United
      States


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549


_________________________________________________________





**FORM
      10-Q**





**ý** **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


** ̈** **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)**


**OF
      THE SECURITIES EXCHANGE ACT OF 1934**





For
      the
      transition period from _________ to __________


_________________________________________________________





**NORTHERN
      STATES FINANCIAL CORPORATION**


(Exact
      name of Registrant as specified in its charter)





Delaware          
                                            
0-19300                                        
                     
36-3449727


(State of Incorporation)    
                              
(Commission                                                       (I.R.S.
      Employer


File
      Number)                                                     Identification
      No.)





1601
      North Lewis Avenue


Waukegan,
      Illinois 60085


(847)
      244-6000


(Address,
      including zip code, and telephone number, including


area
      code, of principal executive office)


_________________________________________________________





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for shorter period that the registrant was required
      to
      file such reports) and (2) has been subject to such filing requirements for
      the
      past 90 days. YES: **ý** NO: ** ̈**





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):


Large
      Accelerated Filer  ** ̈** Accelerated
      Filer **ý** Non-accelerated Filer ** ̈**





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act).  YES: ** ̈**  NO: **ý**








4,233,105
      shares of common stock were outstanding


as
      of
      November 3, 2006








**NORTHERN
      STATES FINANCIAL CORPORATION AND SUBSIDIARY**


**FORM
      10-Q**


**For
      the Quarter Ended September 30, 2006**


**INDEX**







Page
                  NumberPART
                  I.
              FINANCIAL
                  INFORMATIONItem 1.
              Financial
                  Statements
              2Report
                  of Independent Registered Public
                  Accounting Firm
              2Condensed
                  Consolidated Financial Statements
                  and Notes
              3Item 2.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              9Item 3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              21Item 4.
              Controls
                  and Procedures
              23PART
                  II.
              OTHER
                  INFORMATIONItem 1.
              Legal
                  Proceedings
              23Item 1A.
              Risk
                  Factors
              24Item 2.
              Unregistered
                  Sales of Equity Securities and Use of
                  Proceeds
              24Item 3.
              Defaults
                  upon Senior Securities
              24Item 4.
              Submission
                  of Matters to a Vote of Security
                  Holders
              24Item 5.
              Other
                  Information
              24Item 6.
              Exhibits
              24Signatures
              25EXHIBIT
                  INDEX
              26


1
 *Index*




**PART
      I. FINANCIAL INFORMATION**





**ITEM
      1. FINANCIAL STATEMENTS**











REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM








Board
      of
      Directors and Stockholders


Northern
      States Financial Corporation


Waukegan,
      Illinois





We
      have
      reviewed the accompanying interim condensed consolidated balance sheet of NORTHERN
      STATES FINANCIAL CORPORATION as of
      September 30, 2006, the condensed consolidated statements of income for the
      three and nine month periods ended September 30, 2006 and the condensed
      statements of cash flows and stockholders equity for the nine month period
      ended
      September 30, 2006. These interim financial statements are the responsibility
      of
      the company's management.





We
      conducted our review in accordance with standards of the Public Company
      Accounting Oversight Board (United States). A review of interim financial
      information consists principally of applying analytical procedures and making
      inquiries of persons responsible for financial and accounting matters. It is
      substantially less in scope than an audit conducted in accordance with the
      standards of the Public Company Accounting Oversight Board, the objective of
      which is the expression of an opinion regarding the financial statements taken
      as a whole. Accordingly, we do not express such an opinion.





Based
      on
      our review, we are not aware of any material modifications that should be made
      to the accompanying interim condensed financial statements for them to be in
      conformity with accounting principles generally accepted in the United States
      of
      America.





/s/
      Plante & Moran, PLLC





Chicago,
      Illinois


October
      27, 2006




2
 *Index*


NORTHERN
        STATES FINANCIAL CORPORATION
 CONDENSED
        CONSOLIDATED BALANCE
        SHEETS
 September
        30, 2006 and December 31, 2005
 (In
        thousands of dollars) (Unaudited)
  September
                      30,
                  2006
                
                December
                      31,
                  2005AssetsCash
                    and due from banks
                
                $
                19,503
                
                $
                23,586Interest
                    bearing deposits in financial institutions -
                  maturities
                    less than 90 days
                
                
                136
                
                
                120Commercial
                    paper - maturities less than 90 days
                
                
                9,999
                
                
                0Federal
                    funds sold
                
                
                21,322
                
                
                5,962Total cash and cash equivalents
                
                
                50,960
                
                
                29,668Securities
                    available for sale
                
                
                252,497
                
                
                265,067Loans
                    and leases
                
                
                380,991
                
                
                400,502Less:
                    Allowance for loan and lease losses
                
                
                (7,513
                )
                
                (10,618
                )Loans and leases, net
                
                
                373,478
                
                
                389,884Federal
                    Home Loan Bank stock
                
                
                1,647
                
                
                2,086Office
                    buildings and equipment, net
                
                
                9,490
                
                
                9,427Other
                    real estate owned
                
                
                3,056
                
                
                4,431Goodwill
                
                
                9,522
                
                
                9,522Core
                    deposit intangible asset
                
                
                1,971
                
                
                2,318Accrued
                    interest receivable and other assets
                
                
                9,380
                
                
                10,125Total assets
                
                $
                712,001
                
                $
                722,528Liabilities and Stockholders' EquityLiabilitiesDepositsDemand - noninterest bearing
                
                $
                56,195
                
                $
                63,329Interest bearing
                
                
                474,985
                
                
                491,120Total deposits
                
                
                531,180
                
                
                554,449Securities
                    sold under repurchase agreements
                
                
                82,694
                
                
                73,093Federal
                    Home Loan Bank advances
                
                
                6,500
                
                
                6,500Subordinated
                    debentures
                
                
                10,000
                
                
                10,000Advances
                    from borrowers for taxes and insurance
                
                
                469
                
                
                830Accrued
                    interest payable and other liabilities
                
                
                8,416
                
                
                6,904Total liabilities
                
                
                639,259
                
                
                651,776Stockholders'
                    EquityCommon
                    stock
                
                
                1,789
                
                
                1,789Additional
                    paid-in capital
                
                
                11,584
                
                
                11,584Retained
                    earnings
                
                
                66,414
                
                
                65,526Accumulated
                    other comprehensive loss
                
                
                (2,133
                )
                
                (3,487
                )Treasury
                    stock, at cost
                
                
                (4,912
                )
                
                (4,660
                )Total stockholders' equity
                
                
                72,742
                
                
                70,752Total liabilities and stockholders' equity
                
                $
                712,001
                
                $
                722,528


The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




3
 *Index*




NORTHERN
        STATES FINANCIAL CORPORATION
 CONDENSED
        CONSOLIDATED STATEMENTS OF INCOME
 Three
        and
        nine months ended September 30, 2006 and 2005
 (In
        thousands of dollars, except per share data) (Unaudited)
  Three
                      months ended
                  
                  Nine
                      months endedSeptember
                      30,
                    2006
                  
                  September
                      30,
                    2005
                  
                  September
                      30,
                    2006
                  
                  September
                      30,
                    2005Interest
                      incomeLoans (including fee income)
                  
                  $6,849
                  
                  $6,390
                  
                  $20,269
                  
                  $19,262SecuritiesTaxable
                  
                  2,105
                  
                  2,097
                  
                  6,302
                  
                  5,908Exempt from federal income tax
                  
                  56
                  
                  69
                  
                  170
                  
                  229Commercial paper - maturities less than 90 days
                  
                  115
                  
                  0
                  
                  115
                  
                  0Federal funds sold and other
                  
                  301
                  
                  224
                  
                  462
                  
                  618Total interest income
                  
                  9,426
                  
                  8,780
                  
                  27,318
                  
                  26,017Interest
                      expenseTime deposits
                  
                  3,272
                  
                  2,817
                  
                  9,086
                  
                  7,316Other deposits
                  
                  1,059
                  
                  736
                  
                  3,061
                  
                  1,905Repurchase agreements and federal funds purchased
                  
                  971
                  
                  535
                  
                  2,238
                  
                  1,216Federal Home Loan Bank advances
                  
                  65
                  
                  65
                  
                  192
                  
                  224Subordinated debentures
                  
                  170
                  
                  27
                  
                  490
                  
                  27Total interest expense
                  
                  5,537
                  
                  4,180
                  
                  15,067
                  
                  10,688Net
                      interest income
                  
                  3,889
                  
                  4,600
                  
                  12,251
                  
                  15,329Provision
                      for loan and lease losses
                  
                  0
                  
                  1,700
                  
                  0
                  
                  2,428Net
                      interest income after provision for loan and lease losses
                  
                  3,889
                  
                  2,900
                  
                  12,251
                  
                  12,901Noninterest
                      incomeService fees on deposits
                  
                  620
                  
                  626
                  
                  1,844
                  
                  1,782Trust income
                  
                  
                  185
                  
                  
                  167
                  
                  
                  583
                  
                  
                  551Loss on sale of securities available for sale
                  
                  
                  0
                  
                  
                  0
                  
                  
                  0
                  
                  
                  (169
                  )Other operating income
                  
                  
                  496
                  
                  
                  365
                  
                  
                  1,248
                  
                  
                  974Total noninterest income
                  
                  
                  1,301
                  
                  
                  1,158
                  
                  
                  3,675
                  
                  
                  3,138Noninterest
                      expenseSalaries and employee benefits
                  
                  
                  2,207
                  
                  
                  2,200
                  
                  
                  6,686
                  
                  
                  6,672Occupancy and equipment, net
                  
                  
                  508
                  
                  
                  517
                  
                  
                  1,682
                  
                  
                  1,550Data processing
                  
                  
                  395
                  
                  
                  325
                  
                  
                  1,190
                  
                  
                  1,047Legal
                  
                  
                  57
                  
                  
                  83
                  
                  
                  247
                  
                  
                  257Audit and other professional
                  
                  
                  259
                  
                  
                  280
                  
                  
                  911
                  
                  
                  896Amortization of core deposit intangible asset
                  
                  
                  117
                  
                  
                  116
                  
                  
                  348
                  
                  
                  348Printing and supplies
                  
                  
                  85
                  
                  
                  68
                  
                  
                  324
                  
                  
                  236Write-down of other real estate owned
                  
                  
                  0
                  
                  
                  0
                  
                  
                  0
                  
                  
                  1,067Other operating expenses
                  
                  
                  562
                  
                  
                  476
                  
                  
                  1,612
                  
                  
                  1,703Total noninterest expense
                  
                  
                  4,190
                  
                  
                  4,065
                  
                  
                  13,000
                  
                  
                  13,776Income
                      (loss) before income taxes
                  
                  
                  1,000
                  
                  
                  (7
                  )
                  
                  2,926
                  
                  
                  2,263Income
                      tax expense (benefit)
                  
                  
                  279
                  
                  
                  (142
                  )
                  
                  750
                  
                  
                  516Net
                      income
                  
                  $
                  721
                  
                  $
                  135
                  
                  $
                  2,176
                  
                  $
                  1,747Earnings
                      per share
                  
                  $
                  0.17
                  
                  $
                  0.03
                  
                  $
                  0.51
                  
                  $
                  0.41Comprehensive
                      income (loss)
                  
                  $
                  2,040
                  
                  
                  ($296
                  )
                  $
                  3,530
                  
                  $
                  520


The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




4
 *Index*




NORTHERN
        STATES FINANCIAL CORPORATION
 CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS
 Nine
        months ended September 30, 2006 and 2005
 (In
        thousands of dollars) (Unaudited)
 Nine
                      months endedSeptember
                        30,
                    2006
                  
                  September
                        30,
                    2005Cash
                      flows from operating activitiesNet income
                  
                  $
                  2,176
                  
                  $
                  1,747Adjustments to reconcile net income to net cash from operating
                      activities:Depreciation
                  
                  
                  434
                  
                  
                  403Net gain on sales of other real estate owned
                  
                  
                  (62
                  )
                  
                  0Federal Home Loan Bank stock dividends
                  
                  
                  0
                  
                  
                  (79
                  )Loss on sale of securities available for sale
                  
                  
                  0
                  
                  
                  169Provision for loan and lease losses
                  
                  
                  0
                  
                  
                  2,428Write-down of other real estate owned
                  
                  
                  0
                  
                  
                  1,067Deferred loan fees
                  
                  
                  (121
                  )
                  
                  (130
                  )Proceeds from sale of loans
                  
                  
                  0
                  
                  
                  748Loans originated for sale
                  
                  
                  0
                  
                  
                  (748
                  )Amortization of other intangible assets
                  
                  
                  347
                  
                  
                  348Net change in accrued interest receivable and other assets
                  
                  
                  (825
                  )
                  
                  (2,188
                  )Net change in accrued interest payable and other
                      liabilities
                  
                  
                  2,221
                  
                  
                  875Net cash from operating activities
                  
                  
                  4,170
                  
                  
                  4,640Cash
                      flows from investing activitiesProceeds from sales of securities available for sale
                  
                  
                  0
                  
                  
                  6,127Proceeds from maturities and calls of securities available
                      for
                      sale
                  
                  
                  82,126
                  
                  
                  27,290Purchases of securities available for sale
                  
                  
                  (67,346
                  )
                  
                  (59,399
                  )Purchase of Federal Reserve Bank stock
                  
                  
                  0
                  
                  
                  (492
                  )Redemption of Federal Reserve Bank stock
                  
                  
                  439
                  
                  
                  0Change in loans made to customers
                  
                  
                  16,422
                  
                  
                  41,705Property and equipment expenditures
                  
                  
                  (492
                  )
                  
                  (424
                  )Proceeds from sales of other real estate owned
                  
                  
                  1,542
                  
                  
                  0Net cash from investing activities
                  
                  
                  32,691
                  
                  
                  14,807Cash
                      flows from financing activitiesNet increase (decrease) in:Deposits
                  
                  
                  (23,269
                  )
                  
                  3,813Securities sold under repurchase agreements and federal funds
                    purchased
                  
                  
                  9,601
                  
                  
                  (3,340
                  )Advances from borrowers for taxes and insurance
                  
                  
                  (361
                  )
                  
                  (367
                  )Federal
                      Home Loan Bank advances
                  
                  
                  0
                  
                  
                  15,000Repayment
                      of Federal Home Loan Bank advances
                  
                  
                  0
                  
                  
                  (15,000
                  )Issuance of subordinated debentures
                  
                  
                  0
                  
                  
                  10,000Purchases of treasury stock
                  
                  
                  (252
                  )
                  
                  0Dividends paid
                  
                  
                  (1,288
                  )
                  
                  (2,362
                  )Net cash from financing activities
                  
                  
                  (15,569
                  )
                  
                  7,744Net
                      change in cash and cash equivalents
                  
                  
                  21,292
                  
                  
                  27,191Cash
                      and cash equivalents at beginning of period
                  
                  
                  29,668
                  
                  
                  29,299Cash
                      and cash equivalents at end of period
                  
                  $
                  50,960
                  
                  $
                  56,490




The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  5
 *Index*
  NORTHERN
          STATES FINANCIAL CORPORATION
 CONDENSED
          CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
 Nine
          months ended September 30, 2006 and 2005
 (In
          thousands of dollars, except for per share data) (Unaudited)


Common
              Stock
            
            Additional
              Paid-In
              Capital
            
            Retained
              Earnings
            
            Accumulated
              Other
              Comprehensive
              Loss
            
            Treasury
              Stock,
                at Cost
            
            Total
              Stockholders'
              Equity


Balance,
                  December 31, 2004
              
              $
              1,789
              
              $
              11,584
              
              $
              66,102
              
              
              ($1,633
              )
              
              ($4,660
              )
              $
              73,182Net
                  income
              
              
              
              
              
              
              
              
              1,747
              
              
              
              
              
              
              
              
              1,747Cash
                  dividends ($.55 share)
              
              
              
              
              
              
              
              
              (2,362
              )
              
              
              
              
              
              
              
              (2,362
              )Unrealized
                  loss on securities available for sale, net of deferred tax
              
              
              
              
              
              
              
              
              
              
              
              (1,227
              )
              
              
              
              
              (1,227
              )Balance,
                  September 30, 2005
              
              $
              1,789
              
              $
              11,584
              
              $
              65,487
              
              
              ($2,860
              )
              
              ($4,660
              )
              $
              71,340Balance,
                  December 31, 2005
              
              $
              1,789
              
              $
              11,584
              
              $
              65,526
              
              
              ($3,487
              )
              
              ($4,660
              )
              $
              70,752Net
                  income
              
              
              
              
              
              
              
              
              2,176
              
              
              
              
              
              
              
              
              2,176Cash
                  dividends ($.30 share)
              
              
              
              
              
              
              
              
              (1,288
              )
              
              
              
              
              
              
              
              (1,288
              )Purchase
                  of 12,000 shares of common stock as treasury stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (252
              )
              
              (252
              )Unrealized
                  gain on securities available for sale, net of deferred tax
              
              
              
              
              
              
              
              
              
              
              
              1,354
              
              
              
              
              
              1,354Balance,
                  September 30, 2006
              
              $
              1,789
              
              $
              11,584
              
              $
              66,414
              
              
              ($2,133
              )
              
              ($4,912
              )
              $
              72,742






The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




6
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 September
        30, 2006
 
 (Unaudited)
 
 
 Note
        1
        - Basis of Presentation
 
 The
        accompanying interim condensed consolidated financial statements are prepared
        without audit and reflect all adjustments which are of a normal and recurring
        nature and, in the opinion of management, are necessary to present interim
        financial statements of Northern States Financial Corporation (the "Company")
        in
        accordance with accounting principles generally accepted in the United States
        of
        America. The interim financial statements do not purport to contain all the
        necessary financial disclosures covered by accounting principles generally
        accepted in the United States of America that might otherwise be necessary
        for
        complete financial statements.
 
 To
        prepare financial statements in conformity with accounting principles generally
        accepted in the United States of America, management makes estimates and
        assumptions based on available information. These estimates and assumptions
        affect the amounts reported in the financial statements and the disclosures
        provided, and future results could differ. The allowance for loan and lease
        losses and status of contingencies are particularly subject to
        change.
 
 The
        interim condensed financial statements should be read in conjunction with
        the
        audited financial statements and accompanying notes (or "notes thereto")
        of the
        Company for the years ended December 31, 2005 and 2004. The results of
        operations for the three and nine month periods ended September 30, 2006,
        are
        not necessarily indicative of the results to be expected for the full
        year.
 
 Net
        income was utilized to calculate earnings per share for all periods presented.
        The Company had no common stock equivalents during the first nine months
        of 2006
        and the entire year of 2005. The average outstanding common shares used for
        earnings per share follows:
 
 Three
                  months ended
              Nine
                  months endedSeptember
                  30,
                2006
              September
                  30,
                2005
              September
                  30,
                2006
              September
                  30,
                2005Average
                  outstanding common shares
              4,283,105
              4,295,105
              4,290,094
              4,295,105
 
 On
        April
        17, 2002, the Company announced that its Board of Directors had approved
        a stock
        repurchase program that allows the Company to purchase up to 200,000 shares
        of
        Northern States Financial Corporation stock either in open market or private
        transactions. On February 19, 2003, the Company announced that its Board
        of
        Directors had approved an additional repurchase program to purchase 200,000
        additional shares of its stock. During the nine months ended September 30,
        2006,
        12,000 shares of stock were repurchased. At September 30, 2006, the Company
        had
        a total of 189,150 shares of treasury stock that it purchased under these
        programs. Treasury stock is carried at cost.
  7
 *Index*
  **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 September
        30, 2006
 
 (Unaudited)
 
 
 
 Information
        related to common stock was as follows:
 
 September
                  30,
                2006
              
              December
                  31,
                2005Par
                  value per share
              
              $
              0.40
              
              $
              0.40Authorized
                  shares
              
              
              6,500,000
              
              
              6,500,000Issued
                  shares
              
              
              4,472,255
              
              
              4,472,255Treasury
                  shares
              
              
              189,150
              
              
              177,150Outstanding
                  shares
              
              
              4,283,105
              
              
              4,295,105
 
  Note
        2 -
        Subordinated Debentures
 
 
 During
        September 2005, the Company issued $10 million of trust preferred securities
        through Northern States Statutory Trust I, a wholly-owned grantor trust.
        The
        Company issued $10 million of subordinated debentures to Northern States
        Statutory Trust I, which in turn issued $10 million of trust preferred
        securities. The subordinated debentures mature in September 2035. From December
        2005 until September 15, 2010, the subordinated debentures bear interest
        at a
        rate equal to the sum of the product of 50% times the 3-month LIBOR plus
        1.80%,
        plus the product of 50% times 6.186%, and thereafter at a rate equal to the
        3-month LIBOR plus 1.80%. For the three months ended September 30, 2006,
        interest expense on the subordinated debentures was $170,000. For the nine
        months ended September 30, 2006, interest expense on the subordinated debentures
        was $490,000. The subordinated debentures and trust preferred securities
        are
        callable at par after five years.
 
 Regulations
        allow bank holding companies and banks to include subordinated debentures,
        subject to some limitations, as a component of capital for the purpose of
        meeting certain regulatory requirements. In September 2005, the Company
        contributed $2.0 million of the proceeds from the trust preferred securities
        and
        related subordinated debentures to the Bank in order to increase the Bank’s
        capital.
  8
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 
 **ITEM
        2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
        CONDITION**
 **AND
        RESULTS OF OPERATIONS**
 
 The
        following discussion focuses on the consolidated financial condition of Northern
        States Financial Corporation (the “Company”) at September 30, 2006 and the
        consolidated results of operations for the three and nine month periods ended
        September 30, 2006, compared with the same periods of 2005. The Company on
        November 10, 2005 merged its two wholly owned subsidiaries, the Bank of Waukegan
        and First State Bank of Round Lake and named the resulting bank subsidiary
        NorStates Bank (the “Bank”). The purpose of this discussion is to provide a
        better understanding of the condensed consolidated financial statements of
        Northern States Financial Corporation and the operations of NorStates Bank
        and
        the Bank’s wholly owned subsidiary, Northern States Community Development
        Corporation (“NSCDC”). This discussion should be read in conjunction with the
        interim condensed consolidated unaudited financial statements and notes thereto
        included herein.
 
 Statements
        contained in this report that are not historical facts may constitute
        forward-looking statements (within the meaning of Section 21E of the Securities
        Exchange Act of 1934, as amended), which involve significant risks and
        uncertainties. The Company intends such forward-looking statements to be
        covered
        by the safe harbor provisions for forward-looking statements contained in
        the
        Private Securities Litigation Reform Act of 1995, and is including this
        statement for purposes of invoking these safe harbor provisions. Forward-looking
        statements, which are based on certain assumptions and describe future plans,
        strategies and expectations of the Company, are generally identifiable by
        the
        use of the words "believe," "expect," "intend," "anticipate," "estimate,"
        "project," "plan," or similar expressions. The Company's ability to predict
        results or the actual effect of future plans or strategies is inherently
        uncertain and actual results may differ from those predicted. The Company
        undertakes no obligation to update these forward-looking statements in the
        future. The Company cautions readers of this report that a number of important
        factors could cause the Company’s actual results subsequent to September 30,
        2006 to differ materially from those expressed in forward-looking statements.
        Factors that could cause actual results to differ from those predicted and
        could
        have a material adverse effect on the operations of the Company and its
        subsidiaries include, but are not limited to, the potential for further
        deterioration in the credit quality of the Company’s loan and lease portfolios,
        uncertainty regarding the Company’s ability to ultimately recover on the surety
        bonds relating to the remaining equipment lease pools and other loans currently
        on nonaccrual status, unanticipated changes in interest rates, general economic
        conditions, increasing regulatory compliance burdens or potential
        legislative/regulatory changes, monetary and fiscal policies of the U.S.
        Government, including policies of the U.S. Treasury and the Federal Reserve
        Board, the quality or composition of the Company’s loan or investment
        portfolios, deposit flows, competition, demand for loan products and financial
        services in the Company’s market area, and changes in accounting principles,
        policies and guidelines. These risks and uncertainties should be considered
        in
        evaluating forward-looking statements.
 
 OVERVIEW
 
 Total
        assets at September 30, 2006 declined from year-end levels. Assets totaled
        $712.0 million at September 30, 2006, a decrease of $10.5 million or 1.5
        percent
        from total assets of $722.5 million at December 31, 2005. Securities available
        for sale decreased $12.6 million and loans and leases declined $19.5 million
        from year-end 2005. Deposits decreased $23.3 million compared to December
        31,
        2005, while securities sold under repurchase agreements increased $9.6 million.
        Short term investments in commercial paper-maturities less than 90 days
        increased $10.0 million and federal funds sold increased $15.4 million from
        year-end 2005.
 
 9
 *Index*
 
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**






Earnings
      for the three months ended September 30, 2006 were $721,000 or $.17 per share,
      as compared with $.03 per share, or $135,000 for the same quarter of 2005.
      The
      third quarter 2006 earnings improved compared to the same quarter of the preceding
      year as Company determined that the allowance for loan and lease losses at
      quarter-end 2006 was adequate and no provision for loan and lease losses was
      needed for the quarter. During the same quarter last year the Company recorded
      a
      provision of $1.7 million to the allowance for loan and lease losses. Based
      on
      management’s analysis of the allowance for loan and lease losses at September
      30, 2006, management believes that the allowance of $7.5 million is adequate
      to
      cover probable incurred loan and lease losses. Earnings during the third quarter
      of 2006 were affected unfavorably by a decrease in net interest income of
      $711,000.





Noninterest
      income increased $143,000 during the three months ended September 30, 2006
      compared with the same quarter of 2005. The increase to noninterest income
      was
      mainly attributable to a gain on the sale of other real estate owned. A motel
      that had been acquired by the Company through foreclosure in 2005 and had been
      carried at $1,050,000 was sold and the Company received proceeds of $1,135,000
      and recognized a gain of $85,000 on the sale.





CRITICAL
      ACCOUNTING POLICIES





Certain
      critical accounting policies involve estimates and assumptions by management.
      To
      prepare financial statements in conformity with accounting principles generally
      accepted in the United States of America, management makes estimates and
      assumptions based on available information. These estimates and assumptions
      affect the amounts reported in the financial statements and the disclosures
      provided, and future results could differ. The allowance for loan and lease
      losses is a critical accounting policy for the Company because management must
      make estimates of losses and these estimates are subject to change.





The
      allowance for loan and lease losses is a valuation allowance for probable
      incurred credit losses, increased by the provision for loan and lease losses
      and
      decreased by net charge-offs. Management estimates the allowance balance
      required using past loan and lease loss experience, the nature and volume of
      the
      portfolio, information about specific borrower situations, estimated collateral
      values, economic conditions and other factors. Allocations of the allowance
      may
      be made for specific loans and leases, but the entire allowance is available
      for
      any loan or lease that, based on management’s judgment, should be charged-off.





Management
      analyzes the adequacy of the allowance for loan and lease losses at least
      quarterly. Loans and leases judged to be impaired, with probable incurred loss
      exposure, that are no longer accruing interest, and historical net loss
      percentages are reviewed in the analysis of the allowance for loan and lease
      losses. Factors considered in assessing the adequacy of the allowance include:
      changes in the type and volume of the loan and lease portfolio; review of the
      larger credits within the Bank; historical loss experience; current economic
      trends and conditions; review of the present value of expected cash flows or
      fair value of collateral on impaired loans and leases; portfolio growth; and
      other factors management deems appropriate. Based on management’s analysis, the
      allowance for loan and lease losses at September 30, 2006 is adequate to cover
      probable incurred credit losses.





One
      of
      the components used to measure the adequacy of the allowance for loan losses
      is
      historical loss experience. In developing its analysis, management considers
      that different loan classifications within the portfolio have different loss
      experience ratios. For example, loans secured by real estate generally
      experience lower loss experience than loans secured by other assets. At
      September 30, 2006, approximately 83% of the Bank’s loans are secured by real
      estate.




Management
      specifically analyzes its nonperforming loans for probable losses. The change
      in
      the volume of nonperforming loans may significantly impact the amount of
      estimated losses specifically allocated to these loans. The amount of the
      specific allocation is dependent on the adequacy of the loan collateral and
      the
      borrowers’ ability to repay the loans. As specific allocations are done on a
      loan-by-loan




10
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
   basis,
        the amount of the specific allocation is subject to greater fluctuation than
        an
        allocation for a pool of loans based on historical loss trends. The amount
        of
        the allocations on nonperforming loans may fluctuate in future periods due
        to
        changes in conditions of underlying collateral and changes in the borrowers’
ability to repay.





Goodwill
      results from business acquisitions and represents the excess of the purchase
      price over the fair value of acquired tangible assets and liabilities and
      identifiable intangible assets. Goodwill is assessed for impairment annually
      and
      more often if warranted by circumstances. Any such impairment will be recognized
      in the period identified.





Other
      intangible assets consist of core deposit and acquired customer relationship
      intangible assets arising from whole bank and branch acquisitions, which is
      periodically evaluated for impairment. They are initially measured at fair
      value
      and then are amortized on the straight-line method over their estimated useful
      life of seven years.





FINANCIAL
      CONDITION





The
      Company’s federal funds sold at September 30, 2006 increased to $21.3 million
      from $6.0 million at December 31, 2005. The Company’s investment in short-term
      commercial paper also increased by $10.0 million. The Company’s federal funds
      sold and short-term commercial paper increased as a result of the Company’s need
      to increase its liquidity as its deposits decreased $23.3 million from year-end
      2005.





Loans
      and
      leases totaled $381.0 million at September 30, 2006, decreasing $19.5 million
      from $400.5 million at December 31, 2005. Much of the reduction to loans and
      leases in the nine months ended September 30, 2006 is attributable to the
      Company’s efforts to reduce its nonperforming and impaired loans. The Company’s
      nonperforming lease pools were reduced by $5.2 million due to the settlement
      between the Company and ACE/Illinois Union that occurred in the second quarter
      of 2006 as previously disclosed. During the third quarter of 2006 the Company
      received a payoff on a $3.7 million loan that had been impaired and
      restructured. The Company’s loans also were further reduced in 2006 as $3.1
      million in nonperforming loans were charged off to the allowance for loan and
      lease losses. Loans to the lodging industry at September 30, 2006 totaled $18.1
      million, decreasing from $23.9 million at December 31, 2005. At September 30,
      2006, loans to related parties totaled $1.9 million, $800,000 less than at
      December 31, 2005.





Loan
      commitments were $99.6 million at September 30, 2006 compared with $96.3 million
      at December 31, 2005. Loan commitments to related parties were $1.8 million
      at
      September 30, 2006.





Deposits
      decreased $23.3 million from year-end 2005. Commercial demand deposits decreased
      $7.1 million from year-end 2005, due in part to one of the Company’s large
      commercial customers liquidating their businesses and relocating out of the
      Company’s market. Retail time deposits decreased $6.1 million from year-end
      2005, as there has been much local competition for these deposits.




Brokered
      certificates of deposits decreased $5.8 million from year-end and totaled $43.9
      million at September 30, 2006. Brokered deposits are time deposits placed in
      the
      Bank by a broker from depositors outside the Bank’s geographic area. These
      deposits usually bear an interest rate of 10 to 15 basis points greater than
      the
      terms and conditions offered to local depositors and provides a source of
      liquidity to the Company. During the first nine months of 2006, the Company
      sought to lower its reliance on brokered deposits to decrease its interest
      expense.





Securities
      sold under repurchase agreements increased by $9.6 million to $82.7 million
      at
      September 30, 2006 from $73.1 million at December 31, 2005. Securities sold
      under repurchase agreements are financing arrangements that mature within one
      year. At September 30, 2006, $85.2 million of the Company’s securities were
      pledged for the repurchase agreements.




11
 *Index*


**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**


As
      previously disclosed, included in other liabilities at September 30, 2006 is
      $393,000 related to estimated environmental clean-up expenses of a parcel of
      other real estate previously sold. The Company intends to seek reimbursement
      of
      these expenses from the State of Illinois, which has a fund for this type of
      cleanup. However, there can be no assurance that the Company will be successful
      in obtaining any such reimbursement.





CAPITAL




Total
      stockholders’ equity was $72.7 million at September 30, 2006, unchanged from
      year-end 2005. During the nine months ended September 30, 2006 there were
      increases to stockholder’s equity from net income of $2,176,000 and from a
      $1,354,000 adjustment for the unrealized gain on securities available for sale,
      net of deferred tax. Stockholders’ equity was decreased during the first nine
      months of 2006 as a result of the purchase of 12,000 shares of treasury stock
      for a total amount of $252,000 and by the payment of a cash dividend of $.30
      per
      share that totaled $1,288,000. The book value of the Company’s stock at
      September 30, 2006 was $16.98 per share.





On
      a
      consolidated basis, the Company’s Tier 1 to total average assets ratio and total
      capital to assets ratio, on a risk adjusted basis, were 10.33% and 16.55%,
      respectively, as of September 30, 2006, and exceed the regulatory minimum
      for capital adequacy purposes. Management believes that the capital position
      of
      both the Company and the Bank are adequate for current projected needs.





At
      September 30, 2006, Tier 1 capital ratios of the Company include the effect
      of
      the issuance of $10.0 million in trust preferred securities on September 15,
      2005. The trust preferred securities were funded by the issuance of $10.0
      million of subordinated debentures. Federal Reserve guidelines limit the amount
      of trust preferred securities that can be included in Tier 1 capital to 25%
      of
      total Tier 1 capital. During 2005, the Company contributed $2.0 million of
      proceeds from the trust preferred issuance to the Bank as common equity.





LIQUIDITY





The
      Company’s liquidity is measured by the ability to raise funds through deposits,
      borrowed funds, capital or cash flow from the repayment or maturities of loans
      and securities and net profits.   Liquidity is primarily managed through
      the growth
      of
      deposits and by liquid assets such as cash and due from banks less any reserve
      requirements, securities available for sale less any pledged securities and
      federal funds sold.  Asset and liability management is the process of
      ma naging
      the balance sheet to achieve a mix of earning assets and liabilities in such
      a
      way that achieves an interest rate risk profile acceptable to management and
      assists in achieving a desired level of profitability.  An important part
      of the overall asset and liability management process is providing adequate
      liquidity. Liquid assets were $114.1 million at September 30, 2006 compared
      to
      $101.3 million at December 31, 2005.





Management
      reviews the liquidity ratio of the Bank monthly. The liquidity ratio is the
      net
      liquid assets divided by net deposits and short-term liabilities. At September
      30, 2006, this ratio was 25.7% and was within management’s internal policy
      guidelines.





Liquidity
      management involves the Company’s ability to meet the cash flow requirements of
      customers. The Company needs to have sufficient cash flow to meet the
      requirements of depositors wanting to withdraw funds or to fund loans to
      borrowers. The statements of cash flows shows that for the nine months ended
      September 30, 2006 cash and cash equivalents increased $21.2 million to $51.0
      million.





12
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
   Federal
        funds sold, commercial paper-maturities less than 90 days, interest bearing
        deposits in banks and available for sale securities, particularly those of
        shorter maturities, are principal sources of liquidity. Federal funds sold
        at
        September 30, 2006 were $21.3 million, compared with $6.0 million at December
        31, 2005. The Company classifies all of its securities as available for sale,
        which increases the Company's flexibility in that the Company can use its
        unpledged securities to meet liquidity requirements by increasing its repurchase
        agreement balances. Securities available for sale totaled $252.5 million
        at
        September 30, 2006 of which $183.3 million was pledged to secure public deposits
        and repurchase agreements. At December 31, 2005, the Company’s securities
        totaled $265.1 million of which $189.7 million was pledged.





Although
      the Company can sell unpledged securities for liquidity purposes prior to their
      maturity date, the Company, at the present, may have to recognize a loss on
      the
      sale to do so. At September 30, 2006, the Company has $177.5 million in
      securities issued by government-sponsored entities that will mature in 2007
      and
      it is expected that liquidity will be made available in this way during 2007
      without causing recognition of any loss.





During
      the first nine months of 2006, the Company had incoming cash flows from
      maturities and calls of securities available for sale of $82.1 million while
      it
      had cash outflows for purchases of securities of $67.3 million. These securities
      activities during the first nine months of 2006 provided liquidity of $14.8
      million and the increases to repurchase agreements provided $9.6 million in
      liquidity. This liquidity was used to meet the decreases in deposits of $23.3
      million.





Other
      sources of liquidity available to the Company are deposits and borrowings.
      The
      Company also uses brokered deposits as a source of liquidity. To help ensure
      the
      ability to meet its funding needs, including any unexpected strain on liquidity,
      the Company at September 30, 2006 had $25.0 million available through
      arrangements that allow the Company to purchase federal funds from an
      independent bank.





RESULTS
      OF OPERATIONS





NET
      INCOME





Consolidated
      net income for the quarter ended September 30, 2006 was $721,000, increasing
      $586,000 compared with net income of $135,000 for the same quarter of 2005.
      The
      annualized return on average assets was .40% for the quarter, increasing from
      .07% for the same quarter ofthe previous year. Third quarter 2006 earnings increased because the
      Company determined that the allowance for loan and lease losses at quarter-end
      was adequate and no provision for loan and lease losses was needed for the
      quarter. During the same quarter of 2005 the Company recorded a provision of
      $1.7 million to the allowance for loan and lease losses. For the nine months
      ended September 30, 2006, net income was $2,176,000 as compared with $1,747,000
      for the first nine months of 2005. The annualized return on average assets
      for
      the first nine months of 2006 was .41%, increasing from .31% for the same period
      of 2005.





NET
      INTEREST INCOME





Net
      interest income, the difference between interest income on earning assets and
      interest expense on interest bearing liabilities, decreased $711,000 to $3.9
      million during the three months ended September 30, 2006 compared with $4.6
      million for the same quarter of 2005. The decline in the net interest income
      resulted as rates paid on deposits and borrowings have increased to a greater
      extent than yields earned on the Company’s loans and securities.





13
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**


General
      interest rates during the third quarter of 2006 were at a higher level than
      they
      were during the same quarter of 2005. The prime lending rate during the three
      months ended September 30, 2006 was 8.25%. The prime rate during the third
      quarter of 2005 began the quarter at 6.25% and after two 25 basis point
      increases ended the quarter at 6.75%.





During
      the three months ended September 30, 2006 average rates paid on interest bearing
      liabilities increased to a greater extent than the yields on interest earning
      assets when compared with the same quarter of 2005 as indicated in Table 1.
      The
      rates paid on interest bearing liabilities increased 107 basis points while
      the
      yields on earning assets increased only 55 basis points. This caused the net
      interest margin to decline to 1.77% for the quarter as compared with 2.29%
      for
      the same quarter ofthe previous year. The decline in the net interest margin was partially
      because a greater amount of rate sensitive liabilities repriced at the higher
      interest rates during the third quarter of 2006 than rate sensitive assets.





Also
      contributing to the decline in net interest margin was the $13.9 million
      decrease to average loans during the third quarter of 2006 as compared with
      the
      same quarter of 2005. Loans, generally, earn higher interest rates than other
      interest earning assets of the Company.





The
      average yield earned on the Company’s taxable securities during the three months
      ended September 30, 2006 was 3.39% as compared with 3.24% during the same period
      of 2005, an increase of only 15 basis points. As the securities mature, the
      Company has the opportunity to reprice the securities portfolio by buying new
      securities that are expected to earn higher yields. At September 30, 2006,
      the
      Company has $177.5 million in securities issued by government-sponsored entities
      having an average yield of 3.06% that will mature in 2007.





Interest
      expense on time deposits during the third quarter of 2006 was $455,000 greater
      than it was during the third quarter of 2005. Interest expense for other
      borrowings, which include the Federal Home Loan Bank term advance, securities
      sold under repurchase agreements, federal funds purchased and the subordinated
      debentures increased by $579,000 during the three months ended September 30,
      2006 compared with the same period of 2005. Much of the increased interest
      expense on borrowings for the third quarter of 2006 was attributable to interest
      expense on the $10 million subordinated debentures.





The
      Company has taken steps to bolster its net interest margin by lowering some
      of
      its deposit rates. The Company lowered the rate paid on its savings and regular
      NOW deposit products by 25 basis points. Interest rates paid have been tiered
      so
      that rates on lower balanced savings accounts, money market and certificates
      of deposit are 20 or more basis points less than on higher balanced accounts.
      As
      lower balance certificates mature, they will renew at the slightly lower rates.
      The Company has also lowered the amount of brokered deposits by $5.8 million
      that are usually paid higher interest rates than regular time
      deposits.





Table
      2
      shows that during the nine months ended September 30, 2006 net interest income
      on a fully tax equivalent basis declined $3.1 million compared with the same
      period of 2005. The decrease in net interest income is primarily because
      interest rates paid on deposits and borrowings increased more quickly than
      rates
      earned on the Company’s loans and securities. Average yields on interest earning
      assets increased 51 basis points during the nine months ended September 30,
      2006
      as compared with the same nine months last year while average rates paid on
      interest bearing liabilities increased by 118 basis points, causing the net
      interest margin to compress. Also affecting net interest income during the
      nine
      months ended September 30, 2006 was the decline in interest earning assets
      of
      $35.8 million compared with the same period last year.




14
 *Index*




**NORTHERN
          STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
          DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
          AND RESULTS OF OPERATIONS**
  TABLE
          1


NORTHERN
        STATES FINANCIAL CORPORATION
 ANALYSIS
        OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For
        the
        Three Months Ended September 30, 2006 and 2005 - Rates are
        Annualized
 ($
        000s)
  2006
                  
                  
                  
                  
                  
                  2005Average
                    Balance
                  
                  Interest
                  
                  Rate
                  
                  Average
                    Balance
                  
                  Interest
                  
                  RateAssetsLoans (1)(2)(3)
                  
                  $
                  390,944
                  
                  $
                  6,864
                  
                  
                  7.02
                  %
                  $
                  404,830
                  
                  $
                  6,405
                  
                  
                  6.33
                  %Taxable securities (4)
                  
                  
                  243,661
                  
                  
                  2,105
                  
                  
                  3.39
                  %
                  
                  254,725
                  
                  
                  2,097
                  
                  
                  3.24
                  %Tax advantaged securities (2) (4)
                  
                  
                  6,226
                  
                  
                  84
                  
                  
                  5.37
                  %
                  
                  8,594
                  
                  
                  106
                  
                  
                  4.93
                  %Commercial paper - maturities less than
                    90 days
                  
                  
                  8,454
                  
                  
                  115
                  
                  
                  5.44
                  %
                  
                  0
                  
                  
                  0
                  
                  
                  0.00
                  %Federal funds sold
                  
                  
                  22,097
                  
                  
                  301
                  
                  
                  5.45
                  %
                  
                  26,842
                  
                  
                  224
                  
                  
                  3.34
                  %Interest earning assets
                  
                  
                  671,382
                  
                  
                  9,469
                  
                  
                  5.60
                  %
                  
                  694,991
                  
                  
                  8,832
                  
                  
                  5.05
                  %Noninterest earning assets
                  
                  
                  44,649
                  
                  
                  
                  
                  
                  
                  
                  
                  49,760Average assets
                  
                  $
                  716,031
                  
                  
                  
                  
                  
                  
                  
                  $
                  744,751Liabilities and stockholders' equityEquityNOW deposits
                  
                  $
                  51,857
                  
                  $
                  120
                  
                  
                  0.93
                  %
                  $
                  54,931
                  
                  $
                  141
                  
                  
                  1.03
                  %Money market deposits
                  
                  
                  73,976
                  
                  
                  765
                  
                  
                  4.14
                  %
                  
                  63,046
                  
                  
                  351
                  
                  
                  2.23
                  %Savings deposits
                  
                  
                  74,397
                  
                  
                  174
                  
                  
                  0.94
                  %
                  
                  83,590
                  
                  
                  244
                  
                  
                  1.17
                  %Time deposits
                  
                  
                  283,791
                  
                  
                  3,272
                  
                  
                  4.61
                  %
                  
                  327,720
                  
                  
                  2,817
                  
                  
                  3.44
                  %Other borrowings
                  
                  
                  94,908
                  
                  
                  1,206
                  
                  
                  5.08
                  %
                  
                  77,216
                  
                  
                  627
                  
                  
                  3.25
                  %Interest bearing liabilities
                  
                  
                  578,929
                  
                  
                  5,537
                  
                  
                  3.83
                  %
                  
                  606,503
                  
                  
                  4,180
                  
                  
                  2.76
                  %Demand deposits
                  
                  
                  57,669
                  
                  
                  
                  
                  
                  
                  
                  
                  60,742Other noninterest bearing liabilities
                  
                  
                  7,998
                  
                  
                  
                  
                  
                  
                  
                  
                  6,226Stockholders' equity
                  
                  
                  71,435
                  
                  
                  
                  
                  
                  
                  
                  
                  71,280Average
                    liabilities and
                    Stockholders'          
                     equity
                  
                  $
                  716,031
                  
                  
                  
                  
                  
                  
                  
                  $
                  744,751Net interest income
                  
                  
                  
                  
                  $
                  3,932
                  
                  
                  
                  
                  
                  
                  
                  $
                  4,652Net interest margin
                  
                  
                  
                  
                  
                  
                  
                  
                  1.77
                  %
                  
                  
                  
                  
                  
                  
                  
                  2.29
                  %Net
                    yield on interest earning assets (4)
                  
                  
                  
                  
                  
                  
                  
                  
                  2.33
                  %
                  
                  
                  
                  
                  
                  
                  
                  2.66
                  %Interest-bearing liabilities to earning
                    assets ratio
                  
                  
                  
                  
                  
                  
                  
                  
                  86.23
                  %
                  
                  
                  
                  
                  
                  
                  
                  87.27
                  %






(1)
              Interest
                  income on loans includes loan origination and other fees of $62
                  and $116
                  for the three months ended September 30, 2006
                and
                  2005.(2)
              Tax-exempt
                  income is reflected on a fully tax equivalent basis utilizing a
                  34% tax
                  rate.(3)
              Non-accrual
                  loans are included in average loans.(4)
              Rate
                  information was calculated on the average amortized cost for securities.
                  The three months ended September 30, 2006 and 2005 average balance
                  information includes an average unrealized gain (loss) for taxable
                  securities of ($4,871) and ($4,563) and for tax-advantaged securities
                  of
                  ($29) and $2.


15
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**








TABLE
        2
 
 NORTHERN
        STATES FINANCIAL CORPORATION
 ANALYSIS
        OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For
        the
        Nine Months Ended September 30, 2006 and 2005 - Rates are
        Annualized
 ($
        000s)





2006
              
              
              
              
              
              2005Average
                Balance
              
              Interest
              
              Rate
              
              Average
                Balance
              
              Interest
              
              RateAssetsLoans (1)(2)(3)
              
              $92,800
              
              $20,314
              
              6.90
              %
              $418,502
              
              $19,312
              
              6.15%Taxable securities (4)
              
              248,411
              
              6,302
              
              3.31
              %
              242,747
              
              5,908
              
              3.19%Tax advantaged securities (2) (4)
              
              6,326
              
              258
              
              5.42
              %
              9,346
              
              348
              
              4.97%Commercial paper - maturities less than 90 days
              
              2,818
              
              115
              
              5.44
              %
              0
              
              0
              
              0.00%Federal funds sold
              
              11,883
              
              462
              
              5.18
              %
              27,396
              
              618
              
              3.01%Interest earning assets
              
              662,238
              
              27,451
              
              5.48
              %
              697,991
              
              26,186
              
              4.97%Noninterest earning assets
              
              
              44,871
              
              
              
              
              
              
              
              
              49,058Average assets
              
              $
              707,109
              
              
              
              
              
              
              
              $
              747,049Liabilities
                  and stockholders' equityequityNOW deposits
              
              $
              53,263
              
              $
              393
              
              
              0.98
              %
              $
              58,515
              
              $
              383
              
              
              0.87
              %Money market deposits
              
              
              73,142
              
              
              2,079
              
              
              3.79
              %
              
              62,422
              
              
              869
              
              
              1.86
              %Savings deposits
              
              
              76,535
              
              
              589
              
              
              1.03
              %
              
              83,852
              
              
              653
              
              
              1.04
              %Time deposits
              
              
              283,369
              
              
              9,086
              
              
              4.28
              %
              
              331,762
              
              
              7,316
              
              
              2.94
              %Other borrowings
              
              
              83,378
              
              
              2,920
              
              
              4.67
              %
              
              70,024
              
              
              1,467
              
              
              2.79
              %Interest bearing
                  liabilities
              
              
              569,687
              
              
              15,067
              
              
              3.53
              %
              
              606,575
              
              
              10,688
              
              
              2.35
              %Demand deposits
              
              
              58,501
              
              
              
              
              
              
              
              
              61,634Other noninterest bearing liabilities
              
              
              7,708
              
              
              
              
              
              
              
              
              6,566Stockholders' equity
              
              
              71,213
              
              
              
              
              
              
              
              
              72,274Average liabilities and stockholders'
                equity
              
              $
              707,109
              
              
              
              
              
              
              
              $
              747,049Net interest income
              
              
              
              
              $
              12,384
              
              
              
              
              
              
              
              $
              15,498Net interest margin
              
              
              
              
              
              
              
              
              1.95
              %
              
              
              
              
              
              
              
              2.62
              %Net yield on interest earning assets (4)
              
              
              
              
              
              
              
              
              2.47
              %
              
              
              
              
              
              
              
              2.94
              %Interest-bearing liabilities to earning
                assets ratio
              
              
              
              
              
              
              
              
              86.02
              %
              
              
              
              
              
              
              
              86.90
              %




(1)
              Interest
                  income on loans includes loan origination and other fees of $296
                  and $366
                  for the nine months ended September 30, 2006 and
                  2005.
 (2)
              Tax-exempt
                  income is reflected on a fully tax equivalent basis utilizing a
                  34% tax
                  rate.
 (3)
              Non-accrual
                  loans are included in average
                  loans.
 (4)
              Rate
                  information was calculated on the average amortized cost for securities.
                  The nine months ended September 30, 2006 and 2005 average balance
                  information includes an average unrealized gain (loss) for taxable
                  securities of ($5,237) and ($4,133) and for tax-advantaged securities
                  of
                  ($25) and $8.
  16
 *Index*




**NORTHERN
      STATES FINANCIAL CORPORATION**


**MANAGEMENT’S
          DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
          AND RESULTS OF OPERATIONS**






ASSET
      QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES





Management,
      after carefully reviewing the adequacy of the allowance for loan and lease
      losses and the levels of nonperforming and impaired loans and leases, with
      the
      concurrence of the Board of Directors, found that no provision for loan and
      lease losses was necessary for the quarter ended September 30, 2006. During
      the
      same period of 2005, it was determined that a provision for loan and lease
      losses of $1.7 million was required, as previously disclosed. For the nine
      months ended September 30, 2006, no provision for loan and lease losses was
      made
      as compared with $2.42 million during the first nine months of 2005.





At
      September 30, 2006, the allowance for loan and lease losses was $7.5 million,
      decreasing $3.1 million from year-end 2005. During the first nine months of
      2006, $3,141,000 in loans were charged off against the allowance compared with
      $677,000 during the same period last year. During the third quarter of 2006,
      the
      Company charged off $970,000 in loans on 2 motels that were in the process
      of
      foreclosure at quarter end. There was $36,000 in recoveries of loans previously
      charged off during the nine months ended September 30, 2006 compared with
      $66,000 in recoveries during the same period in 2005.





Nonperforming
      loans and leases, which includes loans and leases on nonaccrual status in
      addition to loans and leases 90 days or more past due and still accruing
      interest, decreased $8.1 million to $13.8 million at September 30, 2006 from
      $21.9 million at December 31, 2005, a reduction of 37.2%. Nonperforming loans
      as
      a percentage of total loans and leases were 3.61% at September 30, 2006 as
      compared with 5.47% at December 31, 2005.





The
      Company previously disclosed its involvement in certain lease pools purchased
      in
      2000 and 2001 from Commercial Money Center (“CMC”). Also previously disclosed,
      the Company and NorStates Bank entered into a Settlement Agreement, Mutual
      Release and Policy Rescission with Illinois Union dated as of February 1, 2006
      upon approval of the court of the agreement on May 17, 2006. As a result of
      the
      settlement, the balance of the Company’s nonaccrual loans and leases was reduced
      by $5.2 million during the quarter ended June 30, 2006. At September 30, 2006,
      there are $4.1 million in remaining lease pools secured by both the leased
      equipment and surety bonds issued by RLI Insurance Company. These remaining
      lease pools are carried on nonaccrual status at September 30, 2006. The Company
      is continuing its efforts to collect on these leases from RLI Insurance Company
      through litigation. No assurance can be given as to the exact amounts that
      will
      ultimately be collected, if any, by the Company.





Included
      in nonperforming loans at September 30, 2006, is a $4.3 million nonaccrual
      loan
      that is for a 90-unit condominium construction project. The Company participated
      in this 90-unit condominium project with other financial institutions and only
      has a portion of the total loan. The construction project experienced
      substantial cost overruns and the principal borrowers declared bankruptcy.
      The
      construction project has been completed and all of the units have been sold,
      with the bankruptcy trustee holding the sale proceeds in escrow. There are
      disputed mechanic liens from the construction phase of the project, the majority
      of which are insured by a title company. Once the mechanic liens are resolved,
      the bankruptcy trustee is expected to release the sales proceeds from escrow
      and
      management expects to collect all of the $4.3 million loan balance. It is
      estimated that the mechanic liens issue will not be resolved until 2007.





During
      the third quarter of 2006, the Company charged off $970,000 of nonaccrual loans
      secured by 2 motels leaving remaining loan balances of $2.6 million. In early
      October 2006, the Company foreclosed on the motels and transferred these motels
      into other real estate owned during the fourth quarter of 2006. The Company
      is
      operating the motels through a wholly-owned limited liability corporation until
      the motels are sold.




17
 *Index*




**NORTHERN
        STATES FINANCIAL CORPORATION**
 **MANAGEMENT’S
            DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
            AND RESULTS OF OPERATIONS**
   Also
        on
        nonaccrual status were $1.4 million in loans to a building contractor who
        has
        experienced financial deterioration and cash flow problems. The loans to
        the
        building contractor are secured by real estate and accounts
        receivable.





During
      the second quarter of 2006, the Company charged off $2.0 million of a nonaccrual
      loan on an entertainment center. At September 30, 2006 the balance on this
      loan
      is $736,000. The remaining balance of this loan is secured by stock and real
      estate held by the bankruptcy court’s liquidation trust.





Impaired
      loans and leases at September 30, 2006 totaled $20.0 million, decreasing $12.1
      million or 37.5% from $32.1 million at December 31, 2005. The Company considers
      a loan or lease impaired if full principal and interest will not be collected
      under the contractual terms of the note. Impaired loans and leases are carried
      at the present value of expected cash flows discounted at the loan's effective
      interest rate or at the fair value of the collateral, if the loan or lease
      is
      collateral dependent. The amount of the allowance for loan and lease losses
      specifically allocated for impaired loans and leases was $4.6 million at
      September 30, 2006 compared with $7.6 million at December 31, 2005.





Included
      as impaired loans at September 30, 2006 were $6.7 million of restructured loans
      where the terms and conditions of the loans have been adjusted due to
      deterioration in the financial condition of the borrowers. Payments have been
      received on the restructured loans based on the agreed modified terms of the
      loans and these restructured loans, although classified as impaired, are not
      included as nonperforming loans. During the third quarter the Company received
      payment in full on one restructured loan in the amount of $3.7 million
      accounting for most of the reduction to restructured loans that had totaled
      $10.5 million at December 31, 2005.





Another
      component of nonperforming assets is other real estate owned, which consists
      of
      assets acquired through loan foreclosure and repossession. At September 30,
      2006, other real estate owned totaled $3.1 million, decreasing $1.3 million
      from
      December 31, 2005 as properties were sold during the nine months ended September
      30, 2006. During the nine months ended September 30, 2006, two properties
      securing loans were transferred to other real estate owned totaling $105,000
      and
      were sold. Also sold during the nine months ended September 30, 2006 were two
      properties that at year-end 2005 were carried at $1,050,000 and $325,000. The
      Company recognized net gains of $62,000 on these sales of other real estate
      owned. The fair value of other real estate owned is reviewed by management
      at
      least quarterly to help ensure the reasonableness of its carrying value, which
      is the lower of cost or the fair value less estimated selling
      costs.





Other
      real estate owned includes a property acquired in 1987 through the receipt
      of
      deed in lieu of foreclosure. This property is a former commercial/industrial
      site located overlooking Lake Michigan in Waukegan, Illinois, with a carrying
      value of $1,783,000 at September 30, 2006. Environmental remediation costs
      may
      be incurred in disposing of this property, and the amount of any such costs
      may
      depend on the future use of the property, such as commercial, residential,
      or
      recreational purposes. There is no requirement to undertake any remediation
      activities at this time. Further, there is no pending or threatened litigation
      regarding the property’s environmental issues, nor are there any threatened or
      pending governmental orders, assessments or actions regarding the same. The
      property is currently undergoing a brownfield assessment funded by a government
      grant. The grant money is to be used for the brownfield assessment but not
      for
      any remediation that may be needed. The objective of the brownfield assessment
      is to obtain the environmental data needed to determine the appropriate remedial
      actions, if any, for the property to achieve a “No Further Remediation Letter”
from the Illinois EPA Site Remediation Program. The planned use of the property
      is mixed residential development consistent with the City of Waukegan’s
      Lakefront Downtown Master Plan. The results of the brownfield assessment are
      expected later in 2006. Until the results of the assessment are known, it is
      not
      practical to estimate any remediation costs. Thus, no liability has been
      recorded for any potential environmental remediation costs.




18
 *Index*





**NORTHERN
        STATES FINANCIAL CORPORATION**
 **MANAGEMENT’S
            DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
            AND RESULTS OF OPERATIONS**
  NONINTEREST
        INCOME





Noninterest
      income for the three months ended September 30, 2006 was $1.3 million compared
      to $1.2 million for the three months ended September 30, 2005, an increase
      of
      $143,000. The Company recognized gains on the sale of other real estate owned
      in
      the amount of $85,000 during the third quarter of 2006 that accounts for the
      majority of the increase.





For
      the
      nine months ended September 30, 2006, noninterest income was $3.7 million,
      an
      increase of $537,000 from the same time period last year. The Company did not
      sell any of its securities portfolio in 2006 but it recognized a $169,000 loss
      on the sale of securities available for sale during the first quarter of 2005
      that lowered 2005’s noninterest income. Other operating income growth for year
      to date 2006 was due in part to the one time receipt of life insurance proceeds
      of $75,000 and net gains from
      the sales of other real estate owned of $62,000.





NONINTEREST
      EXPENSE





Noninterest
      expense for the quarter ended September 30, 2006 was $4,190,000, increasing
      $125,000 from the same quarter last year. The majority of the increase is from
      data processing expense that increased $70,000 in the third quarter of 2006
      as
      compared to the same quarter of 2005. The cost of technology needed to update
      and provide products that customers need and to meet competitive pressures
      has
      increased data processing expense.





The
      Company’s efficiency ratio, noninterest expense divided by the sum of net
      interest income and noninterest income, was 80.7% for the third quarter of
      2006
      as compared with 70.6% for the same quarter of 2005. The higher ratio for the
      third quarter of 2006 reflects the decreased net interest income as rates paid
      on deposits and borrowings have increased at a greater pace than interest earned
      on the Company’s loans and securities.





For
      the
      nine months ended September 30, 2006, noninterest expense was $13.0 million,
      decreasing $776,000 from $13.8 million for the same period last year.
      Noninterest expense declined during the first nine months of 2006 primarily
      due
      to the $1,067,000 one time write-down of other real estate owned during the
      first nine months of 2005. If the one time write-down of other real estate
      owned
      is not considered, noninterest expenses increased only $291,000, or 2.3%, during
      the first nine months of 2006 compared with the same period of 2005.





Data
      processing expense during the nine months ended September 30, 2006 increased
      $143,000 and occupancy and equipment expense increased $132,000 as compared
      with
      the same time period of 2005. Occupancy and equipment expense increased $143,000
      due to maintenance and some capitalized improvements to the Company’s buildings
      that increased depreciation expense. It is anticipated that occupancy expense
      will continue to increase compared to previous periods as the Bank does some
      remodeling to update its branch offices.





19
 *Index*





**NORTHERN
        STATES FINANCIAL CORPORATION**
 **MANAGEMENT’S
            DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
            AND RESULTS OF OPERATIONS**




FEDERAL
      AND STATE INCOME TAXES





For
      the
      three months ended September 30, 2006, the Company’s income tax expense was
      $279,000 compared with a tax benefit of $142,000 for the same three months
      last
      year. As a percentage of pre-tax income, tax expense was 27.9% for the three
      months ended September 30, 2006. The tax benefit during the third quarter of
      2005 resulted from the $1.7 million provision for loan and lease losses during
      the quarter and from interest income during the quarter earned on U.S. Treasury
      and U.S. government entity securities that is not subject to state income tax.
      For the nine months ended September 30, 2006 income tax expense as a percentage
      of pre-tax income was 25.6% and 22.8% for the same period of 2005.





CONTRACTUAL
      OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS





The
      Company has contractual obligations that may not appear on the balance sheet.
      Table 3 presents the Company’s significant fixed and determinable contractual
      obligations as of September 30, 2006, by payment date. The payment amounts
      in
      Table 3 represent those amounts contractually due to the recipient and do not
      include any unamortized premiums or discounts or similar carrying amount
      adjustments.




TABLE
        3
 
 NORTHERN
        STATE FINANCIAL CORPORATION
 CONTRACTUAL
        OBLIGATIONS
 As
        of
        September 30, 2006
 ($
        000s)
 
 One
                  year
                or
                  less
              
              Greater
                  than
                1
                  yr. and less
                Than
                  or equal
                To
                  3 yrs.
              
              Greater
                  than
                3
                  yrs. and less
                than
                  or equal
                to
                  5 yrs.
              
              Greater
                  than
                5
                  yrs.
              
              TotalContractual
                  obligationsLong-term
                  debtFederal Home Loan Bank advance
              
              $
              0
              
              $
              6,500
              
              $
              0
              
              $
              0
              
              $
              6,500Subordinated debentures
              
              
              0
              
              
              0
              
              
              0
              
              
              10,000
              
              
              10,000Time deposits
              
              
              199,423
              
              
              70,481
              
              
              10,406
              
              
              0
              
              
              280,310Other
                  contractual obligationsStandby letters of credit
              
              
              5,984
              
              
              0
              
              
              0
              
              
              0
              
              
              5,984Community
                  Reinvestment ActInvestment commitment
              
              
              342
              
              
              300
              
              
              0
              
              
              0
              
              
              642
 
 20
 *Index*





**NORTHERN
      STATES FINANCIAL CORPORATION**








**ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**




The
      Company’s primary market risk exposure is interest rate risk and, to a lesser
      extent, liquidity risk. Interest rate risk is the exposure of a banking
      organization’s financial condition to adverse movements in interest rates. The
      Company seeks to achieve consistent growth in net interest income and net income
      while managing volatility that arises from shifts in interest rates. The
      Company’s Asset and Liability Management Committee (“ALCO”) oversees interest
      rate risk programs instituted by management and measurements of interest rate
      risk to determine that they are within authorized limits set by the Company’s
      Board of Directors.





Evaluating
      a financial institution’s exposure to changes in interest rates includes
      assessing both the adequacy of the management process used to control interest
      rate risk and the organization’s quantitative level of exposure. When assessing
      the interest rate risk management process, the Company seeks to ensure that
      appropriate policies, procedures, management information systems and internal
      controls are in place to maintain interest rate risk at prudent levels with
      consistency and continuity. Evaluating the quantitative level of interest rate
      risk exposure requires the Company to assess the existing and potential future
      effects of changes in interest rates on its consolidated financial condition,
      including capital adequacy, earnings, liquidity, and, where appropriate, asset
      quality.





One
      approach used by management to analyze interest rate risk is to periodically
      evaluate the effect of interest rate “shocks”, an instantaneous decrease and
      increase in rates of 1% and 2%, on net interest income. The Company uses
      computer simulation for the interest rate shocks that shows the effect of the
      shocked rate changes on base 12 month projected net interest income. This
      approach falls under the broad definition of asset/liability management. The
      Company's primary asset/liability management technique is the interest rate
      shock.





Several
      ways the Company can manage interest rate risk include: selling existing assets
      or repaying certain liabilities and matching repricing periods for new assets
      and liabilities, for example, by shortening terms of new loans or securities.
      Financial institutions are also subject to prepayment risk in a falling rate
      environment. For example, a debtor may prepay financial assets so that the
      debtor may refinance obligations at new, lower rates. Prepayments of assets
      carrying higher rates reduce the Company’s interest income and overall asset
      yields. A large portion of an institution’s liabilities may be short term or due
      on demand, while most of its assets may be invested in longer-term loans or
      securities. Accordingly, the Company seeks to have sources of cash to meet
      short-term demands that may be obtained by increasing deposits, borrowing,
      or
      selling assets.





Financial
      institutions are also subject to interest rate risk in a rising rate
      environment. Call features on securities may not be exercised and the lower
      yielding securities may remain in the Company’s securities portfolio until
      maturity.





Table
      4
      shows how interest rate shocks of decreasing rates 1% and 2% and increasing
      rates 1% and 2% affect projected 12 month projected net interest income at
      September 30, 2006 and December 31, 2005. The computer simulation model used
      to
      do the interest rate shocks and calculate the effect on projected net interest
      income takes into consideration maturity and repricing schedules of the various
      assets and liabilities as well as call provisions on the Company’s securities.
      Increasing interest rates were projected in the model for calculation of the
      base forecasted net interest income as of September 30, 2006, with prime rate
      estimated as remaining at 8.25% during the fourth quarter of 2006 and first
      quarter 2007 and then dropping to 8.00% for the balance of 2007. Current policy
      set by the Board of Directors limits exposure to projected net interest income
      from interest rate shocks of plus or minus 2% to plus or minus 10% of the base
      projected forecasted 12 month net interest income.





21
 *Index*





**NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **QUANTITATIVE
        AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**


At
      September 30, 2006 the projected net interest income increases $175,000 when
      rates are shocked downward 2% while projected net interest income decreases
      $939,000 for a 2% upward rate shock. Projected net interest income increases
      when rates are shocked downward 2% as there aremore rate sensitive liabilities repricing than rate sensitive assets
      during the next twelve months. The percentage changes from the base forecasted
      12 month net interest income are within policy guidelines.






TABLE
        4
 NORTHERN
        STATES FINANCIAL CORPORATION
 EFFECT
        OF
        INTEREST SHOCKS ON NET INTEREST INCOME
 as
        of
        September 30, 2006 and December 31, 2005
 ($000s)


Immediate
                  Change in Rates-2.00%
              
              -1.00%
              
              +1.00%
              
              +2.00%September
                  30, 2006:Dollar Change from Base Forecast
              
              $
              175
              
              $
              118
              
              
              ($317
              )
              
              ($939
              )Percent Change from Base Forecast
              
              
              .97
              %
              
              .65
              %
              
              -1.76
              %
              
              -5.20
              %December
                  31, 2005:Dollar Change from Base Forecast
              
              $
              758
              
              $
              396
              
              
              ($489
              )
              
              ($1,062
              )Percent Change from Base Forecast
              
              
              3.64
              %
              
              1.90
              %
              
              -2.35
              %
              
              -5.09
              %




22
 *Index*





**NORTHERN
      STATES FINANCIAL CORPORATION**








**ITEM
      4. CONTROLS AND PROCEDURES**





As
      of the
      end of the period covered by this report, an evaluation was carried out under
      the supervision and with the participation of Northern States Financial
      Corporation’s management, including our Chairman of the Board and President and
      Vice President and Treasurer, of the effectiveness of our disclosure controls
      and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the
      Securities Exchange Act of 1934). Based on and as of the date of their
      evaluation, our Chairman of the Board and President and Vice President and
      Treasurer have concluded that the Company’s disclosure controls and procedures
      are effective, in all material respects, to ensure that information required
      to
      be disclosed by Northern States Financial Corporation in reports that it files
      or submits under the Exchange Act is recorded, processed, summarized and
      reported within the time periods specified in Securities and Exchange Commission
      rules and forms and are effective to ensure that material information related
      to
      the Company and its subsidiaries required to be disclosed in the reports that
      the Company files or submits under the Exchange Act is accumulated and
      communicated to the Company’s management, including our Chairman of the Board
      and President and Vice President and Treasurer, to allow timely decisions
      regarding required disclosure.





There
      was
      no change in the Company’s internal control over financial reporting that
      occurred during the three months ended September 30, 2006, that has materially
      affected, or is reasonably likely to materially affect, the Company’s internal
      control over financial reporting.





**PART
      II. OTHER INFORMATION**





**ITEM
      1. LEGAL PROCEEDINGS**




From
      time
      to time, due to the nature of its business, the Company and its subsidiaries
      are
      often subject to various legal actions. Other than as described below, these
      legal actions, whether pending or threatened, arise through the normal course
      of
      business and neither the Company nor any of its subsidiaries are currently
      involved in any proceedings that would, in management’s judgement, have a
      material adverse effect on the Company’s business, results of operation,
      financial condition or cash flows.





In
      September 2005, the Company filed Motions for Judgement on the Pleadings in
      its
      Commercial Money Center litigation against the sureties. At that time, the
      court
      granted the Motion for Judgement on the Pleadings against ACE/Illinois Union;
      however, the Bank’s motion against the RLI sureties was denied. On October 31,
      2005, the court directed all parties involved in the Commercial Money Center
      litigation to engage in mediation. As a result of the mediation, the Company,
      Bank of Waukegan and NorStates Bank entered into a Settlement Agreement, Mutual
      Release and Policy Rescission with Illinois Union dated as of February 1, 2006
      upon approval of the court of the agreement on May 17, 2006. As a result of
      the
      settlement, the balance of the Company’s nonaccrual loans and leases was reduced
      by $5.2 million during the quarter ended June 30, 2006. The Company and RLI
      were
      unable to reach settlement through mediation. The Company is carrying
      nonperforming lease pools purchased from Commercial Money Center of $4.1 million
      at September 30, 2006 that are insured by RLI Insurance Company. The Company
      is
      continuing its efforts to collect on these leases from RLI Insurance Company
      through litigation. No assurance can be given as to the exact amounts that
      will
      ultimately be collected, if any, by the Company.




23
 *Index*





**NORTHERN
      STATES FINANCIAL CORPORATION**








**ITEM
      1A. RISK FACTORS**





There
      have been no material changes to the risk factors relating to the Company from
      those risk factors previously disclosed in the Company’s Annual Report on Form
      10-K for its fiscal year ended December 31, 2005, in response to Item 1A. to
      Part I of Form 10-K.





**ITEM
      2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS**





**Issuer
      Purchases of Equity Securities**




There
      were no purchases made by, or on behalf of, the Company of shares of the
      Company’s common stock during the quarterly period ended September 30, 2006.





**ITEM
      3. DEFAULTS UPON SENIOR
      SECURITIES**





None ****





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS**





None





**ITEM
      5. OTHER INFORMATION**





None





**ITEM
      6. EXHIBITS**





(a)
            Exhibits.





Exhibit
      3.1 Articles of Incorporation of the Company, as amended to date. (Filed with
      Company’s annual report on Form 10-K for the year ended December 31, 1994
      (Commission File 0-19300) and incorporated herein by reference.)





Exhibit
      3.2 By-Laws of the Company, as amended and restated to date. (Filed with
      Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2004
      (Commission File 0-19300) and incorporated herein by reference.)





Exhibit
      4.1 Certain instruments defining the rights of holders of long-term debt of
      the
      Company and certain of its subsidiaries, none of which authorize a total amount
      of indebtedness in excess of 10% of the total assets of the Company and its
      subsidiaries on a consolidated basis, have not been filed as exhibits. The
      Company hereby agrees to furnish a copy of any of these agreements to the SEC
      upon request.





Exhibit
      31.1 Section 302 Certification of Chairman of the Board and
      President.





Exhibit
      31.2 Section 302 Certification of Vice President and Treasurer.





Exhibit
      32.1 Section 906 Certification.




24
 *Index*





**NORTHERN
      STATES FINANCIAL CORPORATION**


**FORM
      10-Q**


**September
      30, 2006**

















**SIGNATURES**














Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report on Form 10-Q to be signed on its behalf by the
      undersigned hereunto duly authorized, on this 7th day of November
      2006.


**NORTHERN
        STATES FINANCIAL CORPORATION**
 (Registrant)


Date:     
                  November 7, 2006
                By:
                /s/
                  Fred Abdula
 Fred Abdula
 Chairman of the Board of
                    Directors
                      and President
  Date:     
                        November 7, 2006
                      By:
                      /s/
                        Thomas M. Nemeth
 Thomas M.
                        Nemeth
 Vice President and
                              Treasurer
  25
 *Index*


**NORTHERN
      STATES FINANCIAL CORPORATION**


**FORM
      10-Q**


**September
      30, 2006**








**EXHIBIT
      INDEX**








Exhibits





Exhibit
      3.1 Articles of Incorporation of the Company, as amended to date. (Filed with
      Company’s annual report on Form 10-K for the year ended December 31, 1994
      (Commission File 0-19300) and incorporated herein by reference.)





Exhibit
      3.2 By-Laws of the Company, as amended and restated to date. (Filed with
      Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2004
      (Commission File 0-19300) and incorporated herein by reference.)





Exhibit
      4.1 Certain instruments defining the rights of holders of long-term debt of
      the
      Company and certain of its subsidiaries, none of which authorize a total amount
      of indebtedness in excess of 10% of the total assets of the Company and its
      subsidiaries on a consolidated basis, have not been filed as exhibits. The
      Company hereby agrees to furnish a copy of any of these agreements to the SEC
      upon request.





Exhibit
      31.1 Section 302 Certification of Chairman of the Board and
      President.





Exhibit
      31.2 Section 302 Certification of Vice President and Treasurer.





Exhibit
      32.1 Section 906 Certification.





26