          | ** ** | **17,281**                                                                       | ** **     | **(1,298**                                                                       | **)**      | **(15,983** | **)** | **—** |   | 16,757 |   | (3,491 | ) | (13,266 | ) | — |   |
| Income  (loss) before income taxes   | ** ** | **325,512**                                                                      | ** **     | **26,187**                                                                       | ** ** | **(9,632** | **)** | **342,067** |   | 306,044 |   | 21,046 |   | (5,413 | ) | 321,677 |   |
| Income  tax expense                  | ** ** | **(114,405**                                                                     | **)**          | **(10,475**                                                                      | **)**      | **(1,763** | **)** | **(126,643** | **)** | (107,038 | ) | (8,419 | ) | (4,764 | ) | (120,221 | ) |
| Net  income (loss)                   | ** ** | **$**                                                                            | **211,107**    | ** **                                                                       | **$**      | **15,712** | ** ** | **$** | **(11,395** | **)** | **$** | **215,424** |   | $ | 199,006 |   | $ | 12,627 |   | $ | (10,177 | ) | $ | 201,456 |   |
|                                 | ** ** | ** **                                                                       | ** **     | ** **                                                                       | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Average  loans                       | ** ** | **$**                                                                            | **11,810,175** | ** **                                                                       | **$**      | **182,120** | ** ** | **$** | **305** | ** ** | **$** | **11,992,600** |   | $ | 10,724,290 |   | $ | 147,043 |   | $ | 391 |   | $ | 10,871,724 |   |
| Average  earning assets              | ** ** | **15,137,858**                                                                   | ** **     | **182,120**                                                                      | ** ** | **(75,968** | **)** | **15,244,010** |   | 13,703,258 |   | 147,043 |   | 5,328 |   | 13,855,629 |   |
| Average  assets                      | ** ** | **16,607,674**                                                                   | ** **     | **182,681**                                                                      | ** ** | **56,888** | ** ** | **16,847,243** |   | 14,983,948 |   | 147,370 |   | 143,413 |   | 15,274,731 |   |
| Average  deposits                    | ** ** | **12,270,894**                                                                   | ** **     | **298,370**                                                                      | ** ** | **(325,809** | **)** | **12,243,455** |   | 11,270,896 |   | 194,570 |   | (213,685 | ) | 11,251,781 |   |
| Average equity                       | ** ** | **2,049,883**                                                                    | ** **     | **38,068**                                                                       | ** ** | **216,792** | ** ** | **2,304,743** |   | 1,865,378 |   | 33,916 |   | 158,830 |   | 2,058,124 |   |
|                                      |            |                                                                                  |                |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                           | ** ** | **For the 3 months ended September 30, 2006** | ** **     | **For the 3 months ended September 30, 2005** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------|----------------|----------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                                                                       | ** **     | **Banking**                                                                      | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net  interest income                 | ** ** | **$**                                                                            | **162,767**    | ** **                                                                       | **$**      | **3,382** | ** ** | **$** | **(80** | **)** | **$** | **166,069** |   | $ | 157,023 |   | $ | 2,324 |   | $ | (105 | ) | $ | 159,242 |   |
| Provision  for credit losses         | ** ** | **—**                                                                       | ** **     | **—**                                                                       | ** ** | **—** | ** ** | **—** |   | (820 | ) | — |   | — |   | (820 | ) |
| Noninterest  income                  | ** ** | **29,011**                                                                       | ** **     | **27,781**                                                                       | ** ** | **2,975** | ** ** | **59,767** |   | 36,254 |   | 23,794 |   | 3,026 |   | 63,074 |   |
| Noninterest  expenses                | ** ** | **(87,228**                                                                      | **)**          | **(21,256**                                                                      | **)**      | **(3,945** | **)** | **(112,429** | **)** | (92,233 | ) | (17,821 | ) | 1,672 |   | (108,382 | ) |
| Adjustments                          | ** ** | **6,365**                                                                        | ** **     | **(877**                                                                         | **)**      | **(5,488** | **)** | **—** |   | 8,792 |   | (1,080 | ) | (7,712 | ) | — |   |
| Income  (loss) before income taxes   | ** ** | **110,915**                                                                      | ** **     | **9,030**                                                                        | ** ** | **(6,538** | **)** | **113,407** |   | 109,016 |   | 7,217 |   | (3,119 | ) | 113,114 |   |
| Income  tax expense                  | ** ** | **(38,692**                                                                      | **)**          | **(3,612**                                                                       | **)**      | **470** | ** ** | **(41,834** | **)** | (38,218 | ) | (2,887 | ) | (1,053 | ) | (42,158 | ) |
| Net  income (loss)                   | ** ** | **$**                                                                            | **72,223**     | ** **                                                                       | **$**      | **5,418** | ** ** | **$** | **(6,068** | **)** | **$** | **71,573** |   | $ | 70,798 |   | $ | 4,330 |   | $ | (4,172 | ) | $ | 70,956 |   |
|                                 | ** ** | ** **                                                                       | ** **     | ** **                                                                       | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Average  loans                       | ** ** | **$**                                                                            | **12,212,585** | ** **                                                                       | **$**      | **188,248** | ** ** | **$** | **235** | ** ** | **$** | **12,401,068** |   | $ | 11,236,644 |   | $ | 152,712 |   | $ | 375 |   | $ | 11,389,731 |   |
| Average  earning assets              | ** ** | **15,570,864**                                                                   | ** **     | **188,248**                                                                      | ** ** | **(113,262** | **)** | **15,645,850** |   | 14,353,936 |   | 152,712 |   | (15,912 | ) | 14,490,736 |   |
| Average  assets                      | ** ** | **17,084,515**                                                                   | ** **     | **188,824**                                                                      | ** ** | **23,990** | ** ** | **17,297,329** |   | 15,791,343 |   | 153,061 |   | 120,764 |   | 16,065,168 |   |
| Average  deposits                    | ** ** | **12,612,299**                                                                   | ** **     | **307,789**                                                                      | ** ** | **(328,027** | **)** | **12,592,061** |   | 11,807,861 |   | 202,571 |   | (258,442 | ) | 11,751,990 |   |
| Average equity                       | ** ** | **2,109,085**                                                                    | ** **     | **39,539**                                                                       | ** ** | **193,921** | ** ** | **2,342,545** |   | 1,957,448 |   | 34,727 |   | 187,240 |   | 2,179,415 |   |
|                                      |            |                                                                                  |                |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

15

----

12.  Derivative Instruments and Hedging Activities

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

Thefair value of derivative instruments is based on swap and optionvaluations.  The swap value is estimatedby using pricing models that incorporate quoted market prices for swap ratesand futures contracts and assumes all counterparties have the same creditrating.  The option valuation isestimated by using standard market models (such as the modified Black-Scholesmodel on interest rate options), incorporating quoted market prices andvolatilities.  The fair value ofderivative instruments related to customer accommodations recorded in otherassets was $8.4 million (notional $536.1 million) and $5.3 million (notional$345.5 million) at September 30, 2006 and December 31, 2005, respectively.  The fair value of derivative instrumentsrelating to hedges and customer accommodations recorded in other liabilities was$16.4 million (notional $655.2 million) and $12.3 million (notional $609.1million) at September 30, 2006 and December 31, 2005, respectively.

Changesin the fair value of a derivative that is designated and qualifies as a fairvalue hedge, along with the gain or loss on the hedged asset or liability thatis attributable to the hedged risk are recorded as other noninterest income inthe results of operations.  For all hedgerelationships, ineffectiveness resulting from differences between the changesin fair values or cash flows of the hedged item and changes in fair value ofthe derivative are recognized as other noninterest income in the results ofoperations.  The net interest settlementon derivatives designated as fair value or cash flow hedges is treated as anadjustment of the interest income or interest expense of the hedged assets orliabilities.  The fair-value hedges ofnonprepayable fixed-rate debt were effective for the reported periods andqualified for short-cut hedge accounting treatment.  The impact of the hedges increased interestexpense $1.6 million in the first nine months of 2006 as compared with adecrease of $3.5 million for the same period in 2005.

Thefollowing tables summarize the gross position of derivatives relating tohedging activities at September 30, 2006 and December 31, 2005.
| ** **                           | ** ** | **September 30, 2006**          | ** **  | **December 31, 2005**   | ** ** |
|--------------------------------------|------------|-------------------------------------------|-------------|-----------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Notional or  Contractual  Amount** | ** **  | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** | **Notional or  Contractual  Amount** | ** ** | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** |
| *Asset/Liability  Management Hedges* |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Interest Rate  Contracts:            |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                     | **350,000** | ** **                        | **$**      | **118** | ** ** | **$** | **(12,907** | **)** | $ | 350,000 |   | $ | — |   | $ | (10,349 | ) |
|                                 |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| *Customer  Accommodations*           | * *   | * *                                  | * *    | * *                          | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Interest Rate  Contracts:            |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                     | **829,771** | ** **                        | **$**      | **8,489** | ** ** | **$** | **4,965** |   | $ | 592,934 |   | $ | 5,327 |   | $ | 3,462 |   |
| Swaptions/Caps Purchased             | ** ** | **5,755**                                 | ** **  | **40**                            | ** ** | **40** |   | 5,850 |   | 57 |   | 57 |   |
| Swaptions/Caps  Sold                 | ** ** | **5,755**                                 | ** **  | **—**                        | ** ** | **(40** | **)** | 5,850 |   | — |   | (57 | ) |

----

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

16

----

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

13.  Stock-based Compensation Expense

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

UnderSFAS 123(R), awards granted to retirement eligible employees are expensedimmediately.  Under Bankshares’ OmnibusStock Plan, retirement eligible is defined as employees reaching normalretirement at age 65.  As a practice,Bankshares has not granted awards to retirement eligible employees.  As of September 30, 2006, there were noretirement eligible employees with outstanding awards that had not been fullyexpensed.  Prior to implementing SFAS123(R), Bankshares accrued compensation cost for share-based compensation basedon total awards granted, pursuant to SFAS 123. Any subsequent forfeitures were reversed from compensation expense whenthe performance or service requirement was not achieved.  Upon implementation of SFAS 123(R),Bankshares is estimating forfeitures upon the grant of awards and reducing theamount to be charged to expense by this estimate.

Wesponsor several share-based plans, which are described below.  The compensation cost expensed for thoseplans was $3.5 million and $1.1 million for the quarters ended September 30,2006 and 2005, respectively, and $9.0 million and $4.1 million for the ninemonths ended September 30, 2006 and 2005, respectively.  The total income tax benefit recognized inthe income statement for share-based compensation arrangements was $1.3 millionand $416 thousand for the quarters ended September 30, 2006 and 2005,respectively, and $3.4 million and $1.4 million for the nine months endedSeptember 30, 2006 and 2005, respectively. At September 30, 2006, unrecognized compensation cost related tononvested stock options, restricted stock awards and restricted stock units (“RSUs”)totaled $21.0 million.  The cost of thesenonvested awards is expected to be recognized over a weighted average period of2.07 years.

The1999 Omnibus Stock Plan permitted the grant of stock options and other stockincentives, including restricted stock awards and restricted stock units, tokey employees of Bankshares and its affiliates. The 1999 Plan provided for the issuance of up to 4,500,000 shares (asadjusted for the stock split) of Bankshares authorized but unissued commonstock.  The number of shares of commonstock that remained available for future grants under the Plan at September30, 2006 was 857,965 shares. Options issued as a result of mergers or acquisitions are not consideredto be part of the 1999 Omnibus Stock Plan. Options outstanding were granted at market value and included bothperformance-based and nonperformance-based options.  Options become exercisable ratably over threeor four years.  All options terminate 10years from date of grant if not exercised. The estimated forfeiture rate used to calculate the current quarter andyear-to-date compensation cost was 2.0%. Because of the historically low forfeiture rate, the impact tocompensation expense was immaterial for 2006 and 2005.

On March 29, 2006, theCompensation Committee authorized the issuance of up to 317,802performance-based restricted stock units (“Performance RSUs”) pursuant to the2006 Performance Stock Program.  Thevesting of the Performance RSUs will be determined based upon the percentageimprovement in Bankshares’ pre-tax operating income (“PTOI”) over a three-yearperformance period (the “Performance Period”) ending December 31, 2008(with no adjustments for acquisitions or other extraordinary events).  In addition to the performance period, theawards earned are subject to an additional one-year service requirement.  Depending on actual performance, thePerformance RSUs will vest at levels from 0% to 100%.  On the same date, the Committee also awarded104,630 RSUs to Bankshares’ chief executive officer.  The award will vest ratably over fouryears.  The Performance RSUs and the RSUsgranted to Bankshares chief executive officer vest and convert into commonstock in connection with a change of control of Bankshares.

17

----

Thetable below summarizes activity related to stock options during the nine monthsended September 30, 2006.

 
| ** **                      | ** ** | **Options   issued and   outstanding** | ** ** | **Weighted   average  exercise price** | ** ** | **Options  exercisable** | ** **    | **Weighted   average  exercise price** | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------|---------------|--------------------------------------------------|------------|
| Balance,  December 31, 2005     |       | 2,659,240                                        |       | $                                                | 25.01      |                     | 1,489,397     |                                             | $          | 20.80 |   |
| Granted                         |       | 725,566                                          |       | 34.89                                            |       |                     |          |                                             |       |
| Expired/Forfeited               |       | (7,188                                           | )          | 25.92                                            |       |                     |          |                                             |       |
| Exercised                       |       | (118,006                                         | )          | 17.74                                            |       |                     |          |                                             |       |
| **Balance, September 30, 2006** | ** ** | **3,259,612**                                    | ** ** | **$**                                            | **27.46**  | ** **               | **2,124,075** | ** **                                       | **$**      | **23.35** | ** ** |

 

Thetotal intrinsic value of stock options exercised during the nine months endedSeptember 30, 2006 and 2005 was $2.3 million and $6.2 million,respectively.  Cash received from optionsexercised under all share-based payment arrangements for the nine months endedSeptember 30, 2006 and 2005 was $1.8 million and $3.2 million, respectively.  The actual tax return benefit associated withthe tax deductions recognized in the income statement from the option exerciseof the share-based payment arrangements totaled $1.0 million for the ninemonths ended September 30, 2006; there was no actual tax return benefit for thenine months ended September 30, 2005.

Thefollowing table provides selected information on nonvested stock options as ofSeptember 30, 2006, and changes during the nine months ended September 30,2006.

 
| ** **                      | ** ** | **Nonvested  stock options** | ** ** | **Weighted   average  grant-date  fair value** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|----------------------------------------------------------|------------|
| Balance, December  31, 2005     |       | 1,164,825                         |       | $                                                        | 30.36      |   |
| Granted                         |       | 587,500                           |       | 37.73                                                    |       |
| Vested                          |       | (616,788                          | )          | 28.52                                                    |       |
| Forfeited                       |       | —                            |       |                                                     |       |
| **Balance, September 30, 2006** | ** ** | **1,135,537**                     | ** ** | **$**                                                    | **35.17**  | ** ** |

 

Thefollowing table provides selected information on stock options outstanding andexercisable at September 30, 2006.
| ** **                                                                      | ** ** | **September 30, 2006** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | ** **                       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
| Number of  options                                                              | ** ** | **3,259,612**                    | ** ** | **2,124,075** | ** ** |
| Weighted-average  exercise price                                                | ** ** | **$**                            | **27.46**  | ** ** | **$** | **23.35** | ** ** |
| Aggregate  intrinsic value                                                      | ** ** | **$**                            | **28,006** | ** ** | **$** | **26,177** | ** ** |
| Weighted-average  remaining contractual term, in years                          | ** ** | **7.11**                         | ** ** | **6.22** | ** ** |
|                                                                                 |            |                                  |            |  |  |  |  |  |  |

 

Theweighted average grant-date fair value of options granted during the ninemonths ended September 30, 2006 and 2005 was $7.13 and $9.54,respectively.  The total fair value of sharesvested during the nine months ended September 30, 2006 and 2005 was $22.9million and $14.9 million, respectively.

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

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

·                  Dividend yields of 2.76% and 2.69%

·                  Volatilities of 20.60% and 21.85%

·                  Risk-free interest rates of 4.68% and 4.12%

·                  Expected terms of 4.73 and 4.57 years

 

18

----

 

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

Restrictedstock awards outstanding were granted at market value and vest ratably overthree years or in total at the end of a specified three-year period.  The number of restricted stock awards grantedin the nine months ended September 30, 2006 and 2005 was 158,406 and 54,386,respectively.  Compensation expense isrecognized on a straight-line basis over the vesting period.  Relative to awards granted in the nine monthsended September 30, 2006, 85,309 shares are subject to a one-year vesting, and46,327 vest over three years. Additionally, 12,012 shares, representing dividend equivalent sharesrelated to previous awards that vested during the current period, were awardedand vested immediately.

Thefollowing table provides selected information related to restricted stockawards and restricted stock units as of September 30, 2006, and changes duringthe nine months ended September 30, 2006.

 
| ** **                            | ** ** | **Restricted  Stock Awards** | ** ** | **Restricted  Stock Units** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| Outstanding at December  31, 2005     |       | 249,090                           |       | —                           |       |
| Granted                               |       | 158,406                           |       | 422,432                          |       |
| Vested                                |       | (149,369                          | )          | —                           |       |
| Forfeitures                           |       | (1,162                            | )          | —                           |       |
| **Outstanding at September 30, 2006** | ** ** | **256,965**                       | ** ** | **422,432**                      | ** ** |

 

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

14.  Pension & Other Postretirement BenefitPlans

Banksharessponsors qualified and nonqualified pension plans and other postretirementbenefit plans for its employees.  Thefollowing table summarizes the components of the net periodic benefit cost forthe pension plans for the nine and three months ended September 30, 2006 and2005, respectively.

 
| ** **                           | ** ** | **For the 9 months ended September 30, 2006** | ** ** | **For the 9 months ended September 30, 2005** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                                                                       | ** ** | **Qualified**                                                                    | ** ** | **Nonqualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                                                            | **5,703**  | ** **                                                                       | **$**      | **642** | ** ** | **$** | **6,345** |   | $ | 5,640 |   | $ | 455 |   | $ | 6,095 |   |
| Interest cost                        | ** ** | **8,966**                                                                        | ** ** | **323**                                                                          | ** ** | **9,289** |   | 8,457 |   | 121 |   | 8,578 |   |
| Expected return on plan assets       | ** ** | **(13,169**                                                                      | **)**      | **—**                                                                       | ** ** | **(13,169** | **)** | (12,430 | ) | — |   | (12,430 | ) |
| Amortization of prior service cost   | ** ** | **888**                                                                          | ** ** | **23**                                                                           | ** ** | **911** |   | 877 |   | 17 |   | 894 |   |
| Recognized net actuarial loss (gain) | ** ** | **1,613**                                                                        | ** ** | **60**                                                                           | ** ** | **1,673** |   | 1,096 |   | (139 | ) | 957 |   |
| Amortization of transition asset     | ** ** | **—**                                                                       | ** ** | **—**                                                                       | ** ** | **—** |   | — |   | — |   | — |   |
| Net  periodic benefit cost           | ** ** | **$**                                                                            | **4,001**  | ** **                                                                       | **$**      | **1,048** | ** ** | **$** | **5,049** |   | $ | 3,640 |   | $ | 454 |   | $ | 4,094 |   |
|                                      |            |                                                                                  |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                           | ** ** | **For the 3 months ended September 30, 2006** | ** ** | **For the 3 months ended September 30, 2005** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                                                                       | ** ** | **Qualified**                                                                    | ** ** | **Nonqualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                                                            | **1,904**  | ** **                                                                       | **$**      | **214** | ** ** | **$** | **2,118** |   | $ | 1,980 |   | $ | 151 |   | $ | 2,131 |   |
| Interest cost                        | ** ** | **2,989**                                                                        | ** ** | **108**                                                                          | ** ** | **3,097** |   | 2,819 |   | 41 |   | 2,860 |   |
| Expected return on plan assets       | ** ** | **(4,389**                                                                       | **)**      | **—**                                                                       | ** ** | **(4,389** | **)** | (4,143 | ) | — |   | (4,143 | ) |
| Amortization of prior service cost   | ** ** | **296**                                                                          | ** ** | **8**                                                                            | ** ** | **304** |   | 292 |   | 5 |   | 297 |   |
| Recognized net actuarial loss (gain) | ** ** | **538**                                                                          | ** ** | **20**                                                                           | ** ** | **558** |   | 365 |   | (46 | ) | 319 |   |
| Amortization of transition asset     | ** ** | **—**                                                                       | ** ** | **—**                                                                       | ** ** | **—** |   | — |   | — |   | — |   |
| Net  periodic benefit cost           | ** ** | **$**                                                                            | **1,338**  | ** **                                                                       | **$**      | **350** | ** ** | **$** | **1,688** |   | $ | 1,313 |   | $ | 151 |   | $ | 1,464 |   |
|                                      |            |                                                                                  |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

19

----

 

Thefollowing table summarizes the components of the net periodic benefit cost forthe other postretirement benefit plans for the nine and three months endedSeptember 30, 2006 and 2005, respectively.

 
| ** **                           | ** ** | **For the 9 months ended September 30,** | ** ** | **For the 3 months ended September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **                                                             | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost                         | ** ** | **$**                                                                  | **322**    |                                                                   | $          | 400 | ** ** | **$** | **107** |   | $ | 133 |   |
| Interest cost                        | ** ** | **745**                                                                |       | 747                                                                    | ** ** | **249** |   | 249 |   |
| Expected return on plan assets       | ** ** | **—**                                                             |       | —                                                                 | ** ** | **—** |   | — |   |
| Amortization of prior service cost   | ** ** | **—**                                                             |       | —                                                                 | ** ** | **—** |   | — |   |
| Recognized net actuarial loss        | ** ** | **226**                                                                |       | 264                                                                    | ** ** | **74** |   | 88 |   |
| Amortization of transition asset     | ** ** | **—**                                                             |       | —                                                                 | ** ** | **—** |   | — |   |
| Net  periodic benefit cost           | ** ** | **$**                                                                  | **1,293**  |                                                                   | $          | 1,411 | ** ** | **$** | **430** |   | $ | 470 |   |
|                                      |            |                                                                        |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

Aspreviously disclosed in its financial statements for the year ended December31, 2005, Bankshares generally makes cash contributions to the pension plan inamounts up to those permitted by guidelines established under employee benefitand tax laws.  Bankshares estimates thatit could contribute up to approximately $25 million to the pension plan for2006.  Cash contributions are normallymade after valuations have been finalized for the plan year and prior to thetax return filing date.  As of September30, 2006, total contributions of $15 million had been made in 2006.  No further contributions are expected to bemade in the current year.

15.  Recent Accounting Standards

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

InMarch 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets-An Amendment of FASBStatement No. 140.”  This standardamends the guidance in SFAS No.140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities.”  Among otherrequirements, SFAS No. 156 requires an entity to recognize a servicing asset orservicing liability each time it undertakes an obligation to service afinancial asset by entering into a servicing contract.  Thestandard requires initial measurement of all newly purchased or issuedseparately recognized servicing assets and servicing liabilities at fair value,if practicable.  Subsequent measurementsmay be made using either the fair value or amortization method.  SFAS No. 156 iseffective as of the beginning of an entity’s first fiscal year that beginsafter September 15, 2006 with early adoption permitted in the quarter-endedMarch 31, 2006.  Bankshares does notanticipate this statement will have a material effect on its results ofoperations or financial condition.

# On July 13, 2006, the FASB issued FASB InterpretationNo. 48 (“FIN 48”).  FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordancewith SFAS No. 109, “Accounting for Income Taxes”.  FIN 48 prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  An enterprise shall disclose the cumulativeeffect of the change on retained earnings in the statement of financialposition as of the date of adoption and such disclosure is required only in theyear of adoption.  Bankshares is in the process of analyzing theimplications of FIN 48.   Bankshares does not anticipate this statementwill have a material effect on its results of operations or financialcondition.

20

----

OnSeptember 15, 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,”which provides for enhanced guidance for using the fair value to measure assetsand liabilities.  SFAS No. 157 definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles (“GAAP”), and expands disclosures about fairvalue measurements.  SFAS No. 157 is applicableunder other accounting pronouncements that either require or permit fair valuemeasurements and does not require any new fair value measurements.  SFAS No. 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. Bankshares is in the process of analyzing the implications of SFAS No.157.

OnSeptember 20, 2006, the FASB ratified EITF 06-4, “Accounting for DeferredCompensation and Postretirement Benefit Aspects of Endorsement Split-DollarLife InsuranceArrangements.”  EITF 06-4 addresses accounting forsplit-dollar life insurance arrangements after the employer purchases a lifeinsurance policy on the covered employee. This EITF states that an obligation arises as a result of a substantiveagreement with an employee to provide future postretirement benefits.  Under EITF 06-4, the obligation is notsettled upon entering into an insurance arrangement.  Since the obligation is not settled, aliability should be recognized in accordance with applicable authoritativeguidance.  EITF 06-4 is effective forfiscal years beginning after December 15, 2007. Bankshares is in the process of analyzing the implications of EITF 06-4.

OnSeptember 20, 2006, the FASB ratified EITF 06-5, “Accounting for Purchases ofLife Insurance—Determining the Amount That Could Be Realized in Accordance withFASB Technical Bulletin No. 85-4, *Accountingfor Purchases of Life Insurance*.” This issue addresses how an entity should determine the amount thatcould be realized under the insurance contract at the balance sheet date inapplying FTB 85-4 and if thedetermination should be on an individual or group policy basis.  EITF 06-5 is effective for fiscal yearsbeginning after December 15, 2006.  Theadoption of EITF 06-5 is not expected to have a material affect on Banksharesfinancial statements.

OnSeptember 29, 2006, the FASB issued SFAS No.158, “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and132(R).”   SFAS No. 158 requires an entity to recognizein its statement of financial position the overfunded or underfunded status ofa defined benefit postretirement plan measured as the difference between thefair value of plan assets and the benefit obligation.  An entity will be required to recognize as acomponent of other comprehensive income, net of tax, the actuarial gains andlosses and the prior service costs and credits that arise pursuant to FASBStatements No. 87, “Employers’Accounting for Pensions” and No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.”  Furthermore, SFAS No. 158 requires that anentity use a plan measurement date that is the same as its fiscalyear-end.  An entity will be required todisclose additional information in the notes to financial statements aboutcertain effects on net periodic benefit cost in the upcoming fiscal year thatarise from delayed recognition of the actuarial gains and losses and the priorservice costs and credits.  Therequirement to recognize the funded status of a defined benefit postretirementplan and the related disclosure requirements is effective for fiscal yearsending after December 15, 2006.  Therequirement to change the measurement date to the year-end reporting date isfor fiscal years ending after December 15, 2008.  Bankshares does not anticipate this statementwill have a material effect on its results of operations or financial condition.

16.   Subsequent Events

OnOctober 9, 2006, Bankshares announced that it had entered into a MergerAgreement with PNC Financial Services Group, Inc. (“PNC”), which was approvedby PNC’s board.  If the merger iscompleted, each share of Bankshares’ common stock will be converted into 0.4184shares of PNC common stock and $16.45 in cash. The merger is currently expectedto occur in the first quarter of 2007, and is subject to the approval ofBankshares’ shareholders, receipt of specified governmental approvals(including the approval of the Board of Governors of the Federal ReserveSystem), and certain other customary conditions.  

 

21

----

 

**Item 2.   Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**MERCANTILEBANKSHARES CORPORATION**

HIGHLIGHTS

**ConsolidatedFinancial Results**

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

Netincome for the quarter ended September 30, 2006 was $71.6 million, a 0.9%increase from net income of $71.0 million for the same period in 2005 and a2.1% decrease from the $73.1 million reported for the second quarter of2006.  For the quarters ended September30, 2006 and 2005, diluted net income per share was $0.57 per share, whichrepresented a decrease of 3.4% from the $0.59 reported for the second quarterof 2006.  Adjusted weighted averageshares outstanding increased from 124.0 million for the quarter ended September30, 2005 to 125.9 million for the quarter ended September 30, 2006.  The results of operations for James Monroeare included from the merger date forward.

Netinterest income, on a taxable-equivalent basis, for the quarter ended September30, 2006 increased 4.3% to $167.9 million from $161.0 million for the thirdquarter of last year.  Compared with thesecond quarter of 2006, net interest income increased 2.9% from the $163.3million reported for that period.  Asnoted in prior quarters, the competitive pressures on the lending and thefunding fronts have persisted.  Theresult is that the net interest margin continues to be under pressure.  The net interest margin for the currentquarter was 4.26% as compared with 4.31% for the second quarter of 2006.  The net interest margin for the third quarterof 2005 was 4.41%.

AtSeptember 30, 2006, nonperforming assets amounted to $36.1 million, or 0.29%,of period-end loans and other real estate owned, an increase of $8.3 millionfrom the $27.8 million at September 30, 2005. Nonperforming assets were $29.3 million at June 30, 2006.  The comparable nonperforming asset ratio was0.24% at September 30, 2005 and June 30, 2006.  The level of “monitored” loans, or loans withcharacteristics suggesting that they could be classified as nonperforming inthe near future, amounted to $1.7 million at September 30, 2006.  Monitored loans were $3.4 million atSeptember 30, 2005 and $13.5 million at June 30, 2006.  The allowance for possible loan losses was1.15% of loans outstanding at September 30, 2006.

Noninterestincome, which includes investment and wealth management fees, service chargeson deposit accounts, mortgage banking-related fees, securities gains andlosses, nonmarketable investments income and other income, decreased 5.2% to$59.8 million for the third quarter of 2006 from $63.1 million for the thirdquarter of 2005.  This was due to adecrease of $4.7 million in mortgage banking-related fees and of $3.0 millionin nonmarketable investments income, partially offset by a $3.9 millionincrease in investment and wealth management fees.  The decline in mortgage banking-related feeswas attributable to the sale of Bankshares’ ownership interest in ColumbiaNational Real Estate Finance, LLC (“CNREF”) to the minority partners whichclosed on August 2, 2006. For the quarter ended September 30, 2006, CNREF’spretax loss was $249 thousand as compared with a pretax profit of $2.2 millionfor the same period in 2005.  CNREF’spretax profit for the second quarter of 2006 was $729 thousand.

Noninterestincome decreased $4.7 million, or 7.3%, in the third quarter of 2006 from thesecond quarter of 2006.  The decrease wasprimarily due to declines in commercial mortgage banking-related fees, andnonmarketable investments income.

Noninterestexpenses, which include salaries, employee benefits, net occupancy expense ofbank premises, furniture and equipment expenses, communications and suppliesand other expenses, increased by 3.7% for the quarter ended September 30, 2006to $112.4 million from $108.4 million for the third quarter of 2005.

Noninterestexpenses increased $3.0 million from the second quarter of 2006 due primarilyto increased expenses in salaries, marketing and promotions and netoccupancy.  This increase was due primarilyto $2.3 million of operating expenses at James Monroe.  Bankshares also incurred $0.7 million ofmerger expenses related to the James Monroe acquisition.

22

----

Bankshares also reports cash operating earnings, definedas “GAAP”(Generally Accepted Accounting Principles) earnings excluding the amortizationof intangible assets associated with purchase accounting for businesscombinations; securities gains and losses; and other significant gains, lossesor expenses (such as those associated with integrating acquired entities’operations into Bankshares) unrelated toBankshares’ core operations.  We believe these non-GAAP measuresprovide information useful to investors in understanding our ongoing corebusiness and operational performance trends. These measures should not be viewed as a substitute for GAAP.  Management believes presentations offinancial measures excluding the impact of certain items provide usefulsupplemental information and better reflect core operating activities.  In order to arrive at core business operatingresults, the effects of certain non-core business transactions such as gainsand losses on the sale of securities, amortization of intangibles,restructuring charges and merger-related expenses, have been excluded.  Management reviews these same measuresinternally.  For instance, the cashoperating efficiency ratio, rather than the GAAP basis efficiency ratio, isused to measure management’s success at controlling ongoing, core operatingexpenses.  We believe these measures areconsistent with how investors and analysts typically evaluate our industry, andby providing these measures, we facilitate their analysis.  Cashoperating earnings totaled $73.4 million for the third quarter of 2006, anincrease of 0.67% over $72.9 million for the same period in 2005.

Additionally,management believes that reporting several key measures based on tangibleassets (total assets less intangible assets) and tangible equity (total equityless intangible assets) is important, as this more closely approximates thebasis for measuring the adequacy of capital for regulatory purposes.  The ratio of average tangible equity toaverage tangible assets was 9.79% for the quarter ended September 30, 2006compared with 9.53% for the same period in 2005.  See *Reconciliation of Non-GAAPMeasures* for the reconciliation of GAAP measures to non-GAAPmeasures found at the end of this management’s discussion.

Forthe first nine months of 2006, net income was $215.4 million, an increase of6.9% over the $201.5 million reported for the same period in 2005.  Diluted net income per share was $1.73, anincrease of 4.8% from the $1.65 reported for the same period last year.  For the nine months ended September 30, 2006,cash operating earnings were $219.9 million compared with $203.1 million forthe same period last year.  Averagetangible equity to average tangible assets for the year-to-date 2006 and 2005were 9.83% and 9.73%, respectively.

CRITICALACCOUNTING POLICIES AND RELATED ESTIMATES

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

23

----

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

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

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

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

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

Forboth business and retail loans, the formula-based components include additionalqualitative amounts to establish reasonable ranges that consider observedhistorical variability in losses.  Factorswe may consider in setting these amounts include, but are not limited to,industry-specific data, portfolio-specific risks or concentrations, andmacroeconomic conditions. Including these variability components in the modelenables us to capture probable incurred losses that are not yet evident incurrent default rates, delinquencies and other credit-risk measurement tools.

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

24

----

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

Infirst quarter of 2006, we reclassified a portion of the allowance for loanlosses to a reserve for unfunded commitments, which is included in the otherliabilities section of the consolidated balance sheet.  The modeling process used in the firstquarter of 2006 for the determination of the reserve for unfunded lendingcommitments is consistent with the process described above for theformula-based component of the allowance for loan losses, also including as akey factor a benchmark average rate at which unfunded exposures have beenfunded at the time of default.  Thedevelopment of this modeling in 2006 enabled Bankshares to evaluatespecifically the risk inherent in unfunded commitments and make thereclassification discussed above.  As nomodel data existed in previous years, prior period data has not beenreclassified for comparability.  In thethird quarter of 2006, Bankshares reclassified $1.9 million of the allowancefor loan losses to the reserve for unfunded commitments.  This resulted from a refinement in the mannerin which the required reserves for unfunded commitments were calculated.

SEGMENTREPORTING

Asnoted in Note No. 11 - Segment Reporting, Bankshares reports two businesssegments — (1) Banking and (2) Investment and Wealth Management (“IWM”) - forwhich financial information is segregated for use in assessing performance andallocating resources when reporting to the Board of Directors.  Segment financial information is subjectiveand, unlike financial accounting, is not necessarily based on GAAP.  As 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.  Certain expense amounts, suchas operations overhead, have been reclassified for internal financial reportingpurposes in order to provide for proper allocation of costs in the reporteddata.

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

**Banking**

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

Inthe third quarter of 2006, the acquisition of James Monroe as part of theMercantile Potomac Division of Mercantile-Safe Deposit and Trust Company wascompleted.  This acquisition allowed usto increase our presence in the northern Virginia and Washington, D.C.markets.  The Banking segment was theprimary beneficiary of the James Monroe acquisition.

Netincome for the nine months ended September 30, 2006 increased 6.1%, to $211.1million, from the $199.0 million earned during the same period last year.  Net interest income for Banking increased6.3% to $476.8 million for the nine months ended September 30, 2006.  The growth in net interest income reflected a10.5% increase in average earning assets, offset by a 13 basis point decline inthe net interest margin from 4.44% at September 30, 2005 to 4.31% at September30, 2006.  Average loan balancesincreased 10.1% year-over-year. Commercial real estate loan balances increased 13.8%, residential realestate loan balances increased 7.8% and construction loan balances increased25.2%.  Average deposits included growthin money market accounts, time deposits greater than $100,000 andnoninterest-bearing checking, offset by a reduction in balances associated withsavings accounts and checking plus interest accounts in the first nine monthsof 2006, compared with the first nine months of 2005.  The decline in the net interest margin wasprimarily attributable to the growth in premium money market accounts andcertificates of deposit as customers shifted to these higher rate products, andyields on loans and investments lagging the increase in funding costs.

25

----

Reflectingthe favorable credit quality within the loan portfolio, Banking recorded noprovision for credit losses for the first nine months of 2006 as compared with a$1.6 million provision for the same period of 2005.  During the first quarter of 2006, Bankingestablished a reserve for unfunded commitments of $15 million by areclassification of $14 million from the allowance for loan losses and therecording of a $1.0 million provision related to increased unfunded commitmentsduring the quarter.  In the third quarterof 2006, $1.9 million was reclassified from the reserve for loan losses to thereserve for unfunded commitments recorded in other liabilities.  The reclassification in the third quarterresulted from a refinement in the manner in which the required reserves werecalculated.  The allowance for loanlosses as a percent of loans was 1.15% at September 30, 2006 compared with1.35% at December 31, 2005 and 1.37% at September 30, 2005.

Noninterestexpenses were $258.4 million for the nine months of 2006 compared with $256.3million for the same period of 2005, an increase of $2.1 million, or 0.8%.  Noninterest expenses net of adjustments were$241.1 million for the nine months of 2006, a $1.5 million increase, or 0.6%,over $239.6 million for the same period of 2005.  The increase in noninterest expenses wasprimarily related to normal merit and salary increases, higher benefit costs,and the addition of new branches.

**Investment& Wealth Management**

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

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

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

·                  PrivateBanking Services:  Deposits, loans, andmortgages.

·                  Mercantile Funds:  Proprietary mutual funds and Mercantile’shedge funds of funds.

Net income for the first nine months of 2006 increased 24.4%, or $3.1million, to $15.7 million over the $12.6 million in the first nine months of2005.  Pretax profit margins, prior to corporate overhead allocations,were 29.8% and 31.4% for the first nine months of 2006 and 2005,respectively.  For more information oncorporate overhead, see “Other” in Segment Reporting.

Whileequity markets rose during the past twelve months, a slump in the secondquarter was followed by a strong recovery in the third quarter of 2006.  The S&P 500 Index ended September, 2006at 1,336, up 8.7% from 1,229 at the end of September 2005, and rose 5.2% from thesecond quarter of this year.  Between September 30, 2005 and September 30,2006, the Dow Jones Industrial Average increased 10.5% to 11,679 and the Nasdaqrose 5.0% to 2,258.  The fixed income markets, as measured by the LehmanBrothers US Aggregate Bond Index, were down 1.6% for the twelve-month periodended September 30, 2006.  Bankshares’ investment asset base is relativelybalanced between equities (including real estate) and fixed income, cash andother securities.  As of September 30, 2006, 45% of IWM managed assetswere invested in equities, including real estate.  Approximately 39% wereinvested in fixed income securities and 16% were invested in cash and other.

** **

|                                          | ** ** | **As of September 30,** | ** ** |
|------------------------------------------|------------|----------------------------------------|------------|
| **Market Indices**                  | ** ** | ** **                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dow Jones  Industrial Average            | ** ** | **11,679**                             |       | 10,569 |   |
| Year-over-Year %  Change            | ** ** | **10.5**                               | **%**      | 4.8 | % |
| S&P 500  Index-period-end            | ** ** | **1,336**                              |       | 1,229 |   |
| Year-over-Year %  Change            | ** ** | **8.7**                                | **%**      | 10.2 | % |
| Nasdaq                                   | ** ** | **2,258**                              |       | 2,152 |   |
| Year-over-Year %  Change            | ** ** | **5.0**                                | **%**      | 13.4 | % |
| Lehman Brothers  US Aggregate Bond Index | ** ** | **101.0**                              |       | 102.6 |   |
| Year-over-Year %  Change            | ** ** | **-1.6**                               | **%**      | -2.2 | % |
|                                          |            |                                        |            |  |  |  |  |

 

26

----

 

Revenues in the first nine months of 2006 increased $14.1 million, or18.1%, to $92.3 million from $78.2 million in the same period last year. Exceptional revenue growth was realized in Institutional Management (driven bythe restructuring of a major pension advisory relationship in Bankshares’ IWMReal Estate Advisory Unit) and the Private Bank (driven by the adoption ofFunds Transfer Pricing).  Solid revenuegrowth was realized in Mercantile Funds, Private Wealth Management and Brokerage.

PrivateWealth Management benefited from the rise in equity markets during the pastyear and a fee increase on some accounts at the beginning of 2006. Personal Assets under Administration, at September 30, 2006, increased $0.7billion, or 5.6%, to $13.2 billion from September 30, 2005.  At September30, 2006 compared with September 30, 2005, Personal Assets with InvestmentResponsibility increased $0.3 billion, or 3.4%, to $9.1 billion and Assets withNo Investment Responsibility increased $0.4 billion, or 10.8%, to $4.1 billion.

InstitutionalInvestment Management benefited principally from the restructuring of a majorreal estate pension advisory relationship.  The impact of this change wasto increase revenues approximately $7.0 million and to increase expensesapproximately $4.5 million.  Revenuedeclined in our Boyd Watterson Asset Management subsidiary due to decreasedassets under management.  Higher terminations in our institutionalbusiness continued to impede institutional revenue growth in the first ninemonths of 2006, evidenced by the loss of a $6.5 billion institutional custodyaccount in the third quarter of 2006.  At September 30, 2006 compared withSeptember 30, 2005, Total Institutional Assets under Administration (includingBoyd Watterson) declined $5.4 billion, or 16.0%, to $28.3 billion;Institutional Assets with Investment Responsibility declined $0.4 billion, or3.3%, to $11.6 billion; and Assets under Administration with No InvestmentResponsibility declined $5.0 billion, or 23.0%, to $16.7 billion.

TheMercantile Funds benefited from higher asset flows into the funds, improvedequity markets, and solid performance in the hedge funds of funds. Mercantile Fund assets increased $248 million, or 6.4 %, to $4.1 billion,driven by a 6.3% increase in personal trust assets, at September 30, 2006compared with September 30, 2005.

Brokeragecommissions and income benefited from growth in the number of accounts andassets held in accounts. Brokerage assets increased $181 million, or 19%, to$1.1 billion at September 30, 2006 compared with September 30, 2005.

PrivateBanking revenues benefited from $35.1 million in loan growth and $103.8 millionin deposit growth during the past year.

 
| **IWM Asset Data** (Dollars in billions) | ** ** | ** ** | ** ** | **At September 30,** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|--------------------------------|------------|
| ** **                                                        | ** ** | **2006**   | ** ** | **2005**                       | ** ** |
| *Personal*                                                        | * *   | * *   | * *   | * *                       | * *   |
| Assets with  Investment Responsibility                            | ** ** | **$**      | **9.1**    |                           | $          | 8.8 |   |
| Assets with No  Investment Responsibility                         | ** ** | **4.1**    |       | 3.7                            |       |
| Total Personal                                                    | ** ** | **13.2**   |       | 12.5                           |       |
|                                                              |       |       |       |                           |       |
| *Institutional*                                                   | * *   | * *   | * *   | * *                       | * *   |
| Assets with  Investment Responsibility                            | ** ** | **11.6**   |       | 12.0                           |       |
| Assets with No  Investment Responsibility                         | ** ** | **16.7**   |       | 21.7                           |       |
| Total Institutional                                               | ** ** | **28.3**   |       | 33.7                           |       |
|                                                              |       |       |       |                           |       |
| *Mutual  Funds Not Included Above*                                | ** ** | **0.3**    |       | 0.2                            |       |
|                                                              |       |       |       |                           |       |
| *Total*                                                           | * *   | * *   | * *   | * *                       | * *   |
| Assets with  Investment Responsibility                            | ** ** | **21.0**   |       | 21.0                           |       |
| Assets with No  Investment Responsibility                         | ** ** | **20.8**   |       | 25.4                           |       |
| Total Assets  under Administration                                | ** ** | **$**      | **41.8**   |                           | $          | 46.4 |   |

 

27

----

AtSeptember 30, 2006, Assets under Administration by IWM were $41.8 billion, adecrease of $4.6 billion, or 9.9%, from the prior year.  Bankshares hadinvestment responsibility for $21 billion, unchanged from last year.

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

Inthe first nine months of 2006, expenses increased 20.8%, or $11.2 million, to$64.8 million, compared with $53.6 million in the first nine months of lastyear.  Increases occurred in employee-related, technology, marketing,professional services, general operating and occupancy expenses. The realestate advisory businessrestructuring-related expenses including salaries and benefits, marketing,incentive compensation, recruiting and license fees totaled approximately $4.5million.

 

28

----

 

**BANKSHARES EARNINGS PERFORMANCE**

**Analysis ofInterest Rates and Interest Differentials**

Thefollowing table presents the distribution of the average consolidated balancesheet, interest income/expense and annualized yields earned and rates paid forthe nine months ended September 30, 2006 and 2005.
| ** **                                        | ** ** | **2006**       | ** **     | **2005**                      | ** **  |
|---------------------------------------------------|------------|----------------|----------------|-------------------------------|-------------|
| **(Dollars in thousands)**              | ** ** | ** **     | ** **     | **Average  Balance (2)** | ** **  | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** | **Average  Balance (2)** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                    |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Loans:                                            |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Commercial                                        | ** ** | **$**          | **2,938,055**  | ** **                    | **$**       | **161,084** | ** ** | **7.33** | **%** | $ | 2,896,725 |   | $ | 136,123 |   | 6.28 | % |
| Commercial real estate                            | ** ** | **3,837,512**  | ** **     | **201,638**                   | ** **  | **7.03** |   | 3,370,926 |   | 163,681 |   | 6.49 |   |
| Construction                                      | ** ** | **1,801,245**  | ** **     | **109,643**                   | ** **  | **8.14** |   | 1,439,235 |   | 72,480 |   | 6.73 |   |
| Residential real estate                           | ** ** | **1,886,917**  | ** **     | **87,165**                    | ** **  | **6.18** |   | 1,749,577 |   | 77,867 |   | 5.95 |   |
| Home equity lines                                 | ** ** | **486,724**    | ** **     | **27,843**                    | ** **  | **7.65** |   | 505,630 |   | 22,016 |   | 5.82 |   |
| Consumer                                          | ** ** | **1,042,147**  | ** **     | **45,011**                    | ** **  | **5.77** |   | 909,631 |   | 39,435 |   | 5.80 |   |
| Total loans                                       | ** ** | **11,992,600** | ** **     | **632,384**                   | ** **  | **7.05** |   | 10,871,724 |   | 511,602 |   | 6.29 |   |
| Federal funds sold, et al                         | ** ** | **63,384**     | ** **     | **2,609**                     | ** **  | **5.50** |   | 43,658 |   | 1,544 |   | 4.73 |   |
| Securities:                                       |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Taxable securities                                |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| U.S. Treasury and government agencies             | ** ** | **1,424,119**  | ** **     | **40,631**                    | ** **  | **3.81** |   | 1,413,240 |   | 35,747 |   | 3.38 |   |
| Mortgage-backed                                   | ** ** | **1,619,045**  | ** **     | **52,692**                    | ** **  | **4.35** |   | 1,375,285 |   | 41,305 |   | 4.02 |   |
| Other investments                                 | ** ** | **64,114**     | ** **     | **2,007**                     | ** **  | **4.19** |   | 63,765 |   | 1,763 |   | 3.70 |   |
| Tax-exempt securities                             |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| States and political subdivisions                 | ** ** | **80,548**     | ** **     | **3,761**                     | ** **  | **6.24** |   | 87,760 |   | 3,885 |   | 5.92 |   |
| Total securities                                  | ** ** | **3,187,826**  | ** **     | **99,091**                    | ** **  | **4.16** |   | 2,940,050 |   | 82,700 |   | 3.76 |   |
| Interest-bearing deposits in other banks          | ** ** | **200**        | ** **     | **2**                         | ** **  | **1.44** |   | 197 |   | 2 |   | 1.15 |   |
| Total earning assets                              | ** ** | **15,244,010** | ** **     | **734,086**                   | ** **  | **6.44** |   | 13,855,629 |   | 595,848 |   | 5.75 |   |
| Cash and due from banks                           | ** ** | **310,123**    |           |                          |        |   |   | 306,434 |   |   |   |   |   |
| Bank premises and equipment, net                  | ** ** | **139,780**    |           |                          |        |   |   | 144,362 |   |   |   |   |   |
| Other assets                                      | ** ** | **1,301,824**  |           |                          |        |   |   | 1,121,574 |   |   |   |   |   |
| Less: allowance for loan losses                   | ** ** | **(148,494**   | **)**          |                          |        |   |   | (153,268 | ) |   |   |   |   |
| Total assets                                      | ** ** | **$**          | **16,847,243** |                          |        |   |   |   | $ | 15,274,731 |   |   |   |   |   |
| Interest-bearing liabilities                      |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Deposits:                                         |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Savings                                           | ** ** | **$**          | **1,277,603**  | ** **                    | **4,756**   | ** ** | **0.50** |   | $ | 1,447,797 |   | 3,983 |   | 0.37 |   |
| Checking plus interest                            | ** ** | **1,290,233**  | ** **     | **1,887**                     | ** **  | **0.20** |   | 1,399,352 |   | 1,719 |   | 0.16 |   |
| Money market                                      | ** ** | **2,000,814**  | ** **     | **39,246**                    | ** **  | **2.62** |   | 1,606,528 |   | 14,653 |   | 1.22 |   |
| Time deposits $100,000 and over                   | ** ** | **2,065,129**  | ** **     | **67,829**                    | ** **  | **4.39** |   | 1,574,236 |   | 35,254 |   | 2.99 |   |
| Other time deposits                               | ** ** | **2,370,668**  | ** **     | **61,920**                    | ** **  | **3.49** |   | 2,088,820 |   | 39,671 |   | 2.54 |   |
| Total interest-bearing deposits                   | ** ** | **9,004,447**  | ** **     | **175,638**                   | ** **  | **2.61** |   | 8,116,733 |   | 95,280 |   | 1.57 |   |
| Short-term borrowings                             | ** ** | **1,411,287**  | ** **     | **39,738**                    | ** **  | **3.76** |   | 1,069,792 |   | 17,228 |   | 2.15 |   |
| Long-term debt                                    | ** ** | **689,474**    | ** **     | **27,394**                    | ** **  | **5.31** |   | 743,381 |   | 23,634 |   | 4.25 |   |
| Total interest-bearing funds                      | ** ** | **11,105,208** | ** **     | **242,770**                   | ** **  | **2.92** |   | 9,929,906 |   | 136,142 |   | 1.83 |   |
| Noninterest-bearing deposits                      | ** ** | **3,239,008**  |           |                          |        |   |   | 3,135,048 |   |   |   |   |   |
| Other liabilities and accrued expenses            | ** ** | **198,284**    |           |                          |        |   |   | 151,653 |   |   |   |   |   |
| Total liabilities                                 | ** ** | **14,542,500** |           |                          |        |   |   | 13,216,607 |   |   |   |   |   |
| Shareholders’ equity                         | ** ** | **2,304,743**  |           |                          |        |   |   | 2,058,124 |   |   |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**          | **16,847,243** |                          |        |   |   |   | $ | 15,274,731 |   |   |   |   |   |
| Net interest rate spread                          | ** ** | ** **     | ** **     | **$**                         | **491,316** |   | **3.52** | **%** |   |   | $ | 459,706 |   | 3.92 | % |
| Effect of noninterest-bearing funds               | ** ** | ** **     |           |                          |        | **0.79** |   |   |   |   |   | 0.52 |   |
| Net interest margin on earning assets             | ** ** | ** **     |           |                          |        | **4.31** | **%** |   |   |   |   | 4.44 | % |
| Tax-equivalent adjustment included in:            |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Loan income                                       | ** ** | ** **     |           | **$**                         | **4,015**   |   |   |   |   |   | $ | 3,467 |   |   |   |
| Investment securities income                      | ** ** | ** **     |           | **1,509**                     |        |   |   |   |   | 1,547 |   |   |   |
| Total                                             | ** ** | ** **     |           | **$**                         | **5,524**   |   |   |   |   |   | $ | 5,014 |   |   |   |
|                                                   |            |                |                |                               |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

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

29

----

**Analysisof Interest Rates and Interest Differentials**

Thefollowing table presents the distribution of the average consolidated balancesheet, interest income/expense and annualized yields earned and rates paid forthe three months ended September 30, 2006 and 2005.
| ** **                                         | ** ** | **2006**       | ** **     | **2005**                      | ** **  |
|----------------------------------------------------|------------|----------------|----------------|-------------------------------|-------------|
| **(Dollars in thousands)**               | ** ** | ** **     | ** **     | **Average  Balance (2)** | ** **  | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** | **Average  Balance (2)** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                     |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Loans:                                             |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Commercial                                         | ** ** | **$**          | **2,924,627**  | ** **                    | **$**       | **55,810** | ** ** | **7.57** | **%** | $ | 2,914,761 |   | $ | 48,635 |   | 6.62 | % |
| Commercial real estate                             | ** ** | **4,085,822**  | ** **     | **73,607**                    | ** **  | **7.15** |   | 3,610,170 |   | 60,538 |   | 6.65 |   |
| Construction                                       | ** ** | **1,911,222**  | ** **     | **40,571**                    | ** **  | **8.42** |   | 1,544,082 |   | 28,077 |   | 7.21 |   |
| Residential real estate                            | ** ** | **1,951,620**  | ** **     | **30,525**                    | ** **  | **6.21** |   | 1,775,023 |   | 26,771 |   | 5.98 |   |
| Home equity lines                                  | ** ** | **479,436**    | ** **     | **9,723**                     | ** **  | **8.05** |   | 517,798 |   | 8,126 |   | 6.23 |   |
| Consumer                                           | ** ** | **1,048,341**  | ** **     | **15,341**                    | ** **  | **5.81** |   | 1,027,897 |   | 14,797 |   | 5.71 |   |
| Total loans                                        | ** ** | **12,401,068** | ** **     | **225,577**                   | ** **  | **7.22** |   | 11,389,731 |   | 186,944 |   | 6.51 |   |
| Federal funds sold, et  al                         | ** ** | **61,342**     | ** **     | **854**                       | ** **  | **5.52** |   | 57,932 |   | 759 |   | 5.20 |   |
| Securities:                                        |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Taxable securities                                 |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| U.S. Treasury and  government agencies             | ** ** | **1,381,027**  | ** **     | **13,769**                    | ** **  | **3.96** |   | 1,431,397 |   | 12,078 |   | 3.35 |   |
| Mortgage-backed                                    | ** ** | **1,662,093**  | ** **     | **18,624**                    | ** **  | **4.45** |   | 1,455,475 |   | 14,608 |   | 3.98 |   |
| Other investments                                  | ** ** | **63,393**     | ** **     | **669**                       | ** **  | **4.19** |   | 62,318 |   | 526 |   | 3.35 |   |
| Tax-exempt securities                              |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| States and political  subdivisions                 | ** ** | **76,727**     | ** **     | **1,209**                     | ** **  | **6.25** |   | 93,683 |   | 1,390 |   | 5.89 |   |
| Total securities                                   | ** ** | **3,183,240**  | ** **     | **34,271**                    | ** **  | **4.27** |   | 3,042,873 |   | 28,602 |   | 3.73 |   |
| Interest-bearing  deposits in other banks          | ** ** | **200**        | ** **     | **1**                         | ** **  | **1.45** |   | 200 |   | 1 |   | 1.02 |   |
| Total earning assets                               | ** ** | **15,645,850** | ** **     | **260,703**                   | ** **  | **6.61** |   | 14,490,736 |   | 216,306 |   | 5.92 |   |
| Cash and due from banks                            | ** ** | **324,675**    |           |                          |        |   |   | 326,515 |   |   |   |   |   |
| Bank premises and  equipment, net                  | ** ** | **142,120**    |           |                          |        |   |   | 147,248 |   |   |   |   |   |
| Other assets                                       | ** ** | **1,330,705**  |           |                          |        |   |   | 1,257,846 |   |   |   |   |   |
| Less: allowance for  loan losses                   | ** ** | **(146,021**   | **)**          |                          |        |   |   | (157,177 | ) |   |   |   |   |
| Total assets                                       | ** ** | **$**          | **17,297,329** |                          |        |   |   |   | $ | 16,065,168 |   |   |   |   |   |
| Interest-bearing  liabilities                      |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Deposits:                                          |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Savings                                            | ** ** | **$**          | **1,229,751**  | ** **                    | **1,749**   | ** ** | **0.56** |   | $ | 1,420,283 |   | 1,519 |   | 0.42 |   |
| Checking plus interest                             | ** ** | **1,231,558**  | ** **     | **622**                       | ** **  | **0.20** |   | 1,428,344 |   | 626 |   | 0.17 |   |
| Money market                                       | ** ** | **2,202,466**  | ** **     | **16,612**                    | ** **  | **2.99** |   | 1,692,684 |   | 6,566 |   | 1.54 |   |
| Time deposits $100,000  and over                   | ** ** | **2,243,487**  | ** **     | **26,784**                    | ** **  | **4.74** |   | 1,674,265 |   | 13,939 |   | 3.30 |   |
| Other time deposits                                | ** ** | **2,429,730**  | ** **     | **23,025**                    | ** **  | **3.76** |   | 2,295,608 |   | 15,941 |   | 2.76 |   |
| Total interest-bearing  deposits                   | ** ** | **9,336,992**  | ** **     | **68,792**                    | ** **  | **2.92** |   | 8,511,184 |   | 38,591 |   | 1.80 |   |
| Short-term borrowings                              | ** ** | **1,487,948**  | ** **     | **15,215**                    | ** **  | **4.06** |   | 1,185,142 |   | 7,702 |   | 2.58 |   |
| Long-term debt                                     | ** ** | **665,300**    | ** **     | **8,780**                     | ** **  | **5.24** |   | 797,527 |   | 8,990 |   | 4.47 |   |
| Total interest-bearing  funds                      | ** ** | **11,490,240** | ** **     | **92,787**                    | ** **  | **3.20** |   | 10,493,853 |   | 55,283 |   | 2.09 |   |
| Noninterest-bearing  deposits                      | ** ** | **3,255,069**  |           |                          |        |   |   | 3,240,806 |   |   |   |   |   |
| Other liabilities and  accrued expenses            | ** ** | **209,475**    |           |                          |        |   |   | 151,094 |   |   |   |   |   |
| Total liabilities                                  | ** ** | **14,954,784** |           |                          |        |   |   | 13,885,753 |   |   |   |   |   |
| Shareholders’ equity                          | ** ** | **2,342,545**  |           |                          |        |   |   | 2,179,415 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity | ** ** | **$**          | **17,297,329** |                          |        |   |   |   | $ | 16,065,168 |   |   |   |   |   |
| Net interest rate  spread                          | ** ** | ** **     | ** **     | **$**                         | **167,916** |   | **3.41** | **%** |   |   | $ | 161,023 |   | 3.83 | % |
| Effect of  noninterest-bearing funds               | ** ** | ** **     |           |                          |        | **0.85** |   |   |   |   |   | 0.58 |   |
| Net interest margin on  earning assets             | ** ** | ** **     |           |                          |        | **4.26** | **%** |   |   |   |   | 4.41 | % |
| Tax-equivalent  adjustment included in:            |       |           |           |                          |        |   |   |   |   |   |   |   |   |
| Loan income                                        | ** ** | ** **     |           | **$**                         | **1,359**   |   |   |   |   |   | $ | 1,230 |   |   |   |
| Investment securities  income                      | ** ** | ** **     |           | **488**                       |        |   |   |   |   | 551 |   |   |   |
| Total                                              | ** ** | ** **     |           | **$**                         | **1,847**   |   |   |   |   |   | $ | 1,781 |   |   |   |
|                                                    |            |                |                |                               |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

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

30

----

**Rate /Volume Analysis**

Arate/volume analysis, which demonstrates changes in interest income and expensefor significant assets and liabilities, appears below.
| ** **                                | ** ** | **For the 9 months ended September 30,** | ** ** | **For the 3 months ended September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2006 vs. 2005**                                            | ** ** | **2006 vs. 2005**                                            | ** ** |
| ** **                                | ** ** | **Due to variances in**                                 | ** ** | **Due to variances in**                                 | ** ** |
| **(Dollars in thousands)**      | ** ** | ** **                                                             | ** ** | **Total**                                                              | ** ** | **Rates (6)** | ** ** | **Volumes (5),(6)** | ** ** | **Total** | ** ** | **Rates (6)** | ** ** | **Volumes (5),(6)** | ** ** |
| Interest earned on:                       |       |                                                                   |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Loans:                                    |       |                                                                   |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Commercial (1)                            |       | $                                                                      | 24,961     |                                                                   | $          | 22,756 |   | $ | 2,205 |   | $ | 7,175 |   | $ | 6,986 |   | $ | 189 |   |
| Commercial real estate (2)                |       | 37,957                                                                 |       | 13,491                                                                 |       | 24,466 |   | 13,069 |   | 4,526 |   | 8,543 |   |
| Construction (3)                          |       | 37,163                                                                 |       | 15,161                                                                 |       | 22,002 |   | 12,494 |   | 4,717 |   | 7,777 |   |
| Residential real estate                   |       | 9,298                                                                  |       | 2,960                                                                  |       | 6,338 |   | 3,754 |   | 1,008 |   | 2,746 |   |
| Home equity lines                         |       | 5,827                                                                  |       | 6,914                                                                  |       | (1,087 | ) | 1,597 |   | 2,370 |   | (773 | ) |
| Consumer                                  |       | 5,576                                                                  |       | (173                                                                   | )          | 5,749 |   | 544 |   | 248 |   | 296 |   |
| Taxable securities (4)                    |       | 16,515                                                                 |       | 8,692                                                                  |       | 7,823 |   | 5,850 |   | 4,176 |   | 1,674 |   |
| Tax-exempt securities (4)                 |       | (124                                                                   | )          | 212                                                                    |       | (336 | ) | (181 | ) | 85 |   | (266 | ) |
| Federal funds sold, et al                 |       | 1,065                                                                  |       | 253                                                                    |       | 812 |   | 95 |   | 47 |   | 48 |   |
| Interest-bearing deposits  in other banks |       | —                                                                 |       | —                                                                 |       | — |   | — |   | — |   | — |   |
| Total interest income                     |       | 138,238                                                                |       | 71,340                                                                 |       | 66,898 |   | 44,397 |   | 25,230 |   | 19,167 |   |
|                                      |       |                                                                   |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Interest paid on:                         |       |                                                                   |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Savings deposits                          |       | 773                                                                    |       | 1,383                                                                  |       | (610 | ) | 230 |   | 516 |   | (286 | ) |
| Checking plus interest  deposits          |       | 168                                                                    |       | 372                                                                    |       | (204 | ) | (4 | ) | 109 |   | (113 | ) |
| Money market accounts                     |       | 24,593                                                                 |       | 16,853                                                                 |       | 7,740 |   | 10,046 |   | 6,197 |   | 3,849 |   |
| Time deposits $100,000 and  over          |       | 32,575                                                                 |       | 16,500                                                                 |       | 16,075 |   | 12,845 |   | 6,062 |   | 6,783 |   |
| Other time deposits                       |       | 22,249                                                                 |       | 14,875                                                                 |       | 7,374 |   | 7,084 |   | 5,784 |   | 1,300 |   |
| Short-term borrowings                     |       | 22,510                                                                 |       | 12,919                                                                 |       | 9,591 |   | 7,513 |   | 4,412 |   | 3,101 |   |
| Long-term debt                            |       | 3,760                                                                  |       | 5,905                                                                  |       | (2,145 | ) | (210 | ) | 1,539 |   | (1,749 | ) |
| Total interest expense                    |       | 106,628                                                                |       | 81,162                                                                 |       | 25,466 |   | 37,504 |   | 29,460 |   | 8,044 |   |
| Net  interest earned                      |       | $                                                                      | 31,610     |                                                                   | $          | (9,822 | ) | $ | 41,432 |   | $ | 6,893 |   | $ | (4,230 | ) | $ | 11,123 |   |
|                                           |            |                                                                        |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)             Interest year-to-date tax-equivalent adjustmentsof $2.4 million and $2.3 million for 2006 and 2005, respectively, andquarter-to-date tax-equivalent adjustments of $0.8 million for 2006 and 2005are included in the calculation of commercial loan rate variances.

(2)             Interest year-to-date tax-equivalent adjustmentsof $0.6 million and $0.4 million for 2006 and 2005, respectively, andquarter-to-date tax-equivalent adjustments of $0.2 million for 2006 and 2005are included in the calculation of commercial real estate loan rate variances.

(3)             Interest year-to-date tax-equivalent adjustmentsof $1.0 million and $0.7 million for 2006 and 2005, respectively, andquarter-to-date tax-equivalent adjustments of $0.4 million and $0.3 million for2006 and 2005, respectively, are included in the calculation of constructionloan rate variances.

(4)             Interest year-to-date tax-equivalent adjustmentsof $1.5 million for 2006 and 2005, respectively, and quarter-to-datetax-equivalent adjustments of $0.5 million and $0.6 million for 2006 and 2005,respectively, are included in the calculation of investment securities ratevariances.

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

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

31

----

**NetInterest Income and Net Interest Margin**

Net interest income for the quarter ended September30, 2006, on a taxable-equivalent basis, increased 4.3% to $167.9 million from$161.0 million for the third quarter of 2005. The increase was due to growth inaverage earning assets of $1.2 billion, or 8.0%. The net interest margindeclined 15 basis points from 4.41% for the third quarter of 2005 to 4.26% forthe third quarter of 2006.  The declinewas due primarily to growth in premium money market accounts and certificatesof deposit as customers shifted to these higher rate products; increasedcompetition affecting yields on new loans and the increase in the overall yieldon the investment portfolio lagging the increase in funding costs.  Bankshares paid an average rate of 3.2% oninterest-bearing liabilities during the third quarter of 2006, an increase of111 basis points over the third quarter of 2005.  By contrast, the yield on average loans andinvestments increased by 71 basis points and 54 basis points, respectively,over the third quarter of 2005.

On a linked-quarter basis,taxable-equivalent net interest income increased by 2.9% to $167.9 million from$163.3 million.  The increase inlinked-quarter net interest income was attributable to average earning assetgrowth of $448.9 million (primarily from the James Monroe acquisition)partially offset by a five basis point decline in the net interest margin.  The net interest margin decline wasattributable primarily to a 33 basis point increase in the average rate paidfor deposits for the third quarter of 2006 compared with the second quarter of2006.  By contrast, the yield on interestearning assets increased only 18 basis points.

# Net interest income, on ataxable-equivalent basis, for the first nine months of 2006 increased to $491.3million, or 6.9%, over the $459.7 million for the first nine months of 2005 dueto average earning asset growth of $1.4 billion, or 10.0%.  The net interest margin declined from 4.44%to 4.31% as increases in funding costs of 109 basis points outpaced the 69basis point increase in the yield on earning assets.

Average earning assets in the third quarter of 2006increased $1.2 billion, or 8.0%, over the same period in 2005.  Loansaveraged $12.4 billion for the third quarter of 2006, an increase of 8.9% overthe $11.4 billion for the third quarter of 2005, with James Monroe contributing33% of that growth based on $337.7 million in average acquired loans.  Loans increased $480.0 million, or 4.0%, on alinked-quarter basis.  The increase inaverage loans outstanding in the third quarter of 2006 compared to the thirdquarter of 2005 was driven by commercial real estate loan growth of $475.7million, or 13.2%; construction loan growth of $367.1 million, or 23.8%; andresidential mortgage loan growth of $176.6 million, or 9.9%.

Averageinvestment securities for the third quarter of 2006 increased by $140.4million, or 4.6%, compared with the same period in 2005.

Average deposits for the thirdquarter of 2006 increased 7.1% year-over-year with James Monroe contributing42% of that growth, based on $353.5 million in average acquired deposits.  Average noninterest-bearing deposits for thethird quarter of 2006 increased by $14.3 million, or 0.4%, compared with thesame period in 2005.  Total averageinterest-bearing deposits increased by $825.8 million, or 9.7%, for the thirdquarter of 2006, compared with the same period in 2005.

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

32

----

# **Noninterest Income**

Noninterestincome for the quarter ended September 30, 2006 decreased by $3.3 million, or5.2%, to $59.8 million compared with $63.1 million for the same period in2005.  Noninterest income decreased 7.3%compared with the second quarter of 2006.

Thetable below shows the major components of noninterest income.

 
| ** **                                | ** ** | **For the 9 months ended  September 30,** | ** **  | **% Change** | ** ** | **For the 3 months ended   September 30,** | ** ** | **% Change** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------|-------------|-------------------|------------|--------------------------------------------------------------------------|------------|-------------------|------------|
| **(Dollars in thousands)**      | ** ** | ** **                                                         | ** **  | **2006**          | ** ** | **2005**                                                                 | ** ** | **2006/2005**     | ** ** | **2006** | ** ** | **2005** | ** ** | **2006/2005** | ** ** |
| Investment and  wealth management         | ** ** | **$**                                                              | **82,582**  |              | $          | 71,505                                                                   |       | 15.5              | %          | **$** | **27,596** |   | $ | 23,668 |   | 16.6 | % |
| Service charges  on deposit accounts      | ** ** | **33,936**                                                         |        | 32,992            |       | 2.9                                                                      | ** ** | **12,776**        |       | 11,478 |   | 11.3 |   |
| Mortgage banking  related fees            | ** ** | **5,042**                                                          |        | 10,329            |       | (51.2                                                                    | )          | **497**           |       | 5,151 |   | (90.4 | ) |
| Net investment  securities (losses) gains | ** ** | **205**                                                            |        | 458               |       | (55.2                                                                    | )          | **218**           |       | (32 | ) | 781.3 |   |
| Nonmarketable  investments:               |       |                                                               |        |              |       |                                                                     |       |              |       |   |   |   |   |
| Private equity and other investments      | ** ** | **4,958**                                                          |        | 7,069             |       | (29.9                                                                    | )          | **263**           |       | 39 |   | 574.4 |   |
| Hedge funds                               | ** ** | **3,599**                                                          |        | 3,616             |       | (0.5                                                                     | )          | **(801**          | **)**      | 2,897 |   | (127.6 | ) |
| Bank-owned life insurance                 | ** ** | **4,826**                                                          |        | 2,998             |       | 61.0                                                                     | ** ** | **1,688**         |       | 1,254 |   | 34.6 |   |
| Total nonmarketable investments           | ** ** | **13,383**                                                         |        | 13,683            |       | (2.2                                                                     | )          | **1,150**         |       | 4,190 |   | (72.6 | ) |
| Other income:                             |       |                                                               |        |              |       |                                                                     |       |              |       |   |   |   |   |
| Electronic banking fees                   | ** ** | **19,547**                                                         |        | 18,137            |       | 7.8                                                                      | ** ** | **7,424**         |       | 7,010 |   | 5.9 |   |
| Charges and fees on loans                 | ** ** | **8,936**                                                          |        | 9,601             |       | (6.9                                                                     | )          | **3,065**         |       | 3,786 |   | (19.0 | ) |
| Insurance                                 | ** ** | **12,542**                                                         |        | 11,578            |       | 8.3                                                                      | ** ** | **3,680**         |       | 3,480 |   | 5.7 |   |
| All other income                          | ** ** | **8,668**                                                          |        | 12,726            |       | (31.9                                                                    | )          | **3,361**         |       | 4,343 |   | (22.6 | ) |
| Total other income                        | ** ** | **49,693**                                                         |        | 52,042            |       | (4.5                                                                     | )          | **17,530**        |       | 18,619 |   | (5.8 | ) |
| Total                                     | ** ** | **$**                                                              | **184,841** |              | $          | 181,009                                                                  |       | 2.1               | ** ** | **$** | **59,767** |   | $ | 63,074 |   | (5.2 | ) |
|                                           |            |                                                                    |             |                   |            |                                                                          |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

Noninterest income, whichincludes investment and wealth management (“IWM”) fees, service charges ondeposit accounts, mortgage banking-related fees, securities gains and losses,income from nonmarketable investments and other income, decreased $3.3 million,or 5.2%, to $59.8 million for the third quarter of  2006 from $63.1 million for the third quarterof 2005.  IWM revenue increased $3.9million, or 16.6%, for the third quarter of 2006 from the third quarter of2005.  Mortgage banking-related feesdecreased $4.7 million for the third quarter of 2006 from the third quarter of2005 due primarily to the sale of Columbia National Real Estate Finance, LLC (“CNREF”).  Nonmarketable investments revenue for thethird quarter of 2006 decreased by $3.0 million from the same period in 2005due to losses in the hedge funds of funds (“hedge funds”).  Increases in electronic banking fees of $0.4million, $1.3 million in additional fees on deposit accounts and insurancerevenues were offset partially by a $0.7 million decline in charges and fees onloans.

Noninterest income for thethird quarter of 2006 decreased by $4.7 million, or 7.3%, from the second quarterof 2006.  The decrease was due to a $4.8million decline in nonmarketable investments income.  This consisted of a $3.1 million decline inrevenues from private equity investments and a $1.8 million decline in hedgefund revenues driven by a $1.0 million loss related to Amaranth, in which oneof our hedge funds of funds was invested. Furthermore, a $1.3 million decrease in IWM revenues and a $1.8 milliondecline in mortgage banking-related fees were offset by increases of $1.9million in service charges on deposit accounts and $1.2 million in other incomeand earnings on bank-owned life insurance (“BOLI”).

Noninterest income for the ninemonths ended September 30, 2006 increased to $184.8 million, or 2.1%, over the$181.0 million for the nine months ended September 30, 2005.  The year-over-year increase was dueprincipally to an increase of $11.1 million in IWM revenues of whichapproximately $7.0 million was attributable to real estate advisory fees fromthe restructured real estate advisory relationship.  Furthermore, electronic banking feesincreased $1.4 million; service charges on deposits increased $0.9 million;insurance revenues increased $1.0 million; and earnings on BOLI increased $1.8million.  The increases were offset by adecrease of $5.3 million in mortgage banking-related fees from the same periodin 2005 and a $2.1 million decrease in private equity income.  In addition, the nine months ended September30, 2005 included gains of $4.3 million on sales of bank premises that were notrepeated this year.

33

----

**NoninterestExpenses**

Noninterestexpenses for the quarter ended September 30, 2006 increased by $4.0 million, or3.7%, to $112.4 million compared with $108.4 million for the quarter endedSeptember 30, 2005.  Noninterest expensesincreased $3.0 million, or 2.7%, over the second quarter of 2006.  This increase was due primarily to $2.3million of operating expenses associated with the James Monroe acquisitiondiscussed previously.  Bankshares alsoincurred $0.7 million of merger expenses related to James Monroe.

Thetable below shows the major components of noninterest expenses.
| ** **                              | ** ** | **For the 9 months ended   September 30,** | ** **  | **% Change** | ** ** | **For the 3 months ended   September 30,** | ** ** | **% Change** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------------|-------------|-------------------|------------|--------------------------------------------------------------------------|------------|-------------------|------------|
| **(Dollars in thousands)**    | ** ** | ** **                                                               | ** **  | **2006**          | ** ** | **2005**                                                                 | ** ** | **2006/2005**     | ** ** | **2006** | ** ** | **2005** | ** ** | **2006/2005** | ** ** |
| Salaries                                | ** ** | **$**                                                                    | **147,755** |              | $          | 148,482                                                                  | ** ** | (0.5              | )%         | **$** | **51,424** |   | $ | 51,748 |   | (0.6 | )% |
| Employee  benefits                      | ** ** | **42,538**                                                               |        | 35,490            |       | 19.9                                                                     | ** ** | **13,511**        |       | 11,637 |   | 16.1 |   |
| Net occupancy  expense of bank premises | ** ** | **23,991**                                                               |        | 20,918            |       | 14.7                                                                     | ** ** | **8,289**         |       | 7,139 |   | 16.1 |   |
| Furniture and  equipment expenses       | ** ** | **24,752**                                                               |        | 23,168            |       | 6.8                                                                      | ** ** | **8,353**         |       | 7,965 |   | 4.9 |   |
| Communications  and supplies            | ** ** | **12,083**                                                               |        | 11,992            |       | 0.8                                                                      | ** ** | **3,796**         |       | 3,933 |   | (3.5 | ) |
| Other expenses:                         |       |                                                                     |        |              |       |                                                                     |       |              |       |   |   |   |   |
| Professional services                   | ** ** | **17,955**                                                               |        | 16,047            |       | 11.9                                                                     | ** ** | **6,042**         |       | 6,040 |   | — |   |
| Advertising and promotional expenses    | ** ** | **7,572**                                                                |        | 6,550             |       | 15.6                                                                     | ** ** | **3,719**         |       | 2,162 |   | 72.0 |   |
| Electronic banking expense              | ** ** | **11,031**                                                               |        | 10,443            |       | 5.6                                                                      | ** ** | **4,375**         |       | 4,025 |   | 8.7 |   |
| Amortization of intangible assets       | ** ** | **7,064**                                                                |        | 6,482             |       | 9.0                                                                      | ** ** | **2,522**         |       | 2,231 |   | 13.0 |   |
| Outsourcing expense                     | ** ** | **8,256**                                                                |        | 8,166             |       | 1.1                                                                      | ** ** | **2,792**         |       | 3,093 |   | (9.7 | ) |
| All other expenses                      | ** ** | **25,569**                                                               |        | 24,710            |       | 3.5                                                                      | ** ** | **7,606**         |       | 8,409 |   | (9.5 | ) |
| Total other expenses                    | ** ** | **77,447**                                                               |        | 72,398            |       | 7.0                                                                      | ** ** | **27,056**        |       | 25,960 |   | 4.2 |   |
| Total                                   | ** ** | **$**                                                                    | **328,566** |              | $          | 312,448                                                                  |       | 5.2               | ** ** | **$** | **112,429** |   | $ | 108,382 |   | 3.7 |   |
|                                         |            |                                                                          |             |                   |            |                                                                          |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

Theefficiency ratio, a key measure of expense management, increased in the thirdquarter of 2006 compared with the same quarter of 2005.  The efficiency ratio is computed by dividingnoninterest expenses by the sum of net interest income on a taxable-equivalentbasis and noninterest income.  Bankshares’efficiency ratio was 49.38% for the three months ended September 30, 2006compared with 48.36% for the three months ended September 30, 2005.  On a non-GAAP basis, the cash operatingefficiency ratio excludes the amortization of intangible assets associated withpurchase accounting for business combinations; securities gains and losses; andother significant gains, losses or expenses (such as those associated withintegrating acquired entities’ operations into Bankshares) unrelated toBankshares’ core operations.  Bankshares’cash operating efficiency ratio was 48.02% for the three months ended September30, 2006 compared with 46.99% for the same period last year.  The reconciliation of GAAP to non-GAAPmeasures can be found at the end of this management’s discussion.

Salaries, which include base compensation, commissions,incentive compensation and stock-based compensation, are the largest componentof noninterest expense at 45.7%.  Salaryexpense decreased $0.3 million, or 0.6% from the third quarter of 2005.  Normal merit and staff increases of approximately $2.5 million and anadditional $1.3 million increase related to James Monroe were largely offset bya reduction of $4.4 million in salaries expense due to an increase in theamount of deferred loan origination costs. Furthermore, reductions to incentive compensation accruals of $2.6million were partially offset by a $2.3 million increase in stock-basedcompensation.  The $1.9 million increasein employee benefit expenses was due principally to increased medical andpension costs.

Netoccupancy expenses, which include premises depreciation, rents, maintenance andutilities increased $1.2 million, or 16.1%, over the same period in the prioryear.  This increase was due to increasesin bank-leased premises throughout the organization.

Totalother expenses consist of professional services, marketing, electronic bankingand several other categories such as travel and membership, amortization,licensing, insurance and sundry expenses. For the three months ended September 30, 2006 compared with the sameperiod last year, total other expenses increased $1.1 million.  This increase was due primarily to anincrease of $1.6 million in advertising and promotion expenses related to therestructuring of the real estate advisory relationship, a $1.3 million loss onthe sale of CNREF and $1.6 million in increased other professional fees.  

34

----

Offsettingthese increase were a decline in legal fees of $1.1 million, an insurance claimrecovery of $1.4 million and a reduction in minority interest expense of $0.7million.

Noninterestexpenses for the nine months ended September 30, 2006 increased $16.1 million,or 5.2%, to $328.6 million from $312.4 million for the nine months endedSeptember 30, 2005.

Salaryexpenses for the nine months ended September 30, 2006 decreased $0.7 millionfrom the prior year.  Normal merit andstaff increases resulted in $9.8 million of additional expense; directors’fees and stock-based compensation increased $5.2million; severance increased$1.8 million; and the James Monroe acquisition added $1.3 million in salaryexpenses.  Offsetting these increaseswere reductions of $14.5 million in salaries expense due to an increase in theamount of deferred loan origination costs and $4.6 million in incentivecompensation.  Employee benefits expensewas $7.0 million higher than 2005 due principally to increased pension relatedcosts of $3.7 million, $2.0 million in increased health insurance costs and$1.1 million in higher payroll taxes.

Netoccupancy expenses increased $3.1 million year-to-date 2006 over 2005.  The increase was primarily due to theCommunity Bank of Northern Virginia (“CBNV”) and James Monroe acquisitions andincreased costs of leasing bank premises and additional branches.

Totalother expenses for the first nine months of 2006 were $77.4 million, or 7.0%,higher than the same period in 2005. This increase was due primarily to $1.9 million in professional feesprincipally related to efforts to improve efficiency throughout the organization;$1.9 million in licensing fees related to the restructuring of the real estatepension advisory relationship; a $1.3 million loss on the sale of CNREF; a $1.0million increase in advertising and promotional expenses; increased travelexpenses of $0.6 million; an increase of $0.6 million in electronic bankingexpenses and $0.6 million of additional amortization expenses.  Offsetting these increases were $1.4 millionfrom an insurance recovery related to CBNV and a decrease in other expenses of$1.5 million primarily related to legal settlements during the first ninemonths of 2005.

ANALYSISOF FINANCIAL CONDITION

AtSeptember 30, 2006 compared with September 30, 2005, total assets increased7.1%, or $1.2 billion.  At September 30,2006 compared with December 31, 2005, total assets increased 7.0%, or $1.2billion.  This increase is attributable,in part, to the acquisition of James Monroe on July 17, 2006.  On the merger date, James Monroe had totalloans of $414 million, total assets of $552 million and total deposits of $434million.

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

**SecuritiesAvailable-for-Sale**

Thesecurities available-for-sale portfolio includes both debt and marketableequity securities.  Bankshares holds debtsecurities available-for-sale primarily for liquidity, interest rate riskmanagement and yield enhancement purposes. Accordingly, this portfolio primarily includes very liquid, high qualityfederal agency-backed debt securities. At September 30, 2006 and December 31, 2005, the portfolio totaled $3.1billion.  At September 30, 2006, therewas a net unrealized loss of $44.3 million. Two hundred ninety-one securities were in a continuous loss position for12 months or more at September 30, 2006, which consisted primarily ofmortgage-backed securities.  Managementconcluded that because the declines in fair value were due to changes in marketinterest rates, not in estimated cash flows, no other-than-temporary impairmentwas required to be recorded at September 30, 2006.  There was a net unrealized loss on debtsecurities available-for-sale of $44.9 million and $32.8 million atSeptember 30, 2006 and December 31, 2005, respectively.

 

35

----

 

Theweighted-average expected maturity of debt securities available-for-sale was2.3 years at September 30, 2006.  Sinceapproximately 54% of this portfolio was mortgage-backed securities, theexpected remaining maturity may differ from contractual maturity becauseborrowers may have the right to prepay obligations before the underlyingmortgages mature.  See Note No. 4 -Investment Securities to the Financial Statements for securitiesavailable-for-sale by security type.

**LoanPortfolio**

Totalloans at September 30, 2006 were $12.5 billion, compared with $11.6 billion atDecember 31, 2005.  The increase in totalloans was primarily driven by growth in construction lending, commercial realestate and residential mortgages and the acquisition of James Monroe, whichadded $414.3 million in loans. Construction loans totaled $2.0 billion at September 30, 2006, comparedwith $1.6 billion at December 31, 2005, an increase of $344.9 million, or21.5%. Commercial real estate loans increased $445.6 million, or 12.0%, fromDecember 31, 2005.  Residential realestate loans increased $186.0 million, or 10.3%, from December 31, 2005.  Total loans at September 30, 2006 increased$1.1 billion, or 9.5%, over September 30, 2005.
| ** **                           | ** ** | ** **             | ** **     | **% of** | ** ** | ** **            | ** ** | **% of** | ** ** | ** **             | ** ** | **% of** | ** ** |
|--------------------------------------|------------|------------------------|----------------|---------------|------------|-----------------------|------------|---------------|------------|------------------------|------------|---------------|------------|
| ** **                           | ** ** | **September 30,** | ** **     | **Total**     | ** ** | **December 31,** | ** ** | **Total**     | ** ** | **September 30,** | ** ** | **Total**     | ** ** |
| **(Dollars in thousands)** | ** ** | ** **             | ** **     | **2006**      | ** ** | **Loans**             | ** ** | **2005**      | ** ** | **Loans**              | ** ** | **2005**      | ** ** | **Loans** | ** ** |
| Commercial                           | ** ** | **$**                  | **2,925,300**  | ** **    | **23.3**   | **%**                 | $          | 2,957,301     |       | 25.5                   | %          | $             | 2,925,445  |   | 25.6 | % |
| Commercial real estate               | ** ** | **4,148,895**          | ** **     | **33.1**      |       | 3,703,297             |       | 31.9          |       | 3,638,238              |       | 31.8          |       |
| Construction                         | ** ** | **1,952,013**          | ** **     | **15.6**      |       | 1,607,095             |       | 13.8          |       | 1,543,633              |       | 13.5          |       |
| Residential real estate              | ** ** | **1,988,336**          | ** **     | **15.9**      |       | 1,802,373             |       | 15.5          |       | 1,778,684              |       | 15.5          |       |
| Home equity lines                    | ** ** | **476,746**            | ** **     | **3.8**       |       | 505,508               |       | 4.4           |       | 520,214                |       | 4.5           |       |
| Consumer                             | ** ** | **1,043,048**          | ** **     | **8.3**       |       | 1,032,271             |       | 8.9           |       | 1,039,845              |       | 9.1           |       |
| Total loans at end of  period        | ** ** | **$**                  | **12,534,338** | ** **    | **100.0**  | **%**                 | $          | 11,607,845    |       | 100.0                  | %          | $             | 11,446,059 |   | 100.0 | % |
|                                      |            |                        |                |               |            |                       |            |               |            |                        |            |               |            |  |  |  |  |  |

 

**Deposits**

Totaldeposits at September 30, 2006, were $12.8 billion, an increase of $697.8million, or 5.8%, over December 31, 2005. Noninterest-bearing deposits were $3.3 billion at September 30, 2006 andDecember 31, 2005.  Interest-bearingdeposits totaled $9.5 billion at September 30, 2006, compared with $8.8 billionat December 31, 2005, an increase of $720.1 million, or 8.2%.

AtSeptember 30, 2006, total deposits increased 6.1%, or $735.2 million, comparedwith the year-earlier period.  Theincrease in total deposits was primarily driven by the acquisition of JamesMonroe which added $433.6 million in deposit growth in money market accounts andtime deposits $100,000 and over.  Theseproducts are priced at competitive rates, which move with the overall interestrate environment. Money market accounts and time deposits $100,000 and overincreased $465.2 million, or 25.4%, and $542.4 million, or 30.7%, respectively,from September 30, 2005.  Traditionallow-cost savings and checking plus interest accounts declined by 13.6% and15.5%, respectively, from September 30, 2005 as customers moved liquidity tohigher yielding alternative products.

 
| ** **                           | ** ** | ** **    | ** **     | ** **                   | ** ** | ** **                  | ** ** | **% change**            | ** ** |
|--------------------------------------|------------|---------------|----------------|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **(Dollars in thousands)** | ** ** | ** **    | ** **     | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** | **September 30,  2006 /  December 31,  2005** | ** ** | **September 30,  2006 /  September 30,  2005** | ** ** |
| Noninterest-bearing  deposits        | ** ** | **$**         | **3,301,554**  |                         | $          | 3,324,650                   |       | $                            | 3,329,331  |   | (0.7 | )% | (0.8 | )% |
| Savings                              | ** ** | **1,196,573** |           | 1,339,215                    |       | 1,385,106                   |       | (10.7                        | )          | (13.6 | ) |
| Checking plus  interest              | ** ** | **1,229,760** |           | 1,430,524                    |       | 1,454,488                   |       | (14.0                        | )          | (15.5 | ) |
| Money market                         | ** ** | **2,295,341** |           | 1,944,513                    |       | 1,830,111                   |       | 18.0                         |       | 25.4 |   |
| Time deposits  $100,000 and over     | ** ** | **2,308,686** |           | 1,743,885                    |       | 1,766,250                   |       | 32.4                         |       | 30.7 |   |
| Other time  deposits                 | ** ** | **2,443,197** |           | 2,294,563                    |       | 2,274,620                   |       | 6.5                          |       | 7.4 |   |
| Total deposits  at end of period     | ** ** | **$**         | **12,775,111** |                         | $          | 12,077,350                  |       | $                            | 12,039,906 |   | 5.8 |   | 6.1 |   |
|                                      |            |               |                |                              |            |                             |            |                              |            |  |  |  |  |  |  |  |

 

36

----

**Borrowings**

Banksharesutilizes both short-term and long-term borrowings to fund growth of earningassets in excess of deposit growth. Short-term borrowings, which include federal funds purchased, securitiessold under agreements to repurchase and other short-term borrowings, were $1.6billion at September 30, 2006, compared with $1.2 billion at December 31,2005.  Short-term funding is managed tolevels deemed appropriate given alternative funding sources.  Long-term debt was $659.7 million atSeptember 30, 2006, a decrease of $82.5 million, or 11.1%, compared with the$742.2 million at December 31, 2005.

**Capital**

Shareholders’equity at September 30, 2006 was $2.4 billion, an increase of $198.7 millionfrom December 31, 2005, due in part to the shares issued in the James Monroeacquisition.  The 1.8 million sharesissued in the acquisition were valued at $63.1 million.

OnJune 13, 2006, Bankshares’ Board of Directors authorized the repurchase of upto two million shares of the Corporation’s common stock.  This is in addition to the 676 thousandshares remaining from a previously announced program.  During the first nine months of 2006,Bankshares repurchased 38,471 shares in the privately negotiated net settlementof the minimum tax liability for vested restricted stock awards.

OnJanuary 10, 2006, Bankshares announced a three-for-two stock split on itscommon stock payable in the form of a stock dividend on January 27, 2006 tostockholders of record as of the close of business on January 20, 2006.  For comparative purposes, certain share,average share and per share amounts have been restated.  At September 30, 2006 and December 31, 2005,the cash-dividend payout ratio was 47.13% and 43.42%, respectively.  For more details, see the Statements ofChanges in Consolidated Shareholders’ Equity.

RISKMANAGEMENT

**CreditRisk Analysis**

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

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

**NonperformingAssets**

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

37

----

Nonperformingloans increased to $36.0 million at September 30, 2006 from $22.6 million atDecember 31, 2005.  The increase resultedfrom loans to a single borrower aggregating $18.0 million.

Otherreal estate owned declined to $67 thousand at September 30, 2006 from $667thousand at December 31, 2005.  Thedecline resulted from the sale of an OREO property owned as a result of theCBNV acquisition.

Duringthe nine months ended September 30, 2006, total nonperforming assets increasedto $36.1 million from $23.2 million at December 31, 2005.  Nonperforming assets as a percent of period-endloans and other real estate owned was 0.29% at September 30, 2006 and 0.20% atDecember 31, 2005.

AtSeptember 30, 2006 and December 31, 2005, monitored loans, or loans withcharacteristics suggesting that they could be classified as nonperforming inthe near future, were $1.7 million and $2.2 million, respectively.  Loans past due 30-89 days were $34.5 millionat September 30, 2006 compared with $65.2 million at December 31, 2005.

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

 
| ** **                                                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | ** September 30, ** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|------------------------------------|------------|
| **(Dollars in thousands)**                                               | ** ** | ** **             | ** ** | **2006**              | ** ** | **2005**                           | ** ** | **2005** | ** ** |
| Nonaccrual loans(1)                                                                |       |                   |       |                  |       |                               |       |
| Commercial                                                                         | ** ** | **$**                  | **8,206**  |                  | $          | 15,771                             |       | $ | 21,065 |   |
| Commercial real estate                                                             | ** ** | **5,056**              |       | 4,451                 |       | 3,240                              |       |
| Construction                                                                       | ** ** | **19,519**             |       | 376                   |       | 377                                |       |
| Residential real estate                                                            | ** ** | **2,640**              |       | 1,505                 |       | 1,845                              |       |
| Home equity lines                                                                  | ** ** | **151**                |       | 88                    |       | 89                                 |       |
| Consumer                                                                           | ** ** | **430**                |       | 374                   |       | 406                                |       |
| Total                                                                              | ** ** | **36,002**             |       | 22,565                |       | 27,022                             |       |
| Renegotiated  loans (1)                                                            | ** ** | **—**             |       | —                |       | —                             |       |
| Loans  contractually past due 90 days or more                                      |       |                   |       |                  |       |                               |       |
| And still accruing interest                                                        | ** ** | **—**             |       | —                |       | —                             |       |
| Total nonperforming loans                                                          | ** ** | **36,002**             |       | 22,565                |       | 27,022                             |       |
| Other real  estate owned                                                           | ** ** | **67**                 |       | 667                   |       | 777                                |       |
| Total nonperforming assets                                                         | ** ** | **$**                  | **36,069** |                  | $          | 23,232                             |       | $ | 27,799 |   |
| Nonperforming  loans as a percent of period-end loans                              | ** ** | **0.29**               | **%**      | 0.19                  | %          | 0.24                               | %          |
| Nonperforming assets as  a percent of period-end loans and other real estate owned | ** ** | **0.29**               | **%**      | 0.20                  | %          | 0.24                               | %          |
|                                                                                    |            |                        |            |                       |            |                                    |            |  |  |  |  |  |

----

(1)             Aggregategross interest income of $2.4 million, $2.1 million and $1.9 million for thefirst nine months of 2006, the year 2005 and the first nine months of 2005,respectively, on nonaccrual and renegotiated loans, would have been recorded ifthese loans had been accruing on their original terms throughout the period orsince origination if held for part of the period.  The amount of interest income on thenonaccrual and renegotiated loans that was recorded totaled $0.5 million forthe first nine months of 2006 and 2005 and the year 2005.

**NetRecoveries/Charge-offs**

Netrecoveries for the nine months ended September 30, 2006 were $9 thousand ascompared to net charge-offs of $488 thousand in 2005.

38

----

**Provisionfor Credit Losses**

Therewere no provisions for credit losses for the nine months ended September 30,2006 compared with $1.6 million for the nine months ended September 30, 2005,reflecting improved loan quality and continued favorable economic conditions.

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

Theallowance for loan losses declined $12.8 million to $143.9 million at September30, 2006, or 1.15% of period-end loans, compared with $156.7 million, or 1.35%of period-end loans, at December 31, 2005 and declined $13.3 million comparedwith $157.2 million, or 1.37% of period end loans, at September 30, 2005.  The decline from year-end 2005 was primarily relatedto the reclassification of $14.0 million and $1.9 million in the first andthird quarters of 2006, respectively, from the reserve for loan losses toestablish the reserve for unfunded commitments in other liabilities.  The reclassification in the third quarterresulted from a refinement in the manner in which the required reserves forunfunded commitments were calculated. The acquired allowance from James Monroe was approximately $4.0 million.

Thefollowing table presents a summary of the activity in the Allowance for LoanLosses and the Reserve for Unfunded Commitments.
| ** **                                      | ** ** | **For the 9 months ended  September 30,** | ** **  | **For the 3 months ended  September 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------|-------------|--------------------------------------------------------------------|------------|
| **(Dollars in thousands)**            | ** ** | ** **                                                         | ** **  | **2006**                                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Allowance for  loan losses, beginning of period | ** ** | **$**                                                              | **156,673** |                                                               | $          | 149,002 | ** ** | **$** | **142,860** |   | $ | 157,101 |   |
| Allowance of  acquired bank                     | ** ** | **3,985**                                                          |        | 7,086                                                              | ** ** | **3,985** |   | — |   |
| Charge-offs:                                    |       |                                                               |        |                                                               |       |   |   |   |   |
| Commercial                                      | ** ** | **(1,470**                                                         | **)**       | (2,252                                                             | )          | **(876** | **)** | (570 | ) |
| Commercial real estate                          | ** ** | **(362**                                                           | **)**       | (32                                                                | )          | **—** |   | — |   |
| Construction                                    | ** ** | **—**                                                         |        | —                                                             | ** ** | **—** |   | — |   |
| Residential real estate                         | ** ** | **(54**                                                            | **)**       | (42                                                                | )          | **(52** | **)** | (28 | ) |
| Home equity lines                               | ** ** | **—**                                                         |        | (69                                                                | )          | **—** |   | — |   |
| Consumer                                        | ** ** | **(2,251**                                                         | **)**       | (2,430                                                             | )          | **(981** | **)** | (1,112 | ) |
| Total                                           | ** ** | **(4,137**                                                         | **)**       | (4,825                                                             | )          | **(1,909** | **)** | (1,710 | ) |
| Recoveries:                                     |       |                                                               |        |                                                               |       |   |   |   |   |
| Commercial                                      | ** ** | **2,440**                                                          |        | 1,813                                                              | ** ** | **358** |   | 233 |   |
| Commercial real estate                          | ** ** | **88**                                                             |        | 151                                                                | ** ** | **28** |   | 27 |   |
| Construction                                    | ** ** | **2**                                                              |        | 446                                                                | ** ** | **1** |   | 445 |   |
| Residential real estate                         | ** ** | **60**                                                             |        | 232                                                                | ** ** | **7** |   | 167 |   |
| Home equity lines                               | ** ** | **24**                                                             |        | —                                                             | ** ** | **—** |   | — |   |
| Consumer                                        | ** ** | **1,532**                                                          |        | 1,695                                                              | ** ** | **379** |   | 93 |   |
| Total                                           | ** ** | **4,146**                                                          |        | 4,337                                                              | ** ** | **773** |   | 965 |   |
| Net recoveries (charge-offs)                    | ** ** | **9**                                                              |        | (488                                                               | )          | **(1,136** | **)** | (745 | ) |
| Provision for  credit losses                    | ** ** | **(990**                                                           | **)**       | 1,576                                                              | ** ** | **—** |   | 820 |   |
| Transfer to  reserve for unfunded commitments   | ** ** | **(15,824**                                                        | **)**       | —                                                             | ** ** | **(1,856** | **)** | — |   |
| Allowance for  loan losses, end of period       | ** ** | **$**                                                              | **143,853** |                                                               | $          | 157,176 | ** ** | **$** | **143,853** |   | $ | 157,176 |   |
|                                                 |            |                                                                    |             |                                                                    |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                               | ** ** | **For the 9 months ended  September 30,** | ** **     | **For the 3 months ended   September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------|----------------|--------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**                                     | ** ** | ** **                                                         | ** **     | **2006**                                                                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Reserve for  unfunded lending commitments, beginning of period           | ** ** | **$**                                                              | **—**     |                                                                     | $          | — | ** ** | **$** | **14,958** |   | $ | — |   |
| Provision for  credit losses                                             | ** ** | **990**                                                            |           | —                                                                   | ** ** | **—** |   | — |   |
| Transfer from  allowance for loan losses                                 | ** ** | **15,824**                                                         |           | —                                                                   | ** ** | **1,856** |   | — |   |
| Reserve for  unfunded lending commitments, end of period                 | ** ** | **$**                                                              | **16,814**     |                                                                     | $          | — | ** ** | **$** | **16,814** |   | $ | — |   |
|                                                                     |       |                                                               |           |                                                                     |       |   |   |   |   |
| Average loans                                                            | ** ** | **$**                                                              | **11,992,600** |                                                                     | $          | 10,871,724 | ** ** | **$** | **12,401,068** |   | $ | 11,389,731 |   |
| Period-end loans                                                         | ** ** | **$**                                                              | **12,534,338** |                                                                     | $          | 11,446,059 |   |   |   |   |   |
|                                                                     |       |                                                               |           |                                                                     |       |   |   |   |   |
| **Allowance  for loan losses**                                           | ** ** | ** **                                                         | ** **     | ** **                                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Percent of net  (recoveries) charge-offs, (annualized), to average loans | ** ** | **—**                                                         | **%**          | 0.01                                                                     | %          | **0.04** | **%** | 0.03 | % |
| Percent of allowance  for loan losses to period-end loans                | ** ** | **1.15**                                                           | **%**          | 1.37                                                                     | %          |   |   |   |   |
|                                                                          |            |                                                                    |                |                                                                          |            |  |  |  |  |  |  |  |  |  |  |

** **

39

----

**InterestRate Risk**

Theobjective of interest rate risk management is to contain the risks associatedwith interest rate fluctuations.  Theprocess involves identification and management of the sensitivity of netinterest income to changing interest rates and other market factors.  Interest rate risk, one of the more prominentrisks in terms of potential earnings impact, is an inevitable part of being afinancial intermediary.  For moreinformation see “Risk Management — Interest Rate Risk” in Bankshares 2005Annual Report on Form 10-K.

EARNINGSSIMULATION MODEL PROJECTIONS

Banksharesassesses interest rate risk by comparing projected net interest income in thecurrent rate environment with various interest rate scenarios that differ inthe direction of interest rate changes, the degree of change over time, thespeed of the change and the projected shape of the yield curve.  This analysis incorporates substantially allof Bankshares’ assets and liabilities and off-balance sheet instruments.  Through these simulations, managementestimates the impact on net interest income of a 200 basis point upward anddownward change in interest rates.  Thefollowing table summarizes the effect that a +/- 200 basis point change ininterest rates would have on Bankshares’ net interest income over the next 12months.

 

|                                                             | ** ** | **Calculated increase / (decrease) in  projected net interest income** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|
| **Change in interest rates  (basis points)** | ** ** | ** **                                                                                                | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
| +200                                                        | ** ** | **0.97**                                                                                                  | **%**      | 2.32 | % |
| +100                                                        | ** ** | **0.53**                                                                                                  | **%**      | 1.25 | % |
| –100                                                   | ** ** | **(0.94**                                                                                                 | **)%**     | (1.77 | )% |
| –200                                                   | ** ** | **(2.66**                                                                                                 | **)%**     | (4.57 | )% |
|                                                             |            |                                                                                                           |            |  |  |  |  |

 

AtSeptember 30, 2006, Bankshares’ interest sensitivity position was less assetsensitive than it was at September 30, 2005. Based on its most recent simulation model, Bankshares’ net interestincome would increase by $3.5 million, or 0.53%, and $6.3 million, or 0.97%, ifinterest rates were to move up gradually over the next six months by 100 basispoints or 200 basis points, respectively. A downward movement of 100 basis points would reduce net interest incomeby $6.1 million, or 0.94%.  A downwardmovement of 200 basis points would reduce net interest income by $17.4 million,or 2.66%.  Bankshares manages theinterest rate risk profile within policy limits.  At September 30, 2006, and December 31, 2005,Bankshares was within its policy guidelines. In response to action by the Federal Reserve to increase short-terminterest rates, Bankshares’ prime interest rate continues to rise.  At September 30, 2006, Bankshares hadapproximately $4.7 billion in loans that will reprice daily or monthly asmarket rates change.  The effects of arising rate environment on interest expense are less predictable due tocustomer behavior that can result in changes in the mix of depositproducts.  Current trends have generatedgrowth in higher-rate premium money market and certificate of depositaccounts.  Given the current rateenvironment, the flatness of the yield curve and competitive pressure on bothloan and deposit pricing, we anticipate that the net interest margin willremain under some pressure throughout the year.

Banksharesalso utilizes interest rate derivatives to hedge interest rate riskexposures.  The credit risk amount andestimated net fair values of these derivatives as of September 30, 2006 andDecember 31, 2005 are presented in Note No. 12 - Derivative Instruments andHedging Activities.  Derivatives are usedfor asset/liability management in three ways:

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

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

·                  To hedge the mortgage origination pipeline byutilizing forward rate commitments for loans held-for-sale.

 

40

----

 

MARKETVALUE OF EQUITY MODELING

Banksharesalso utilizes the market value of equity as a measurement tool in managinginterest rate sensitivity.  The marketvalue of equity measures the degree to which the market values of Bankshares’assets and liabilities and off-balance sheet instruments will change given achange in interest rates. The Asset/Liability Management Committee guidelineslimit the change in market value of equity in a 200 basis point parallel rateshock to 12.5% of the market value of equity assuming interest rates atSeptember 30, 2006.  The up 200 basispoint scenario resulted in a 4.6% decrease at September 30, 2006 compared witha 2.9% decrease at December 31, 2005. The down 200 basis point scenario resulted in a 1.1% decrease at September30, 2006 and a 3.9% decrease at December 31, 2005.  At September 30, 2006 and December 31, 2005,Bankshares was within its policy guidelines.

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

**MarketRisk**

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

*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’ capitalmarkets business is to accommodate customers in the management of their marketprice risks.  Derivative transactions executedwith customers are simultaneously hedged in the capital markets.  All derivatives transacted with customersused to hedge capital market transactions with customers are carried at fairvalue.  The Asset/Liability ManagementCommittee establishes and monitors counterparty risk limits.  The notional amount, exposure amount andestimated net fair value of all customer accommodation derivatives at September30, 2006 are included in Note No. 12 - Derivative Instruments and HedgingActivities.

*Equity Markets*

Banksharesis directly and indirectly affected by changes in the equity markets.  Bankshares has made investments in privateequities. These investments are made within capital allocations approved bymanagement.  Management reviews theseinvestments at least quarterly and assesses them for possibleother-than-temporary impairment.  Privateequity investments totaled $24.8 million at September 30, 2006 and $22.1million at September 30, 2005.

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

41

----

**LiquidityRisk**

Liquidityrisk is the possibility that Bankshares will not be able to fund present andfuture financial obligations.  Theobjective of liquidity management is to maintain the ability to meetcommitments to fund loans, purchase securities and repay deposits and otherliabilities in accordance with their terms. To achieve this objective, the Asset/Liability Management Committeeestablishes and monitors liquidity guidelines that require sufficientasset-based liquidity to cover potential funding requirements and to avoidover-reliance on volatile, less reliable funding markets.  Debt securities in the available-for-saleportfolio provide liquidity, in addition to the immediately liquid resources ofcash and due from banks, federal funds sold and securities purchased underresale agreements.  By limiting thematurity of securities and maintaining a conservative investment posture,management can rely on the investment portfolio to help meet any short-termfunding needs.  U.S. Treasury and agencysecurities, which provide the greatest liquidity, averaged $1.4 billion in thethird quarter of 2006 and 2005 and the second quarter of 2006.

Corecustomer deposits have historically provided a substantial source of relativelystable and low-cost funds.  For the threemonths ended September 30, 2006, core deposits (total deposits lesscertificates of deposit of $100,000 and over), averaged $10.3 billion comparedwith $10.1 billion for the second quarter of 2006 and for the third quarter of2005.  Although not viewed as coredeposits, a substantial portion of short-term borrowings, comprised ofsecurities sold under agreements to repurchase and commercial paper, originatefrom core deposit relationships tied to the overnight cash management programoffered to customers.  Long-term debt andshort-term borrowings funded the remaining assets.

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

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

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

**ContractualObligations and Commitments**

Inthe normal course of business, Bankshares enters into certain contractualobligations and other commitments.  Suchobligations generally relate to funding operations through debt arrangements aswell as leases of premises and equipment. As a financial services provider, Bankshares routinely enters intocommitments to extend credit, including loan commitments, standby letters ofcredit and financial guarantees.  For adiscussion of these commitments, see Note No. 7 - Commitments andContingencies.  For a discussion ofcontractual commitments see “Off-Balance Sheet Arrangements and ContractualObligations” in Bankshares’ 2005 Annual Report on Form 10-K.  Items disclosed in the Annual Report on Form10-K have not changed materially since the report was filed.

42

----

**Cautionary Statement**

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

This report containsforward-looking statements within the meaning of and pursuant to the safeharbor provisions of the Private Securities Litigation Reform Act of 1995.  A forward-looking statement encompasses anyestimate, prediction, opinion or statement of belief contained in this reportand the underlying management assumptions. Such statements in this report include: identification of trends; loan growth; deposit retention; comments onadequacy of the allowance for loan losses; credit quality; effects of assetsensitivity and interest rate changes; and information concerning market riskreferenced in Item 3.  Forward-lookingstatements are based on current expectations and assessments of potentialdevelopments affecting market conditions, interest rates and other economic conditions,and results may ultimately vary from the statements made in this report.  In addition, the following factors, amongothers, could cause actual results to differ materially from the anticipatedresults or expectations expressed in the forward-looking statements:administrative and operational efficiencies may not improve to the degreeprojected; and competitive pressures and regulatory complexities that affectour banks may be more severe than expected.

43

----

**Supplemental Information byQuarter**Select Financial DataIn thousands, except per share data(unaudited)
| ** **                                                                            | ** ** | **3Q 06** | ** **     | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|----------------|----------------|------------|----------------|------------|----------------|------------|
| **OPERATING RESULTS**                                                                 |       |           |           |           |       |           |       |           |       |
| Net interest income (1)                                                               | ** ** | **$**          | **166,069**    |           | $          | 161,410        |       | $              | 158,313    |   | $ | 162,434 |   |
| Net interest income —  taxable equivalent (1)                                    | ** ** | **167,916**    |           | 163,254        |       | 160,146        |       | 164,267        |       |
| Provision for credit  losses                                                          | ** ** | **—**     |           | —         |       | —         |       | —         |       |
| Net income                                                                            | ** ** | **71,573**     |           | 73,092         |       | 70,759         |       | 74,863         |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **PER COMMON SHARE DATA***                                                            | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Basic net income                                                                      | ** ** | **$**          | **0.57**       |           | $          | 0.59           |       | $              | 0.58       |   | $ | 0.61 |   |
| Diluted net income                                                                    | ** ** | **0.57**       |           | 0.59           |       | 0.57           |       | 0.60           |       |
| Dividends paid                                                                        | ** ** | **0.28**       |           | 0.28           |       | 0.26           |       | 0.25           |       |
| Book value at period  end                                                             | ** ** | **19.07**      |           | 18.34          |       | 18.05          |       | 17.81          |       |
| Market value at period  end                                                           | ** ** | **36.27**      |           | 35.67          |       | 38.45          |       | 37.63          |       |
| Market range:                                                                         |       |           |           |           |       |           |       |           |       |
| High                                                                                  | ** ** | **37.96**      |           | 39.53          |       | 39.82          |       | 40.09          |       |
| Low                                                                                   | ** ** | **34.29**      |           | 35.00          |       | 36.88          |       | 34.11          |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **AVERAGE BALANCE SHEET DATA**                                                        |       |           |           |           |       |           |       |           |       |
| Total loans                                                                           | ** ** | **$**          | **12,401,068** |           | $          | 11,921,540     |       | $              | 11,646,904 |   | $ | 11,497,885 |   |
| Total earning assets                                                                  | ** ** | **15,645,850** |           | 15,196,996     |       | 14,880,775     |       | 14,698,731     |       |
| Total assets                                                                          | ** ** | **17,297,329** |           | 16,798,972     |       | 16,435,964     |       | 16,258,275     |       |
| Total deposits                                                                        | ** ** | **12,592,061** |           | 12,190,193     |       | 11,940,956     |       | 11,894,394     |       |
| Shareholders’ equity                                                             | ** ** | **2,342,545**  |           | 2,309,149      |       | 2,261,646      |       | 2,210,050      |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **STATISTICS AND RATIOS (Net  income annualized)**                                    | ** ** | ** **     | ** **     | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Return on average  assets                                                             | ** ** | **1.64**       | **%**          | 1.75           | %          | 1.75           | %          | 1.83           | %          |
| Return on average  equity (2)                                                         | ** ** | **12.12**      |           | 12.70          |       | 12.69          |       | 13.44          |       |
| Return on average  tangible equity (2)                                                | ** ** | **17.87**      |           | 18.80          |       | 18.97          |       | 20.26          |       |
| Average equity to  average assets (2)                                                 | ** ** | **13.54**      |           | 13.75          |       | 13.76          |       | 13.59          |       |
| Average tangible equity  to average tangible assets (2)                               | ** ** | **9.79**       |           | 9.88           |       | 9.81           |       | 9.61           |       |
| Net interest rate  spread — taxable equivalent                                   | ** ** | **3.41**       |           | 3.51           |       | 3.64           |       | 3.78           |       |
| Net interest margin on  earning assets — taxable equivalent                      | ** ** | **4.26**       |           | 4.31           |       | 4.36           |       | 4.43           |       |
| Efficiency ratio  (1),(3)                                                             | ** ** | **49.38**      |           | 48.05          |       | 48.34          |       | 47.87          |       |
| Cash operating  efficiency ratio (1),(3)                                              | ** ** | **48.02**      |           | 47.08          |       | 47.30          |       | 46.69          |       |
| Dividend payout ratio*                                                                | ** ** | **49.12**      |           | 47.46          |       | 44.83          |       | 40.98          |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| Bank offices                                                                          | ** ** | **241**        |           | 237            |       | 238            |       | 240            |       |
| Employees                                                                             | ** ** | **3,592**      |           | 3,667          |       | 3,658          |       | 3,606          |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                |       |           |           |           |       |           |       |           |       |
| Net  charge-offs/(recoveries)                                                         | ** ** | **$**          | **1,136**      |           | $          | (986           | )          | $              | (159       | ) | $ | 503 |   |
| Nonaccrual loans                                                                      | ** ** | **36,002**     |           | 29,245         |       | 22,890         |       | 22,565         |       |
| Restructured loans                                                                    | ** ** | **—**     |           | —         |       | —         |       | —         |       |
| Total nonperforming  loans                                                            | ** ** | **36,002**     |           | 29,245         |       | 22,890         |       | 22,565         |       |
| Other real estate  owned, net                                                         | ** ** | **67**         |           | 49             |       | 713            |       | 667            |       |
| Total nonperforming  assets                                                           | ** ** | **36,069**     |           | 29,294         |       | 23,603         |       | 23,232         |       |
|                                                                                  | ** ** | ** **     |           |           |       |           |       |           |       |
| **CREDIT QUALITY RATIOS**                                                             |       |           |           |           |       |           |       |           |       |
| Net  charge-offs/(recoveries), annualized, as a percent of period-end loans           | ** ** | **0.04**       | **%**          | (0.03          | )%         | (0.01          | )%         | 0.02           | %          |
| Nonperforming loans as  a percent of period-end loans                                 | ** ** | **0.29**       |           | 0.24           |       | 0.20           |       | 0.19           |       |
| Allowance for loan  losses as a percent of period-end loans**                    | ** ** | **1.15**       |           | 1.19           |       | 1.21           |       | 1.35           |       |
| Allowance for loan  losses as a percent of nonperforming loans                        | ** ** | **399.57**     |           | 488.49         |       | 619.81         |       | 694.32         |       |
| Other real estate owned  as a percent of period-end loans and other real estate owned | ** ** | **—**     |           | —         |       | 0.01           |       | 0.01           |       |
| Nonperforming assets as  a percent of period-end loans and other real estate owned    | ** ** | **0.29**       |           | 0.24           |       | 0.20           |       | 0.20           |       |
| Nonperforming assets as a percent of total assets                                     | ** ** | **0.21**       |           | 0.17           |       | 0.14           |       | 0.14           |       |

 

44

----

**Supplemental Information byQuarter (continued)**Select Financial DataIn thousands, except per share data(unaudited)
| ** **                                                                            | ** ** | **3Q 05** | ** ** | **3Q 06  vs  2Q 06** | ** ** | **3Q 06  vs  3Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|------------|--------------------------------|------------|--------------------------------|------------|
| **OPERATING  RESULTS**                                                                | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Net interest  income (1)                                                              |       | $              | 159,242    |                           | 2.9        | %                              | 4.3        | % |
| Net interest  income — taxable equivalent (1)                                    |       | 161,023        |       | 2.9                            |       | 4.3                            |       |
| Provision for  credit losses                                                          |       | 820            |       | —                         |       | (100.0                         | )          |
| Net income                                                                            |       | 70,956         |       | (2.1                           | )          | 0.9                            |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **PER  COMMON SHARE DATA***                                                           | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Basic net income                                                                      |       | $              | 0.58       |                           | (3.4       | )%                             | (1.7       | )% |
| Diluted net  income                                                                   |       | 0.57           |       | (3.4                           | )          | —                         |       |
| Dividends paid                                                                        |       | 0.25           |       | —                         |       | 12.0                           |       |
| Book value at  period end                                                             |       | 17.47          |       | 4.0                            |       | 9.2                            |       |
| Market value at  period end                                                           |       | 35.92          |       | 1.7                            |       | 1.0                            |       |
| Market range:                                                                         |       |           |       |                           |       |                           |       |
| High                                                                                  |       | 37.46          |       | (4.0                           | )          | 1.3                            |       |
| Low                                                                                   |       | 34.13          |       | (2.0                           | )          | 0.5                            |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **AVERAGE  BALANCE SHEET DATA**                                                       | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Total loans                                                                           |       | $              | 11,389,731 |                           | 4.0        | %                              | 8.9        | % |
| Total earning  assets                                                                 |       | 14,490,736     |       | 3.0                            |       | 8.0                            |       |
| Total assets                                                                          |       | 16,065,168     |       | 3.0                            |       | 7.7                            |       |
| Total deposits                                                                        |       | 11,751,990     |       | 3.3                            |       | 7.1                            |       |
| Shareholders’  equity                                                            |       | 2,179,415      |       | 1.4                            |       | 7.5                            |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **STATISTICS  AND RATIOS (Net income annualized)**                                    | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Return on average  assets                                                             |       | 1.75           | %          |                           |       |                           |       |
| Return on  average equity (2)                                                         |       | 12.92          |       |                           |       |                           |       |
| Return on  average tangible equity (2)                                                |       | 19.62          |       |                           |       |                           |       |
| Average equity  to average assets (2)                                                 |       | 13.57          |       |                           |       |                           |       |
| Average tangible  equity to average tangible assets (2)                               |       | 9.53           |       |                           |       |                           |       |
| Net interest  rate spread — taxable equivalent                                   |       | 3.83           |       |                           |       |                           |       |
| Net interest  margin on earning assets — taxable equivalent                      |       | 4.41           |       |                           |       |                           |       |
| Efficiency ratio  (1),(3)                                                             |       | 48.36          |       |                           |       |                           |       |
| Cash operating  efficiency ratio (1),(3)                                              |       | 46.99          |       |                           |       |                           |       |
| Dividend payout  ratio*                                                               |       | 43.10          |       |                           |       |                           |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| Bank offices                                                                          |       | 238            |       | 4                              |       | 3                              |       |
| Employees                                                                             |       | 3,607          |       | (75                            | )          | (15                            | )          |
|                                                                                  |       |           |       |                           |       |                           |       |
| **CREDIT  QUALITY DATA AT PERIOD END**                                                | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Net  charge-offs/(recoveries)                                                         |       | $              | 745        |                           | (215.2     | )%                             | 52.5       | % |
| Nonaccrual loans                                                                      |       | 27,022         |       | 23.1                           |       | 33.2                           |       |
| Restructured  loans                                                                   |       | —         |       | —                         |       | —                         |       |
| Total  nonperforming loans                                                            |       | 27,022         |       | 23.1                           |       | 33.2                           |       |
| Other real  estate owned, net                                                         |       | 777            |       | 36.7                           |       | (91.4                          | )          |
| Total  nonperforming assets                                                           |       | 27,799         |       | 23.1                           |       | 29.7                           |       |
|                                                                                  |       |           |       |                           |       |                           |       |
| **CREDIT  QUALITY RATIOS**                                                            | ** ** | ** **     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Net  charge-offs/(recoveries), annualized, as a percent of period-end loans           |       | 0.03           | %          |                           |       |                           |       |
| Nonperforming  loans as a percent of period-end loans                                 |       | 0.24           |       |                           |       |                           |       |
| Allowance for  loan losses as a percent of period-end loans**                         |       | 1.37           |       |                           |       |                           |       |
| Allowance for  loan losses as a percent of nonperforming loans                        |       | 581.66         |       |                           |       |                           |       |
| Other real  estate owned as a percent of period-end loans and other real estate owned |       | 0.01           |       |                           |       |                           |       |
| Nonperforming  assets as a percent of period-end loans and other real estate owned    |       | 0.24           |       |                           |       |                           |       |
| Nonperforming assets as  a percent of total assets                                    |       | 0.17           |       |                           |       |                           |       |

----

*InJanuary 2006, Bankshares announced a three-for-two stock split on its commonstock.  Per share amounts and otherapplicable information have been adjusted to give effect to the split.

** The decline in theallowance for loan losses was due primarily to the reclassification of $14.0million in the first quarter of 2006 and $1.9 million in the third quarter of2006 out of the allowance for loan losses to a separate reserve for unfundedcommitments, which is recorded in other liabilities in the consolidated balancesheet.

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

45

----

**Statements of Consolidated Income**In thousands, except pershare data(unaudited)
| ** **                                                 | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **3Q 06** | ** ** | **3Q 06** | ** ** |
|------------------------------------------------------------|------------|----------------|-------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                                 | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| ** **                                                 | ** ** | **3Q 06** | ** **  | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 06** | ** ** | **3Q 05** | ** ** |
| **INTEREST  INCOME**                                       | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Interest and fees  on loans                                | ** ** | **$**          | **224,218** |           | $          | 208,096        |       | $              | 196,055    |           | $          | 192,697        |       | $              | 185,714    |   | 7.7 | % | 20.7 | % |
| Interest and  dividends on investment securities:          |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| Taxable interest income                                    | ** ** | **32,393**     |        | 31,135         |       | 29,795         |       | 30,081         |       | 26,686         |       | 4.0            |       | 21.4           |       |
| Tax-exempt interest income                                 | ** ** | **730**        |        | 765            |       | 778            |       | 813            |       | 839            |       | (4.6           | )          | (13.0          | )          |
| Other investment income                                    | ** ** | **660**        |        | 699            |       | 627            |       | 722            |       | 526            |       | (5.6           | )          | 25.5           |       |
|                                                       | ** ** | **33,783**     |        | 32,599         |       | 31,200         |       | 31,616         |       | 28,051         |       | 3.6            |       | 20.4           |       |
| Other interest  income                                     | ** ** | **855**        |        | 1,098          |       | 658            |       | 890            |       | 760            |       | (22.1          | )          | 12.5           |       |
| Total interest income                                      | ** ** | **258,856**    |        | 241,793        |       | 227,913        |       | 225,203        |       | 214,525        |       | 7.1            |       | 20.7           |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **INTEREST  EXPENSE**                                      | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Interest on  deposits                                      | ** ** | **68,792**     |        | 57,603         |       | 49,243         |       | 44,637         |       | 38,591         |       | 19.4           |       | 78.3           |       |
| Interest on  short-term borrowings                         | ** ** | **15,215**     |        | 13,500         |       | 11,023         |       | 9,038          |       | 7,702          |       | 12.7           |       | 97.5           |       |
| Interest on  long-term debt                                | ** ** | **8,780**      |        | 9,280          |       | 9,334          |       | 9,094          |       | 8,990          |       | (5.4           | )          | (2.3           | )          |
| Total interest expense                                     | ** ** | **92,787**     |        | 80,383         |       | 69,600         |       | 62,769         |       | 55,283         |       | 15.4           |       | 67.8           |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INTEREST INCOME**                                   | ** ** | **166,069**    |        | 161,410        |       | 158,313        |       | 162,434        |       | 159,242        |       | 2.9            |       | 4.3            |       |
| Provision for  credit losses                               | ** ** | **—**     |        | —         |       | —         |       | —         |       | 820            |       | —         |       | (100.0         | )          |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES** | ** ** | **166,069**    | ** **  | 161,410        | ** ** | 158,313        | ** ** | 162,434        | ** ** | 158,422        | ** ** | 2.9            | ** ** | 4.8            | ** ** |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **NONINTEREST  INCOME**                                    | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Investment and  wealth management                          | ** ** | **27,596**     |        | 28,865         |       | 26,121         |       | 24,251         |       | 23,668         |       | (4.4           | )          | 16.6           |       |
| Service charges  on deposit accounts                       | ** ** | **12,776**     |        | 10,868         |       | 10,292         |       | 10,893         |       | 11,478         |       | 17.6           |       | 11.3           |       |
| Mortgage  banking-related fees                             | ** ** | **497**        |        | 2,335          |       | 2,210          |       | 4,690          |       | 5,151          |       | (78.7          | )          | (90.4          | )          |
| Investment  securities gains and (losses)                  | ** ** | **218**        |        | —         |       | (13            | )          | (53            | )          | (32            | )          | —         |       | 781.3          |       |
| Nonmarketable  investments                                 | ** ** | **1,150**      |        | 5,964          |       | 6,269          |       | 6,199          |       | 4,190          |       | (80.7          | )          | (72.6          | )          |
| Other income                                               | ** ** | **17,530**     |        | 16,436         |       | 15,727         |       | 16,131         |       | 18,619         |       | 6.7            |       | (5.8           | )          |
| Total noninterest income                                   | ** ** | **59,767**     |        | 64,468         |       | 60,606         |       | 62,111         |       | 63,074         |       | (7.3           | )          | (5.2           | )          |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **NONINTEREST  EXPENSES**                                  | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Salaries                                                   | ** ** | **51,424**     |        | 47,232         |       | 49,099         |       | 51,740         |       | 51,748         |       | 8.9            |       | (0.6           | )          |
| Employee benefits                                          | ** ** | **13,511**     |        | 14,292         |       | 14,735         |       | 10,685         |       | 11,637         |       | (5.5           | )          | 16.1           |       |
| Net occupancy  expense of bank premises                    | ** ** | **8,289**      |        | 7,931          |       | 7,771          |       | 7,678          |       | 7,139          |       | 4.5            |       | 16.1           |       |
| Furniture and  equipment expenses                          | ** ** | **8,353**      |        | 8,094          |       | 8,305          |       | 8,491          |       | 7,965          |       | 3.2            |       | 4.9            |       |
| Communications  and supplies                               | ** ** | **3,796**      |        | 4,469          |       | 3,818          |       | 4,414          |       | 3,933          |       | (15.1          | )          | (3.5           | )          |
| Other expenses                                             | ** ** | **27,056**     |        | 27,404         |       | 22,987         |       | 25,365         |       | 25,960         |       | (1.3           | )          | 4.2            |       |
| Total noninterest expenses                                 | ** ** | **112,429**    |        | 109,422        |       | 106,715        |       | 108,373        |       | 108,382        |       | 2.7            |       | 3.7            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| Income before  income taxes                                | ** ** | **113,407**    |        | 116,456        |       | 112,204        |       | 116,172        |       | 113,114        |       | (2.6           | )          | 0.3            |       |
| Applicable income  taxes                                   | ** ** | **41,834**     |        | 43,364         |       | 41,445         |       | 41,309         |       | 42,158         |       | (3.5           | )          | (0.8           | )          |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INCOME**                                            | ** ** | **$**          | **71,573**  |           | $          | 73,092         |       | $              | 70,759     |           | $          | 74,863         |       | $              | 70,956     |   | (2.1 | ) | 0.9 |   |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| Weighted average  shares outstanding*                      | ** ** | **124,750**    |        | 123,222        |       | 123,043        |       | 122,923        |       | 122,797        |       | 1.2            |       | 1.6            |       |
| Adjusted weighted  average shares outstanding*             | ** ** | **125,893**    |        | 124,324        |       | 124,294        |       | 124,134        |       | 123,953        |       | 1.3            |       | 1.6            |       |
|                                                       |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INCOME PER COMMON SHARE:***                         | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Basic                                                      | ** ** | **$**          | **0.57**    |           | $          | 0.59           |       | $              | 0.58       |           | $          | 0.61           |       | $              | 0.58       |   | (3.4 | ) | (1.7 | ) |
| Diluted                                                    | ** ** | **$**          | **0.57**    |           | $          | 0.59           |       | $              | 0.57       |           | $          | 0.60           |       | $              | 0.57       |   | (3.4 | ) | — |   |

----

*InJanuary 2006, Bankshares announced a three-for-two stock split on its commonstock.  Per share amounts and otherapplicable information have been adjusted to give effect to the split.

46

----

**Statementsof Consolidated Noninterest Income and Noninterest Expenses**In thousands(unaudited)
| ** **                                | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **3Q 06** | ** ** | **3Q 06** | ** ** |
|-------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| **Noninterest Income**               | ** ** | **3Q 06** | ** ** | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 06** | ** ** | **3Q 05** | ** ** |
| Investment and wealth  management         | ** ** | **$**          | **27,596** |           | $          | 28,865         |       | $              | 26,121     |           | $          | 24,251         |       | $              | 23,668     |   | (4.4 | )% | 16.6 | % |
| Service charges on  deposit accounts      | ** ** | **12,776**     |       | 10,868         |       | 10,292         |       | 10,893         |       | 11,478         |       | 17.6           |       | 11.3           |       |
| Mortgage  banking-related fees            | ** ** | **497**        |       | 2,335          |       | 2,210          |       | 4,690          |       | 5,151          |       | (78.7          | )          | (90.4          | )          |
| Investment securities  gains and (losses) | ** ** | **218**        |       | —         |       | (13            | )          | (53            | )          | (32            | )          | —         |       | 781.3          |       |
| Nonmarketable  investments:               |       |           |       |           |       |           |       |           |       |           |       |           |       |           |       |
| Private equity  and other investments     | ** ** | **263**        |       | 3,371          |       | 1,324          |       | 3,310          |       | 39             |       | (92.2          | )          | 574.4          |       |
| Hedge funds                               | ** ** | **(801**       | **)**      | 1,005          |       | 3,395          |       | 1,104          |       | 2,897          |       | (179.7         | )          | (127.6         | )          |
| Bank-owned life  insurance                | ** ** | **1,688**      |       | 1,588          |       | 1,550          |       | 1,785          |       | 1,254          |       | 6.3            |       | 34.6           |       |
| Total  nonmarketable investments          | ** ** | **1,150**      |       | 5,964          |       | 6,269          |       | 6,199          |       | 4,190          |       | (80.7          | )          | (72.6          | )          |
| Other income:                             |       |           |       |           |       |           |       |           |       |           |       |           |       |           |       |
| Electronic  banking fees                  | ** ** | **7,424**      |       | 6,487          |       | 5,636          |       | 5,832          |       | 7,010          |       | 14.4           |       | 5.9            |       |
| Charges and fees  on loans                | ** ** | **3,065**      |       | 3,106          |       | 2,765          |       | 3,063          |       | 3,786          |       | (1.3           | )          | (19.0          | )          |
| Insurance                                 | ** ** | **3,680**      |       | 3,761          |       | 5,101          |       | 3,439          |       | 3,480          |       | (2.2           | )          | 5.7            |       |
| All other income                          | ** ** | **3,361**      |       | 3,082          |       | 2,225          |       | 3,797          |       | 4,343          |       | 9.1            |       | (22.6          | )          |
| Total other  income                       | ** ** | **17,530**     |       | 16,436         |       | 15,727         |       | 16,131         |       | 18,619         |       | 6.7            |       | (5.8           | )          |
| Total                                     | ** ** | **$**          | **59,767** |           | $          | 64,468         |       | $              | 60,606     |           | $          | 62,111         |       | $              | 63,074     |   | (7.3 | ) | (5.2 | ) |

 
| ** **                              | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **3Q 06** | ** ** | **3Q 06** | ** ** |
|-----------------------------------------|------------|----------------|-------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                              | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| **Noninterest Expenses**           | ** ** | **3Q 06** | ** **  | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 06** | ** ** | **3Q 05** | ** ** |
| Salaries                                | ** ** | **$**          | **51,424**  |           | $          | 47,232         |       | $              | 49,099     |           | $          | 51,740         |       | $              | 51,748     |   | 8.9 | % | (0.6 | )% |
| Employee benefits                       | ** ** | **13,511**     |        | 14,292         |       | 14,735         |       | 10,685         |       | 11,637         |       | (5.5           | )          | 16.1           |       |
| Net occupancy expense  of bank premises | ** ** | **8,289**      |        | 7,931          |       | 7,771          |       | 7,678          |       | 7,139          |       | 4.5            |       | 16.1           |       |
| Furniture and equipment  expenses       | ** ** | **8,353**      |        | 8,094          |       | 8,305          |       | 8,491          |       | 7,965          |       | 3.2            |       | 4.9            |       |
| Communications and  supplies            | ** ** | **3,796**      |        | 4,469          |       | 3,818          |       | 4,414          |       | 3,933          |       | (15.1          | )          | (3.5           | )          |
| Other expenses:                         |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| Professional  services                  | ** ** | **6,042**      |        | 6,743          |       | 5,170          |       | 5,867          |       | 6,040          |       | (10.4          | )          | —         |       |
| Advertising and  promotional expenses   | ** ** | **3,719**      |        | 2,355          |       | 1,498          |       | 2,553          |       | 2,162          |       | 57.9           |       | 72.0           |       |
| Electronic  banking expenses            | ** ** | **4,375**      |        | 3,529          |       | 3,127          |       | 3,503          |       | 4,025          |       | 24.0           |       | 8.7            |       |
| Amortization of  intangible assets      | ** ** | **2,522**      |        | 2,217          |       | 2,325          |       | 2,291          |       | 2,231          |       | 13.8           |       | 13.0           |       |
| Outsourcing  expenses                   | ** ** | **2,792**      |        | 2,641          |       | 2,823          |       | 3,065          |       | 3,093          |       | 5.7            |       | (9.7           | )          |
| All other  expenses                     | ** ** | **7,606**      |        | 9,919          |       | 8,044          |       | 8,086          |       | 8,409          |       | (23.3          | )          | (9.5           | )          |
| Total other  expenses                   | ** ** | **27,056**     |        | 27,404         |       | 22,987         |       | 25,365         |       | 25,960         |       | (1.3           | )          | 4.2            |       |
| Total                                   | ** ** | **$**          | **112,429** |           | $          | 109,422        |       | $              | 106,715    |           | $          | 108,373        |       | $              | 108,382    |   | 2.7 |   | 3.7 |   |

 

47

----

**ConsolidatedAverage Balance Sheets**In thousands(unaudited)
| ** **                                        | ** ** | **3Q 06** | ** **     | **2Q 06**  | ** ** | **1Q 06** | ** ** |
|---------------------------------------------------|------------|----------------|----------------|-----------------|------------|----------------|------------|
| **Earning assets**                           | ** ** | **Average**    | ** **     | **Yield(1)**    | ** ** | **Average**    | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** |
| **Loans:**                                        | ** ** | **Balance**    | ** **     | **/ Rate** | ** ** | **Balance**    | ** ** | **/ Rate** | ** ** | **Balance** | ** ** | **/ Rate** | ** ** |
| Commercial and leasing                            | ** ** | **$**          | **2,924,627**  | ** **      | **7.57**   | **%**          | $          | 2,956,420 |   | 7.35 | % | $ | 2,933,214 |   | 7.06 | % |
| Commercial real estate                            | ** ** | **4,085,822**  | ** **     | **7.15**        |       | 3,748,795      |       | 7.02 |   | 3,673,385 |   | 6.89 |   |
| Construction                                      | ** ** | **1,911,222**  | ** **     | **8.42**        |       | 1,808,734      |       | 8.09 |   | 1,681,253 |   | 7.86 |   |
| Residential real estate                           | ** ** | **1,951,620**  | ** **     | **6.21**        |       | 1,876,209      |       | 6.16 |   | 1,831,603 |   | 6.16 |   |
| Home equity lines                                 | ** ** | **479,436**    | ** **     | **8.05**        |       | 484,396        |       | 7.65 |   | 496,526 |   | 7.25 |   |
| Consumer                                          | ** ** | **1,048,341**  | ** **     | **5.81**        |       | 1,046,986      |       | 5.78 |   | 1,030,923 |   | 5.73 |   |
| Total loans                                       | ** ** | **12,401,068** | ** **     | **7.22**        |       | 11,921,540     |       | 7.05 |   | 11,646,904 |   | 6.87 |   |
| Federal funds sold, et al                         | ** ** | **61,342**     | ** **     | **5.52**        |       | 71,448         |       | 6.16 |   | 57,318 |   | 4.65 |   |
| Securities: (2)                                   |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Taxable securities                                |       |           |           |            |       |           |       |   |   |   |   |   |   |
| U.S. Treasury and government agencies             | ** ** | **1,381,027**  | ** **     | **3.96**        |       | 1,451,800      |       | 3.85 |   | 1,440,180 |   | 3.64 |   |
| Mortgage-backed                                   | ** ** | **1,662,093**  | ** **     | **4.45**        |       | 1,605,222      |       | 4.30 |   | 1,589,017 |   | 4.30 |   |
| Other investments                                 | ** ** | **63,393**     | ** **     | **4.19**        |       | 65,748         |       | 4.30 |   | 63,199 |   | 4.06 |   |
| Tax-exempt securities                             |       |           |           |            |       |           |       |   |   |   |   |   |   |
| States and political subdivisions                 | ** ** | **76,727**     | ** **     | **6.25**        |       | 81,038         |       | 6.26 |   | 83,957 |   | 6.22 |   |
| Total securities                                  | ** ** | **3,183,240**  | ** **     | **4.27**        |       | 3,203,808      |       | 4.14 |   | 3,176,353 |   | 4.05 |   |
| Interest-bearing deposits in other banks          | ** ** | **200**        | ** **     | **1.45**        |       | 200            |       | 1.51 |   | 200 |   | 1.36 |   |
| Total earning assets                              | ** ** | **15,645,850** | ** **     | **6.61**        |       | 15,196,996     |       | 6.43 |   | 14,880,775 |   | 6.26 |   |
| Cash and due from banks                           | ** ** | **324,675**    | ** **     | ** **      |       | 304,132        | ** ** | ** ** |   | 301,305 |   |   |   |
| Bank premises and equipment, net                  | ** ** | **142,120**    | ** **     | ** **      |       | 138,941        | ** ** | ** ** |   | 138,237 |   |   |   |
| Other assets                                      | ** ** | **1,330,705**  | ** **     | ** **      |       | 1,301,459      | ** ** | ** ** |   | 1,272,673 |   |   |   |
| Less: allowance for loan losses                   | ** ** | **(146,021**   | **)**          | ** **      |       | (142,556       | )          | ** ** |   | (157,026 | ) |   |   |
| Total assets                                      | ** ** | **$**          | **17,297,329** | ** **      | ** ** |           | $          | 16,798,972 | ** ** | ** ** |   | $ | 16,435,964 |   |   |   |
|                                              |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Interest-bearing  liabilities                     |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Deposits:                                         |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Savings                                           | ** ** | **$**          | **1,229,751**  | ** **      | **0.56**   |           | $          | 1,282,700 |   | 0.48 |   | $ | 1,321,364 |   | 0.45 |   |
| Checking plus interest                            | ** ** | **1,231,558**  | ** **     | **0.20**        |       | 1,298,636      |       | 0.20 |   | 1,341,714 |   | 0.19 |   |
| Money market                                      | ** ** | **2,202,466**  | ** **     | **2.99**        |       | 1,947,364      |       | 2.62 |   | 1,848,724 |   | 2.18 |   |
| Time deposits $100,000 and over                   | ** ** | **2,243,487**  | ** **     | **4.74**        |       | 2,044,074      |       | 4.37 |   | 1,904,098 |   | 4.00 |   |
| Other time deposits                               | ** ** | **2,429,730**  | ** **     | **3.76**        |       | 2,362,074      |       | 3.47 |   | 2,318,985 |   | 3.23 |   |
| Total interest-bearing deposits                   | ** ** | **9,336,992**  | ** **     | **2.92**        |       | 8,934,848      |       | 2.59 |   | 8,734,885 |   | 2.29 |   |
| Short-term borrowings                             | ** ** | **1,487,948**  | ** **     | **4.06**        |       | 1,423,480      |       | 3.80 |   | 1,320,595 |   | 3.39 |   |
| Long-term debt                                    | ** ** | **665,300**    | ** **     | **5.24**        |       | 673,599        |       | 5.53 |   | 730,236 |   | 5.18 |   |
| Total interest-bearing funds                      | ** ** | **11,490,240** | ** **     | **3.20**        |       | 11,031,927     |       | 2.92 |   | 10,785,716 |   | 2.62 |   |
| Noninterest-bearing deposits                      | ** ** | **3,255,069**  | ** **     | ** **      |       | 3,255,345      | ** ** | ** ** |   | 3,206,071 |   |   |   |
| Other liabilities and accrued expenses            | ** ** | **209,475**    | ** **     | ** **      |       | 202,551        | ** ** | ** ** |   | 182,531 |   |   |   |
| Total liabilities                                 | ** ** | **14,954,784** | ** **     | ** **      |       | 14,489,823     | ** ** | ** ** |   | 14,174,318 |   |   |   |
| Shareholders’ equity                         | ** ** | **2,342,545**  | ** **     | ** **      |       | 2,309,149      | ** ** | ** ** |   | 2,261,646 |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**          | **17,297,329** | ** **      | ** ** |           | $          | 16,798,972 | ** ** | ** ** |   | $ | 16,435,964 |   |   |   |
|                                              |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Net interest rate spread                          |       |           | ** **     | **3.41**        | **%**      |           |       | 3.51 | % |   |   | 3.64 | % |
| Effect of noninterest-bearing funds               |       |           | ** **     | **0.85**        |       |           |       | 0.80 |   |   |   | 0.72 |   |
| Net interest  margin on earning assets            |       |           | ** **     | **4.26**        | **%**      |           |       | 4.31 | % |   |   | 4.36 | % |

 

48

----

**Consolidated Average BalanceSheets (continued)**In thousands(unaudited)
| ** **                               | ** ** | **4Q 05** | ** ** | **3Q 05**  | ** ** | **Average Balance** | ** ** |
|------------------------------------------|------------|----------------|------------|-----------------|------------|--------------------------|------------|
| ** **                               | ** ** | ** **     | ** ** | ** **      | ** ** | ** **               | ** ** | ** ** | ** ** | **3Q 06** | ** ** | **3Q 06** | ** ** |
| **Earning assets**                  | ** ** | **Average**    | ** ** | **Yield(1)**    | ** ** | **Average**              | ** ** | **Yield(1)** | ** ** | **vs** | ** ** | **vs** | ** ** |
| **Loans:**                               | ** ** | **Balance**    | ** ** | **/ Rate** | ** ** | **Balance**              | ** ** | **/ Rate** | ** ** | **2Q 06** | ** ** | **3Q 05** | ** ** |
| Commercial and leasing                   |       | $              | 2,912,089  |            | 6.86       | %                        | $          | 2,914,761 |   | 6.62 | % | (1.1 | )% | 0.3 | % |
| Commercial real estate                   |       | 3,664,491      |       | 6.79            |       | 3,610,170                |       | 6.65 |   | 9.0 |   | 13.2 |   |
| Construction                             |       | 1,574,597      |       | 7.56            |       | 1,544,082                |       | 7.21 |   | 5.7 |   | 23.8 |   |
| Residential real estate                  |       | 1,798,686      |       | 6.05            |       | 1,775,023                |       | 5.98 |   | 4.0 |   | 9.9 |   |
| Home equity lines                        |       | 511,673        |       | 6.73            |       | 517,798                  |       | 6.23 |   | (1.0 | ) | (7.4 | ) |
| Consumer                                 |       | 1,036,349      |       | 5.68            |       | 1,027,897                |       | 5.71 |   | 0.1 |   | 2.0 |   |
|                                     |       | 11,497,885     |       | 6.69            |       | 11,389,731               |       | 6.51 |   | 4.0 |   | 8.9 |   |
| Federal funds sold, et al                |       | 76,062         |       | 4.64            |       | 57,932                   |       | 5.20 |   | (14.1 | ) | 5.9 |   |
| Securities: (2)                          |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| Taxable securities:                      |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| U.S. Treasury and government agencies    |       | 1,429,583      |       | 3.41            |       | 1,431,397                |       | 3.35 |   | (4.9 | ) | (3.5 | ) |
| Mortgage-backed                          |       | 1,545,324      |       | 4.56            |       | 1,455,475                |       | 3.98 |   | 3.5 |   | 14.2 |   |
| Other investments                        |       | 60,998         |       | 4.77            |       | 62,318                   |       | 3.35 |   | (3.6 | ) | 1.7 |   |
| Tax-exempt securities:                   |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| States and political subdivisions        |       | 88,679         |       | 6.01            |       | 93,683                   |       | 5.89 |   | (5.3 | ) | (18.1 | ) |
|                                     |       | 3,124,584      |       | 4.08            |       | 3,042,873                |       | 3.73 |   | (0.6 | ) | 4.6 |   |
| Interest-bearing deposits in other banks |       | 200            |       | 1.35            |       | 200                      |       | 1.02 |   | — |   | — |   |
|                                     |       | 14,698,731     |       | 6.13            |       | 14,490,736               |       | 5.92 |   | 3.0 |   | 8.0 |   |
| Cash and due from banks                  |       | 319,176        |       |            |       | 326,515                  |       |   |   | 6.8 |   | (0.6 | ) |
| Bank premises and equipment, net         |       | 139,662        |       |            |       | 147,248                  |       |   |   | 2.3 |   | (3.5 | ) |
| Other assets                             |       | 1,258,868      |       |            |       | 1,257,846                |       |   |   | 2.2 |   | 5.8 |   |
| Less: allowance for loan losses          |       | (158,162       | )          |            |       | (157,177                 | )          |   |   | 2.4 |   | (7.1 | ) |
| Total assets                             |       | $              | 16,258,275 |            |       |                     | $          | 16,065,168 |   |   |   | 3.0 |   | 7.7 |   |
|                                     |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| Interest-bearing liabilities             |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| Deposits:                                |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| Savings                                  |       | $              | 1,371,020  |            | 0.45       |                     | $          | 1,420,283 |   | 0.42 |   | (4.1 | ) | (13.4 | ) |
| Checking plus interest                   |       | 1,398,809      |       | 0.18            |       | 1,428,344                |       | 0.17 |   | (5.2 | ) | (13.8 | ) |
| Money market                             |       | 1,785,001      |       | 1.86            |       | 1,692,684                |       | 1.54 |   | 13.1 |   | 30.1 |   |
| Time deposits $100,000 and over          |       | 1,784,340      |       | 3.66            |       | 1,674,265                |       | 3.30 |   | 9.8 |   | 34.0 |   |
| Other time deposits                      |       | 2,300,075      |       | 3.03            |       | 2,295,608                |       | 2.76 |   | 2.9 |   | 5.8 |   |
|                                     |       | 8,639,245      |       | 2.05            |       | 8,511,184                |       | 1.80 |   | 4.5 |   | 9.7 |   |
| Short-term borrowings                    |       | 1,213,396      |       | 2.96            |       | 1,185,142                |       | 2.58 |   | 4.5 |   | 25.6 |   |
| Long-term debt                           |       | 766,451        |       | 4.71            |       | 797,527                  |       | 4.47 |   | (1.2 | ) | (16.6 | ) |
|                                     |       | 10,619,092     |       | 2.35            |       | 10,493,853               |       | 2.09 |   | 4.2 |   | 9.5 |   |
| Noninterest-bearing deposits             |       | 3,255,149      |       |            |       | 3,240,806                |       |   |   | — |   | 0.4 |   |
| Other liabilities and accrued expenses   |       | 173,984        |       |            |       | 151,094                  |       |   |   | 3.4 |   | 38.6 |   |
|                                     |       | 14,048,225     |       |            |       | 13,885,753               |       |   |   | 3.2 |   | 7.7 |   |
| Shareholders’ equity                |       | 2,210,050      |       |            |       | 2,179,415                |       |   |   | 1.4 |   | 7.5 |   |
|                                     |       | $              | 16,258,275 |            |       |                     | $          | 16,065,168 |   |   |   | 3.0 |   | 7.7 |   |
|                                     |       |           |       |            |       |                     |       |   |   |   |   |   |   |
| Net interest rate spread                 |       |           |       | 3.78            | %          |                     |       | 3.83 | % |   |   |   |   |
| Effect of noninterest-bearing funds      |       |           |       | 0.65            |       |                     |       | 0.58 |   |   |   |   |   |
| Net interest  margin on earning assets   |       |           |       | 4.43            | %          |                     |       | 4.41 | % |   |   |   |   |

----

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

(2) Average investment securities are reported atamortized cost; excludes unrealized gains (losses) on securitiesavailable-for-sale.  Nonaccrual loans areincluded in average loans.

49

----

**Reconciliationof Non-GAAP Measures**

Webelieve the non-GAAP measures we use provide information useful to investors inunderstanding our ongoing core business and operational performancetrends.  These measures should not beviewed as a substitute for GAAP. Management believes presentations of financial measures excluding theimpact of certain items provide useful supplemental information and betterreflect its core operating activities. In order to arrive at core business operating results, the effects ofcertain non-core business transactions such as gains and losses on the sales ofsecurities, amortization of intangibles, restructuring charges andmerger-related expenses, have been excluded. Management reviews these same measures internally.  For instance, the cash operating efficiencyratio, rather than the GAAP basis efficiency ratio, is used to measuremanagement’s success at controlling ongoing, core operating expenses.  Additionally, management believes thatreporting several key measures based on tangible assets (total assets lessintangible assets) and tangible equity (total equity less intangible assets) isimportant as this more closely approximates the basis for measuring theadequacy of capital for regulatory purposes.
| ** ** | ** ** | **YTD**    | ** ** | **YTD**  | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
|------------|------------|------------|------------|----------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** ** | ** ** | **2006**   | ** ** | **2005** | ** ** | **3Q 06** | ** ** | **2Q 06** | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** |
|       | ** ** | ** ** |       |     | ** ** | ** **     |       |           |       |           |       |           |       |           |       |

----

(1) The net interestmargin and efficiency ratios are presented on a fully taxable-equivalent (FTE)and annualized basis. The FTE basis adjusts for the tax-favored status ofincome from certain loans and investments. Management believes this measure tobe the preferred industry measurement of net interest income and provides arelevant comparison between taxable and nontaxable investments.
| Net interest income (GAAP basis)          | ** ** | **$**     | **485,792** |   | $          | 454,692   | ** ** | **$** | **166,069** |   | $      | 161,410 |   | $     | 158,313 |   | $ | 162,434 |   | $ | 159,242 |   |
|-------------------------------------------|------------|-----------|-------------|--------|------------|-----------|------------|-------|-------------|--------|--------|---------|--------|-------|---------|--------|---|---------|--------|---|---------|--------|
| Taxable-equivalent adjustment             | ** ** | **5,524** |        | 5,014  | ** ** | **1,847** |       | 1,844 |        | 1,833  |   | 1,833   |   | 1,781 |    |
| Net interest  income - taxable equivalent | ** ** | **$**     | **491,316** |   | $          | 459,706   | ** ** | **$** | **167,916** |   | $      | 163,254 |   | $     | 160,146 |   | $ | 164,267 |   | $ | 161,023 |   |

----

(2) Management excludes the balance of intangibleassets and their related amortization expense from its calculation of return onaverage tangible equity and average tangible equity to average tangible assets.This adjustment allows management to review the core operating results and corecapital position of Bankshares. This is consistent with the treatment by thebank regulatory agencies that excludes goodwill and other intangible assetsfrom their calculation of risk-based capital ratios.
| Return on average equity (GAAP basis)                      | ** ** | **12.50** | **%**  | 13.09  | %          | **12.12** | **%**  | 12.70  | %      | 12.69  | %      | 13.44  | %      | 12.92  | %      |
|-----------------------------------------------------------------|------------|-----------|--------|--------|------------|-----------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding average intangible assets and  amortization | ** ** | **6.03**  |   | 6.20   | ** ** | **5.75**  |   | 6.10   |   | 6.28   |   | 6.82   |   | 6.70   |   |
| Return on average tangible equity                               | ** ** | **18.53** | **%**  | 19.29  | %          | **17.87** | **%**  | 18.80  | %      | 18.97  | %      | 20.26  | %      | 19.62  | %      |
|                                                            |       |      |   |   |       |      |   |   |   |   |   |   |   |   |   |
| Average equity to average assets (GAAP basis)              | ** ** | **13.68** | **%**  | 13.47  | %          | **13.54** | **%**  | 13.75  | %      | 13.76  | %      | 13.59  | %      | 13.57  | %      |
| Impact of excluding average intangible assets and  amortization | ** ** | **(3.85** | **)**  | (3.74  | )          | **(3.75** | **)**  | (3.87  | )      | (3.95  | )      | (3.98  | )      | (4.04  | )      |
| Average tangible equity to average tangible assets              | ** ** | **9.83**  | **%**  | 9.73   | %          | **9.79**  | **%**  | 9.88   | %      | 9.81   | %      | 9.61   | %      | 9.53   | %      |

----

(3) The efficiency ratio is measured by dividingnoninterest expenses by the sum of net interest income on an FTE basis andnoninterest income. When computing the cash operating efficiency ratio and cashoperating earnings, management excludes the amortization of intangible assets,restructuring charges, merger-related expenses, and gains and losses on salesof premises and from the sales of investment securities in order to assess thecore operating results of Bankshares and because of the uncertainty as totiming and amount of gain or loss to be recognized.
| Efficiency ratio (GAAP basis)       | ** ** | **48.59**  | **%**  | 48.77  | %          | **49.38**  | **%**  | 48.05  | %      | 48.34  | %      | 47.87  | %      | 48.36  | %      |
|-------------------------------------|------------|------------|--------|--------|------------|------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding:                | ** ** | ** ** |   |   | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Securities gains and (losses)       | ** ** | **0.02**   |   | 0.03   | ** ** | **0.05**   |   | — |   | — |   | (0.01  | )      | — |   |
| Gains/(losses) on sales of premises | ** ** | **0.01**   |   | 0.33   | ** ** | **—** |   | 0.01   |   | 0.02   |   | — |   | (0.05  | )      |
| Amortization of deposit intangibles | ** ** | **(0.70**  | **)**  | (0.66  | )          | **(0.74**  | **)**  | (0.66  | )      | (0.68  | )      | (0.66  | )      | (0.65  | )      |
| Amortization of other intangibles   | ** ** | **(0.35**  | **)**  | (0.35  | )          | **(0.37**  | **)**  | (0.32  | )      | (0.38  | )      | (0.35  | )      | (0.34  | )      |
| Restructuring charges               | ** ** | **—** |   | — | ** ** | **—** |   | — |   | — |   | — |   | — |   |
| Merger-related expenses             | ** ** | **(0.10**  | **)**  | (0.18  | )          | **(0.30**  | **)**  | — |   | — |   | (0.16  | )      | (0.33  | )      |
| Cash operating efficiency ratio     | ** ** | **47.47**  | **%**  | 47.94  | %          | **48.02**  | **%**  | 47.08  | %      | 47.30  | %      | 46.69  | %      | 46.99  | %      |

----

(4) Bankshares presents cash operating earnings inorder to assess its core operating results.
| Net income (GAAP basis)                                                  | ** ** | **$**     | **215,424** |   | $          | 201,456   | ** ** | **$**  | **71,573** |   | $      | 73,092 |   | $      | 70,759 |   | $ | 74,863 |   | $ | 70,956 |   |
|--------------------------------------------------------------------------|------------|-----------|-------------|--------|------------|-----------|------------|--------|------------|--------|--------|--------|--------|--------|--------|--------|---|--------|--------|---|--------|--------|
| Less: Securities (gains) and losses, net of tax                          | ** ** | **(124**  | **)**       | (277   | )          | **(132**  | **)**      | — |       | 8      |   | 32     |   | 19     |   |
|     (Gains)/losses on sales of  premises, net of tax | ** ** | **(62**   | **)**       | (2,624 | )          | —    |       | (14    | )          | (48    | )      | — |   | 117    |   |
| Plus: Amortization of deposit intangibles, net of tax                    | ** ** | **2,813** |        | 2,593  | ** ** | **1,015** |       | 899    |       | 899    |   | 899    |   | 892    |   |
|     Amortization of other intangibles,  net of tax   | ** ** | **1,457** |        | 1,326  | ** ** | **510**   |       | 440    |       | 507    |   | 486    |   | 458    |   |
|     Restructuring charges, net of  tax               | ** ** | —    |        | — | ** ** | —    |       | — |       | — |   | — |   | — |   |
|     Merger-related expenses, net  of tax             | ** ** | **411**   |        | 661    | ** ** | **411**   |       | — |       | — |   | 216    |   | 449    |   |
| Cash operating  earnings                                                 | ** ** | **$**     | **219,919** |   | $          | 203,135   | ** ** | **$**  | **73,377** |   | $      | 74,417 |   | $      | 72,125 |   | $ | 76,496 |   | $ | 72,891 |   |

#  

50

----

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

Informationresponsive to this item as of December 31, 2005 appears under the caption “Asset/Liabilityand Market Risk Management” of Bankshares’ Form 10-K for the year endedDecember 31, 2005. There was no material change in such information as ofSeptember 30, 2006.

# **Item 4. Controls andProcedures**

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

# **PART II — OTHERINFORMATION**

# **Item 1. Legal Proceedings**

# **Item 1A. Risk Factors**

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

**Item 6.        Exhibits**

Exhibits

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

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

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

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

51

----

**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934 the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                  | ** ** | **Mercantile Bankshares  Corporation** |
|------------------|------------|----------------------------------------|
|             |       | (Registrant)                           |
|             |       |                                   |
|             |       |                                   |
| October 30, 2006 |       |                                   |   | /s/ Edward J. Kelly,  III |
| Date             |       | By: Edward J. Kelly,  III              |
|             |       | Chairman of the Board,                 |
|             |       | President and Chief  Executive Officer |
|             |       |                                   |
|             |       |                                   |
| October 30, 2006 |       |                                   |   | /s/ Terry L. Troupe |
| Date             |       | By: Terry L. Troupe                    |
|             |       | Executive Vice  President and          |
|             |       | Chief Financial Officer                |
|             |       |                                   |
|             |       |                                   |
| October 30, 2006 |       |                                   |   | /s/ William T. Skinner,  Jr. |
| Date             |       | By: William T. Skinner,  Jr.           |
|             |       | Controller                             |

 

52

----