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 June 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
                    (State
                      of Incorporation)
                  0-19300
                    (Commission
                      File Number)
                  36-3449727
                    (I.R.S.
                      Employer
                    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**
 
 4,283,105
        shares of common stock were outstanding
 as
        of
        August 4, 2006
  
  **NORTHERN
        STATES FINANCIAL CORPORATION AND SUBSIDIARY**
 **FORM
        10-Q**
 **For
        the Quarter Ended June 30, 2006**
 **INDEX**
 
  PageNumberPART
                      I.
                  FINANCIAL
                      INFORMATIONItem 1.
                  Financial
                      StatementsReport
                      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
                  25Item 5.
                  Other
                      Information
                  25Item 6.
                  Exhibits
                  25Signatures
                  26EXHIBIT
                      INDEX
                  27
 1
  **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
        June 30, 2006, the condensed consolidated statements of income for the three
        and
        six month periods ended June 30, 2006 and the condensed statements of cash
        flows
        and stockholders equity for the six month period ended June 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
 July
        28,
        2006
 
 2
 *Table
            of Contents*
 NORTHERN
          STATES FINANCIAL CORPORATION
 CONDENSED
          CONSOLIDATED BALANCE SHEETS
 June
          30,
          2006 and December 31, 2005
 (In
          thousands of dollars) (Unaudited)
 Assets
                
                
                June
                    30,
                  2006
                
                
                December
                    31,
                  2005Cash
                    and due from banks
                
                $
                19,075
                
                $
                23,586Interest
                    bearing deposits in financial institutions -
                  maturities
                    less than 90 days
                
                
                179
                
                
                120Federal
                    funds sold
                
                
                422
                
                
                5,962Total
                    cash and cash equivalents
                
                
                19,676
                
                
                29,668Securities
                    available for sale
                
                
                250,747
                
                
                265,067Loans
                    and leases
                
                
                394,029
                
                
                400,502Less:
                    Allowance for loan and lease losses
                
                
                (8,617
                )
                
                (10,618
                )Loans
                    and leases, net
                
                
                385,412
                
                
                389,884Federal
                    Home Loan Bank stock
                
                
                1,647
                
                
                2,086Office
                    buildings and equipment, net
                
                
                9,390
                
                
                9,427Other
                    real estate owned
                
                
                4,106
                
                
                4,431Goodwill
                
                
                9,522
                
                
                9,522Core
                    deposit intangible asset
                
                
                2,087
                
                
                2,318Accrued
                    interest receivable and other assets
                
                
                9,862
                
                
                10,125Total
                    assets
                
                $
                692,449
                
                $
                722,528Liabilities
                    and Stockholders' EquityLiabilitiesDepositsDemand
                    - noninterest bearing
                
                $
                58,616
                
                $
                63,329Interest
                    bearing
                
                
                481,179
                
                
                491,120Total
                    deposits
                
                
                539,795
                
                
                554,449Securities
                    sold under repurchase agreements
                
                
                49,376
                
                
                73,093Federal
                    funds purchased
                
                
                8,700
                
                
                0Federal
                    Home Loan Bank advances
                
                
                6,500
                
                
                6,500Subordinated
                    debentures
                
                
                10,000
                
                
                10,000Advances
                    from borrowers for taxes and insurance
                
                
                891
                
                
                830Accrued
                    interest payable and other liabilities
                
                
                6,486
                
                
                6,904Total
                    liabilities
                
                
                621,748
                
                
                651,776Stockholders'
                    EquityCommon
                    stock
                
                
                1,789
                
                
                1,789Additional
                    paid-in capital
                
                
                11,584
                
                
                11,584Retained
                    earnings
                
                
                65,692
                
                
                65,526Accumulated
                    other comprehensive loss
                
                
                (3,452
                )
                
                (3,487
                )Treasury
                    stock, at cost
                
                
                (4,912
                )
                
                (4,660
                )Total
                    stockholders' equity
                
                
                70,701
                
                
                70,752Total
                    liabilities and stockholders' equity
                
                $
                692,449
                
                $
                722,528The
                    accompanying notes are an integral part of these condensed consolidated
                    financial statements.




3
 *Table
          of Contents*




NORTHERN
        STATES FINANCIAL CORPORATION
 CONDENSED
        CONSOLIDATED STATEMENTS OF INCOME
 Three
        and
        six months ended June 30, 2006 and 2005
 (In
        thousands of dollars, except per share data) (Unaudited)
  Three
                  months ended
              
              Six
                  months endedJune
                  30,
                2006
              
              June
                  30,
                2005
              
              June
                  30,
                2006
              
              June
                  30,
                2005Interest
                  incomeLoans
                  (including fee income)
              
              $
              6,946
              
              $
              6,369
              
              $
              13,420
              
              $
              12,872SecuritiesTaxable
              
              
              2,061
              
              
              1,908
              
              
              4,197
              
              
              3,811Exempt
                  from federal income tax
              
              
              56
              
              
              77
              
              
              114
              
              
              160Federal
                  funds sold and other
              
              
              78
              
              
              301
              
              
              161
              
              
              394Total
                  interest income
              
              
              9,141
              
              
              8,655
              
              
              17,892
              
              
              17,237Interest
                  expenseTime
                  deposits
              
              
              2,982
              
              
              2,482
              
              
              5,814
              
              
              4,499Other
                  deposits
              
              
              1,024
              
              
              630
              
              
              2,002
              
              
              1,169Repurchase
                  agreements and federal funds purchased
              
              
              564
              
              
              366
              
              
              1,267
              
              
              681Federal
                  Home Loan Bank advances
              
              
              64
              
              
              64
              
              
              127
              
              
              159Subordinated
                  debentures
              
              
              165
              
              
              0
              
              
              320
              
              
              0Total
                  interest expense
              
              
              4,799
              
              
              3,542
              
              
              9,530
              
              
              6,508Net
                  interest income
              
              
              4,342
              
              
              5,113
              
              
              8,362
              
              
              10,729Provision
                  for loan and lease losses
              
              
              0
              
              
              75
              
              
              0
              
              
              728Net
                  interest income after provision for
                loan
                  and lease losses
              
              
              4,342
              
              
              5,038
              
              
              8,362
              
              
              10,001Noninterest
                  incomeService
                  fees on deposits
              
              
              639
              
              
              602
              
              
              1,224
              
              
              1,156Trust
                  income
              
              
              182
              
              
              190
              
              
              398
              
              
              384Loss
                  on sale of securities available for sale
              
              
              0
              
              
              0
              
              
              0
              
              
              (169
              )Other
                  operating income
              
              
              463
              
              
              319
              
              
              752
              
              
              609Total
                  noninterest income
              
              
              1,284
              
              
              1,111
              
              
              2,374
              
              
              1,980Noninterest
                  expenseSalaries
                  and employee benefits
              
              
              2,223
              
              
              2,222
              
              
              4,479
              
              
              4,472Occupancy
                  and equipment, net
              
              
              558
              
              
              525
              
              
              1,174
              
              
              1,033Data
                  processing
              
              
              416
              
              
              346
              
              
              795
              
              
              722Legal
              
              
              88
              
              
              102
              
              
              190
              
              
              174Audit
                  and other professional
              
              
              325
              
              
              303
              
              
              652
              
              
              616Amortization
                  of core deposit intangible asset
              
              
              115
              
              
              116
              
              
              231
              
              
              232Printing
                  and supplies
              
              
              99
              
              
              75
              
              
              239
              
              
              168Write-down
                  of other real estate owned
              
              
              0
              
              
              1,067
              
              
              0
              
              
              1,067Other
                  operating expenses
              
              
              551
              
              
              601
              
              
              1,050
              
              
              1,227Total
                  noninterest expense
              
              
              4,375
              
              
              5,357
              
              
              8,810
              
              
              9,711Income
                  (loss) before income taxes
              
              
              1,251
              
              
              792
              
              
              1,926
              
              
              2,270Income
                  tax expense (benefit)
              
              
              339
              
              
              205
              
              
              471
              
              
              658Net
                  income
              
              $
              912
              
              $
              587
              
              $
              1,455
              
              $
              1,612Earnings
                  per share
              
              $
              0.21
              
              $
              0.14
              
              $
              0.34
              
              $
              0.38Comprehensive
                  income (loss)
              
              $
              764
              
              $
              1,440
              
              $
              1,490
              
              $
              816The
                  accompanying notes are an integral part of these condensed consolidated
                  financial statements.
 
 4
 *Table
            of Contents*
 
 NORTHERN
        STATES FINANCIAL CORPORATION
 CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS
 Six
        months ended June 30, 2006 and 2005
 (In
        thousands of dollars) (Unaudited)
 
 Six
                  months endedJune
                  30,
              
              June
                  30,2006
              
              2005Cash
                  flows from operating activitiesNet
                  income
              
              $
              1,455
              
              $
              1,612Adjustments
                  to reconcile net income to net cash from
                operating
                  activities:Depreciation
              
              
              294
              
              
              269Loss
                  on sale of securities available for sale
              
              
              0
              
              
              169Loss
                  on sale of other real estate owned
              
              
              22
              
              
              0Provision
                  for loan and lease losses
              
              
              0
              
              
              728Write-down
                  of other reale estate owned
              
              
              0
              
              
              1,067Proceeds
                  from sale of loans
              
              
              0
              
              
              276Loans
                  originated for sale
              
              
              0
              
              
              (276
              )Amortization
                  of other intangible assets
              
              
              231
              
              
              232Net
                  change in accrued interest receivable and other assets
              
              
              (542
              )
              
              (876
              )Net
                  change in accrued interest payable and other liabilities
              
              
              291
              
              
              314Net
                  cash from operating activities
              
              
              1,751
              
              
              3,515Cash
                  flows from investing activitiesProceeds
                  from sales of securities available for sale
              
              
              0
              
              
              6,127Proceeds
                  from maturities and calls of securities available for sale
              
              
              49,720
              
              
              22,555Purchases
                  of securities available for sale
              
              
              (35,344
              )
              
              (28,478
              )Proceeds
                  from the redemption of Federal Home Loan Bank stock
              
              
              439
              
              
              0Change
                  in loans made to customers
              
              
              4,437
              
              
              33,041Proceeds
                  from sales of other real estate owned
              
              
              408
              
              
              0Property
                  and equipment expenditures
              
              
              (252
              )
              
              (344
              )Net
                  cash from investing activities
              
              
              19,408
              
              
              32,901Cash
                  flows from financing activitiesNet
                  increase (decrease) in:Deposits
              
              
              (14,654
              )
              
              18,628Securities
                  sold under repurchase agreements
                and
                  federal funds purchased
              
              
              (15,017
              )
              
              (16,689
              )Advances
                  from borrowers for taxes and insurance
              
              
              61
              
              
              57Federal
                  Home Loan Bank advances
              
              
              0
              
              
              15,000Repayment
                  of Federal Home Loan Bank advances
              
              
              0
              
              
              (15,000
              )Purchase
                  of treasury stock
              
              
              (252
              )
              
              0Dividends
                  paid
              
              
              (1,289
              )
              
              (2,362
              )Net
                  cash from financing activities
              
              
              (31,151
              )
              
              (366
              )Net
                  change in cash and cash equivalents
              
              
              (9,992
              )
              
              36,050Cash
                  and cash equivalents at beginning of period
              
              
              29,668
              
              
              29,299Cash
                  and cash equivalents at end of period
              
              $
              19,676
              
              $
              65,349The
                  accompanying notes are an integral part of these condensed consolidated
                  financial statements.
 
 5
 *Table
            of Contents*
 
 NORTHERN
        STATES FINANCIAL CORPORATION
 CONDENSED
        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 Six
        months ended June 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'
                EquityBalance,
                  December 31, 2004
              
              $
              1,789
              
              $
              11,584
              
              $
              66,102
              
              
              ($1,633
              )
              
              ($4,660
              )
              $
              73,182Net
                  income
              
              
              
              
              
              
              
              
              1,612
              
              
              
              
              
              
              
              
              1,612Cash
                  dividends ($0.55 per share)
              
              
              
              
              
              
              
              
              (2,362
              )
              
              
              
              
              
              
              
              (2,362
              )Unrealized
                  loss on securities
                available
                  for sale, net of deferred tax
              
              
              
              
              
              
              
              
              
              
              
              (796
              )
              
              
              
              
              (796
              )Balance,
                  June 30, 2005
              
              $
              1,789
              
              $
              11,584
              
              $
              65,352
              
              
              ($2,429
              )
              
              ($4,660
              )
              $
              71,636Balance,
                  December 31, 2005
              
              $
              1,789
              
              $
              11,584
              
              $
              65,526
              
              
              ($3,487
              )
              
              ($4,660
              )
              $
              70,752Net
                  income
              
              
              
              
              
              
              
              
              1,455
              
              
              
              
              
              
              
              
              1,455Cash
                  dividends ($0.30 per share)
              
              
              
              
              
              
              
              
              (1,289
              )
              
              
              
              
              
              
              
              (1,289
              )Purchase
                  of 12,000 shares of
                treasury
                  stock ($20.98 per share)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (252
              )
              
              (252
              )Unrealized
                  gain on securities
                available
                  for sale, net of deferred tax
              
              
              
              
              
              
              
              
              
              
              
              35
              
              
              
              
              
              35Balance,
                  June 30, 2006
              
              $
              1,789
              
              $
              11,584
              
              $
              65,692
              
              
              ($3,452
              )
              
              ($4,912
              )
              $
              70,701The
                  accompanying notes are an integral part of these condensed consolidated
                  financial statements.
 
 6
 *Table
            of Contents*
 
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 June
        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 six month periods ended June 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 six months of
        2006
        and the entire year of 2005. The average outstanding common shares used for
        earnings per share follows:
 
 Three
                  months ended
              
              Six
                  months endedJune
                  30,
                2006
              
              June
                  30,
                2005
              
              June
                  30,
                2006
              
              June
                  30,
                2005Average
                  outstanding common shares
              
              
              4,292,204
              
              
              4,295,105
              
              
              4,293,646
              
              
              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 six months ended June 30, 2006,
        12,000 shares of stock were repurchased. At June 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
 *Table
            of Contents*
 
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 June
        30,
        2006
 
 (Unaudited)
 
 
 
 
 
 
 Information
        related to common stock was as follows:
 
 June
                  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, an unconsolidated wholly-owned
        grantor trustee. 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 June 30,
        2006,
        interest expense on the subordinated debentures was $165,000. For the six
        months
        ended June 30, 2006, interest expense on the subordinated debentures was
        $320,000. 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
 *Table
            of Contents*
 **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 June 30, 2006 and the
        consolidated results of operations for the three and six month periods ended
        June 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 June 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 June 30, 2006 declined from year-end levels. Assets totaled $692.4
        million at June 30, 2006, a decrease of $30.1 million or 4.2 percent from
        total
        assets of $722.5 million at December 31, 2005. Securities decreased $14.3
        million and loans and leases declined $6.5 million from year-end 2005. Deposits
        decreased $14.7 million compared to December 31, 2005, while securities sold
        under repurchase agreements declined $23.7 million.
  Earnings
        for the three months ended June 30, 2006 were $912,000 or $.21 per share,
        as
        compared with $.14 per share, or $587,000 for the same quarter of 2005, an
        increase of 55%. The second quarter 2006 earnings improvement compared to
        the
        same quarter of the proceeding year is due in large part to a one time expense
        of $1,067,000 taken during the second quarter of 2005 to write-down other
        real
        estate
  9
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 
 owned
        to
        better reflect the market value of those properties. Earnings during the
        second
        quarter of 2006 were affected unfavorably by a decrease in net interest income
        of $771,000. The decline in net interest income was minimized in this quarter
        by
        the collection of cash basis interest of $307,000 on nonaccrual lease pools
        as
        the result of a settlement entered into during the second quarter 2006 between
        the Company and ACE/Illinois Union, the carrier that had insured a portion
        of
        the lease pools carried by the Company.
  Contributing
        to the increase of second quarter 2006 earnings compared with the same quarter
        of 2005 was that no provision for loan and lease losses was recorded during
        the
        second quarter of 2006, as compared with $75,000 during the second quarter
        of
        2005. Based on management’s analysis of the allowance for loan and lease losses
        at June 30, 2006, management believes that the allowance of $8.6 million
        is
        adequate to cover probable incurred loan and lease losses.
  Noninterest
        income increased $173,000 during the three months ended June 30, 2006 compared
        with the same quarter of 2005. The increase to noninterest income was
        attributable to an increase in service fees on deposits of $37,000 and an
        increase to other operating income of $144,000 due in part to the one time
        receipt of life insurance proceeds of $75,000.
  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 charge-offs less recoveries. 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 June 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 June
        30,
        2006, approximately 82% of the Bank’s loans are secured by real
        estate.
 
 10
 *Table
            of Contents*
  **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 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 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 quarterly
        and 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 June 30, 2006 decreased to $422,000 from $6.0
        million at December 31, 2005. The Company’s federal funds sold position
        decreased as a result of the Company’s deposits decreasing $14.7 million and
        securities sold under repurchase agreements declining $23.7 million from
        year-end 2005.
  Loans
        and
        leases totaled $394.0 million at June 30, 2006, decreasing $6.5 million from
        $400.5 million at December 31, 2005. Although the majority of the Company’s
        loans have variable rates or the rate changes periodically based on index,
        more
        borrowers have recently been requesting fixed rate loans as they perceive
        further interest rate increases during 2006. Loans to the lodging industry
        at
        June 30, 2006 totaled $25.3 million. At June 30, 2006, loans to related parties
        totaled $2.1 million, $600,000 less than at December 31, 2005.
  Loan
        commitments have decreased $10.5 million to $85.8 million at June 30, 2006
        compared with $96.3 million at December 31, 2005 as some borrowers have allowed
        the loan commitments issued to them to lapse. Loan commitments to related
        parties were $1.8 million at June 30, 2006.
  Deposits
        decreased $14.7 million from year-end 2005. Most of the decline in deposits
        was
        in brokered certificates of deposits that decreased $7.9 million from year-end
        and totaled $41.8 million at June 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. Brokered
        certificates of deposit are a source of liquidity that the Company uses from
        time to time. During the first half of 2006, the Company sought to lower
        its
        reliance on brokered deposits to decrease its interest expense. Commercial
        demand deposits decreased $3.5 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. Finally, certificates of deposits from
        public entities decreased $2.2 million from year-end. This decrease in public
        deposits frequently occurs at mid-year as the local real estate tax installments
        are due in June and September. Until the taxes are received and invested
        by the
        public entities, the public deposit balances decrease as the funds are used
        by
        the public entities for operating purposes.
  11
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 Securities
        sold under repurchase agreements decreased by $23.7 million to $49.4 million
        at
        June 30, 2006 from $73.1 million at December 31, 2005. The decline was the
        result of a commercial customer who had liquidated his businesses at year-end
        and had temporarily placed $20.0 million of the sales proceeds in securities
        sold under repurchase agreements until they matured in the second quarter
        of
        2006. As a result of the decline in repurchase agreements, the Company had
        federal funds purchased, a short-term borrowing, of $8.7 million at June
        30,
        2006 compared with no federal funds purchased at year-end 2005.
  As
        previously disclosed, included in other liabilities at June 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 $70.7 million at June 30, 2006, unchanged from year-end
        2005. During the six months ended June 30, 2006 there were increases to
        stockholder’s equity from net income of $1,455,000 and from a $35,000 adjustment
        for the unrealized gain on securities available for sale, net of deferred
        tax.
        Stockholders’ equity was decreased during the first half 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 $1,289,000.
        The book value of the Company’s stock at June 30, 2006 was $16.51 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 10.59% and 16.30%,
        respectively, as of June 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
        June
        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 achieved 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 $117.7 million at June 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 June
        30,
        2006, this ratio was 25.7% and was within management’s internal policy
        guidelines.
  12
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 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 show that for the six months ended
        June
        30, 2006 that cash and cash equivalents declined $10.0 million to $19.7
        million.
  Federal
        funds sold, interest bearing deposits in banks and available for sale
        securities, particularly those of shorter maturities, are principal sources
        of
        liquidity. Federal funds sold at June 30, 2006 were $422,000, 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 sell any of its unpledged securities to meet liquidity requirements.
        Securities available for sale totaled $250.7 million at June 30, 2006 of
        which
        $148.3 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. The decrease in pledged securities at June 30,
        2006
        compared with December 31, 2005 helped to increase the Company’s
        liquidity.
  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 June 30, 2006, the Company has $175.9 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 half of 2006, the Company had incoming cash flows from maturities
        and
        calls of securities available for sale of $49.7 million while it had cash
        outflows for purchases of securities of $35.3 million. These securities
        activities during the first half of 2006 provided liquidity of $14.4 million
        that was used to meet a part of the decreases in deposits of $14.7 million
        and
        the decline in repurchase agreements of $23.7 million.
  Affecting
        liquidity seasonally are public certificates of deposits that decreased $2.2
        million from year-end. This decrease to public deposits frequently occurs
        at
        mid-year as the local real estate tax installments are due in June and
        September. The public entities will draw down their balances at mid-year
        until
        the taxes are received and invested by the public entities after which the
        public deposit balances will then increase.
  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 has arrangements that allow it to purchase $25.0 million in federal
        funds from an independent bank of which $8.7 million had been purchased at
        June
        30, 2006.
  RESULTS
        OF OPERATIONS
  NET
        INCOME
  Consolidated
        net income for the quarter ended June 30, 2006 was $912,000, increasing $325,000
        compared with net income of $587,000 for the same quarter of 2005. The
        annualized return on average assets was .53% for the quarter, increasing
        from
        .31% for the same quarter the previous year. The increase to net income for
        the
        quarter is primarily the result a one-time write down of $1,067,000 to other
        real estate owned during the second quarter of 2005. For the six months ended
        June 30, 2006, net income was $1,455,000 as compared with $1,612,000 for
        the
        first half of 2005. The annualized return on average assets for the first
        six
        months of 2006 was .41%, decreasing from .43% for the same period of
        2005.
  13
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 NET
        INTEREST INCOME
  Net
        interest income, the difference between interest income on earning assets
        and
        interest expense on interest bearing liabilities, decreased $771,000 to $4.3
        million during the three months ended June 30, 2006 compared with $5.1 million
        for the same quarter of 2005. The major reason for the decline in the net
        interest income is that as interest rates have increased the rates paid on
        deposits and borrowings have risen more quickly than rates earned on the
        Company’s loans and securities. Minimizing the decrease to net interest income
        during the quarter ended June 30, 2006 was the one time collection of $307,000
        of interest paid on nonaccrual lease pools through a settlement entered into
        during the second quarter of 2006 between the Company and ACE/Illinois Union,
        who had insured a portion of the lease pools.
  Net
        interest income during the second quarter of 2006 was affected by the increasing
        levels of interest rates as indicated by the increased prime lending rate.
        In
        the second quarter of 2006 the prime lending rate increased from 7.75% to
        8.25%
        at June 30, 2006. Average yields on interest earning assets increased 67
        basis
        points during the quarter ended June 30, 2006 as compared with the same quarter
        of 2005. Average rates paid on interest bearing liabilities increased to
        a
        greater extent than the yields on interest earning assets and increased by
        114
        basis points during the second quarter of 2006 compared with the same quarter
        last year. This caused the net interest margin to decline to 2.15% for the
        quarter as compared with 2.62% for the same quarter the previous year. The
        decline in the net interest margin was partially because a lesser amount
        of rate
        sensitive assets repriced at the higher interest rates during the second
        quarter
        of 2006 than rate sensitive liabilities.
  Average
        yields on loans increased 98 basis points to 7.14% during the second quarter
        of
        2006 as compared with 6.16% for the same quarter of 2005. Loans, generally,
        earn
        higher interest rates than other interest earning assets of the Company.
        Average
        loans were $24.3 million lower during the second quarter of 2006 compared
        with
        the same quarter of 2005 due to loan payoffs and a decline in loan demand
        and
        contributed to the decline of net interest income. Another factor affecting
        yields earned on loans was the level of nonaccrual loans, which totaled $15.4
        million at June 30, 2006 compared with $14.6 million at June 30,
        2005.
  The
        average yield earned on the Company’s taxable securities during the three months
        ended June 30, 2006 was 3.29% as compared with 3.18% during the same period
        of
        2005, an increase of only 11 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 June 30, 2006, the Company has
        $175.9 million in securities issued by government-sponsored entities having
        an
        average yield of 3.07% that will mature in 2007.
  The
        average rates paid on interest bearing liabilities increased 114 basis points
        during the second quarter of 2006 to 3.47% as compared with 2.33% during
        the
        same quarter of 2005. Interest expense on time deposits during the second
        quarter of 2006 was $500,000 greater than it was during the second quarter
        of
        2005. Interest expense for other borrowings, which include the Federal Home
        Loan
        term advance, securities sold under repurchase agreements, federal funds
        purchased and the subordinated debentures increased by $363,000 during the
        three
        months ended June 30, 2006 compared with the same period of 2005.
  The
        Company has taken steps to increase its net interest income 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 money market and certificate of deposits are
        10 to
        25 basis points less than on higher balanced accounts. As lower balance
        certificates mature, they will renew at the slightly lower rates. The Company
        does not believe that the lower rates offered on the lower balanced time
        deposits will materially affect time deposit balance totals. The Company
        has
        also lowered the amount of brokered deposits that are paid higher interest
        rates
        by $7.9 million since December 31, 2005.
 
 14
 *Table
            of Contents*
 **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 June 30, 2006 and 2005 - Rates are Annualized
 ($
        000s)
 
 2006
              
              
              
              
              
              2005Average
                Balance
              
              Interest
              
              Rate
              
              Average
                Balance
              
              Interest
              
              RateAssetsLoans
                  (1)(2)(3)
              
              $
              390,179
              
              $
              6,960
              
              
              7.14
              %
              $
              414,487
              
              $
              6,386
              
              
              6.16
              %Taxable
                  securities (4)
              
              
              245,377
              
              
              2,061
              
              
              3.29
              %
              
              235,330
              
              
              1,908
              
              
              3.18
              %Tax
                  advantaged securities (2) (4)
              
              
              6,247
              
              
              87
              
              
              5.54
              %
              
              9,396
              
              
              116
              
              
              4.93
              %Federal
                  funds sold
              
              
              6,699
              
              
              78
              
              
              4.66
              %
              
              40,341
              
              
              301
              
              
              2.98
              %Interest
                  earning assets
              
              
              648,502
              
              
              9,186
              
              
              5.62
              %
              
              699,554
              
              
              8,711
              
              
              4.95
              %Noninterest
                  earning assets
              
              
              42,805
              
              
              
              
              
              
              
              
              50,233Average
                  assets
              
              $
              691,307
              
              
              
              
              
              
              
              $
              749,787Liabilities
                  and stockholders' equityNOW
                  deposits
              
              $
              54,216
              
              $
              127
              
              
              .94
              %
              $
              57,058
              
              $
              126
              
              
              0.88
              %Money
                  market deposits
              
              
              73,977
              
              
              705
              
              
              3.81
              %
              
              60,609
              
              
              280
              
              
              1.85
              %Savings
                  deposits
              
              
              77,824
              
              
              192
              
              
              .99
              %
              
              84,976
              
              
              224
              
              
              1.05
              %Time
                  deposits
              
              
              279,734
              
              
              2,982
              
              
              4.26
              %
              
              341,749
              
              
              2,482
              
              
              2.91
              %Other
                  borrowings
              
              
              67,399
              
              
              793
              
              
              4.71
              %
              
              63,761
              
              
              430
              
              
              2.70
              %Interest
                  bearing liabilities
              
              
              553,150
              
              
              4,799
              
              
              3.47
              %
              
              608,153
              
              
              3,542
              
              
              2.33
              %Demand
                  deposits
              
              
              59,421
              
              
              
              
              
              
              
              
              62,041Other
                  noninterest bearing liabilities
              
              
              7,550
              
              
              
              
              
              
              
              
              7,612Stockholders'
                  equity
              
              
              71,186
              
              
              
              
              
              
              
              
              71,981Average
                  liabilities and
                stockholders'
                  equity
              
              $
              691,307
              
              
              
              
              
              
              
              $
              749,787Net
                  interest income
              
              
              
              
              $
              4,387
              
              
              
              
              
              
              
              $
              5,169Net
                  interest margin
              
              
              
              
              
              
              
              
              2.15
              %
              
              
              
              
              
              
              
              2.62
              %Net
                  yield on interest earning assets (4)
              
              
              
              
              
              
              
              
              2.68
              %
              
              
              
              
              
              
              
              2.94
              %Interest-bearing
                  liabilities
                to
                  earning assets ratio
              
              
              
              
              
              
              
              
              85.30
              %
              
              
              
              
              
              
              
              86.93
              %
 
 (1)
        -
        Interest income on loans includes loan origination and other fees of $173
        and
        $151 for the three months ended June 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 June 30, 2006 and 2005 average balance information
        includes an average unrealized gain (loss) for taxable securities of ($5,399)
        and ($4,622) and for tax-advantaged securities of ($36) and ($13).
  15
 *Table
            of Contents*
 **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
        Six Months Ended June 30, 2006 and 2005 - Rates are Annualized
 ($
        000s)
  
 2006
              
              
              
              
              
              2005Average
                Balance
              
              Interest
              
              Rate
              
              Average
                Balance
              
              Interest
              
              RateAssetsLoans
                  (1)(2)(3)
              
              $
              393,728
              
              $
              13,450
              
              
              6.83
              %
              $
              425,338
              
              $
              12,907
              
              
              6.07
              %Taxable
                  securities (4)
              
              
              250,786
              
              
              4,197
              
              
              3.28
              %
              
              236,758
              
              
              3,811
              
              
              3.17
              %Tax
                  advantaged securities (2) (4)
              
              
              6,376
              
              
              174
              
              
              5.44
              %
              
              9,722
              
              
              242
              
              
              4.98
              %Federal
                  funds sold
              
              
              6,776
              
              
              161
              
              
              4.75
              %
              
              27,673
              
              
              394
              
              
              2.85
              %Interest
                  earning assets
              
              
              657,666
              
              
              17,982
              
              
              5.42
              %
              
              699,491
              
              
              17,354
              
              
              4.93
              %Noninterest
                  earning assets
              
              
              44,982
              
              
              
              
              
              
              
              
              48,707Average
                  assets
              
              $
              702,648
              
              
              
              
              
              
              
              $
              748,198Liabilities
                  and stockholders' equityNOW
                  deposits
              
              $
              53,966
              
              $
              273
              
              
              1.01
              %
              $
              60,307
              
              $
              242
              
              
              0.80
              %Money
                  market deposits
              
              
              72,725
              
              
              1,314
              
              
              3.61
              %
              
              62,110
              
              
              518
              
              
              1.67
              %Savings
                  deposits
              
              
              77,604
              
              
              415
              
              
              1.07
              %
              
              83,983
              
              
              409
              
              
              0.97
              %Time
                  deposits
              
              
              283,158
              
              
              5,814
              
              
              4.11
              %
              
              333,783
              
              
              4,499
              
              
              2.70
              %Other
                  borrowings
              
              
              77,613
              
              
              1,714
              
              
              4.42
              %
              
              66,428
              
              
              840
              
              
              2.53
              %Interest
                  bearing liabilities
              
              
              565,066
              
              
              9,530
              
              
              3.37
              %
              
              606,611
              
              
              6,508
              
              
              2.15
              %Demand
                  deposits
              
              
              58,917
              
              
              
              
              
              
              
              
              62,080Other
                  noninterest bearing liabilities
              
              
              7,563
              
              
              
              
              
              
              
              
              6,736Stockholders'
                  equity
              
              
              71,102
              
              
              
              
              
              
              
              
              72,771Average
                  liabilities and
                stockholders'
                  equity
              
              $
              702,648
              
              
              
              
              
              
              
              $
              748,198Net
                  interest income
              
              
              
              
              $
              8,452
              
              
              
              
              
              
              
              $
              10,846Net
                  interest margin
              
              
              
              
              
              
              
              
              2.05
              %
              
              
              
              
              
              
              
              2.78
              %Net
                  yield on interest earning assets (4)
              
              
              
              
              
              
              
              
              2.55
              %
              
              
              
              
              
              
              
              3.08
              %Interest-bearing
                  liabilities
                to
                  earning assets ratio
              
              
              
              
              
              
              
              
              85.92
              %
              
              
              
              
              
              
              
              86.72
              %
 
 (1)
        -  Interest
        income on loans includes loan origination and other fees of $234 and $250
        for
        the six months ended June 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 six months ended June 30, 2006 and 2005 average balance information includes
        an average unrealized gain (loss) for taxable securities of ($5,420) and
        ($3,918) and for tax-advantaged securities of ($23) and $11.
  16
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 Table
        2
        shows that during the six months ended June 30, 2006 net interest income
        on a
        fully tax equivalent basis declined $2.4 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 67 basis points during the six months ended June 30, 2006 as compared
        with the same six months last year while average rates paid on interest bearing
        liabilities increased by 114 basis points, causing the net margin to compress.
        Also affecting net interest income during the six months ended June 30, 2006
        was
        the decline in interest earning assets of $41.8 million compared with the
        same
        period last year.
  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 June 30, 2006, compared
        with
        $75,000 for the same period of 2005. For the six months ended June 30, 2006,
        no
        provision for loan and lease losses was made as compared with $728,000 during
        the first half of 2005.
  At
        June
        30, 2006, the allowance for loan and lease losses was $8.6 million, decreasing
        $2.0 million from year-end 2005. During the first half of 2006, $2,007,000
        in
        loans were charged off against the allowance compared with $598,000 during
        the
        same period last year. The Company charged off a $2.0 million loan during
        the
        second quarter of 2006 relating to an entertainment center where the principal
        gaurantors declared bankruptcy. There was $6,000 in recoveries of loans
        previously charged off during the six months ended June 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 $5.6 million to $16.3 million at June 30, 2006 from $21.9
        million at December 31, 2005, a reduction of 25.6%. Nonperforming loans as
        a
        percentage of total loans and leases were 4.14% at June 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 June 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 June 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 June 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, 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.
  17
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 The
        Company, as previously mentioned above, has charged-off $2.0 million of a
        nonaccrual loan on an entertainment center leaving a remaining balance of
        $1.6
        million. The remaining balance of this loan is carried as a nonaccrual loan
        and
        is secured by leasehold improvements and equipment that are in the process
        of
        being sold.
  Also
        on
        nonaccrual status are loans on two motels totaling $3.5 million in which
        the
        borrower has had deterioration to its financial condition. The Company has
        taken
        steps to foreclose on these motels. Also on nonaccrual status are loans totaling
        $1.8 million 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.
  Impaired
        loans and leases at June 30, 2006 totaled $25.9 million , decreasing $6.5
        million or 19.3% 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. Nonaccrual loans and leases are
        included as impaired. 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.
  Included
        as impaired loans at June 30, 2006 were $10.4 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. The amount of the allowance for loan and
        lease
        losses specifically allocated for impaired loans and leases was $5.5 million
        at
        June 30, 2006 compared with $7.6 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 June 30, 2006,
        other real estate owned totaled $4.1 million, decreasing $325,000 from December
        31, 2005 as a property carried at that amount was sold during the second
        quarter
        2006. Also during the second quarter 2006, two other properties securing
        loans
        were transferred to other real estate owned totaling $105,000 that were also
        sold during the quarter. The Company recognized a net loss of $22,000 on
        the
        sales of other real estate owned during the quarter. 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 June 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 end use of the property
        is
        mixed use 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
 *Table
            of Contents*
 **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 June 30, 2006 was $1.3 million compared
        to
        $1.1 million for the three months ended June 30, 2005, an increase of $173,000.
        Service fees on deposits increased $37,000 and other operating income increased
        $144,000. Other operating income growth was due in part to the one time receipt
        of life insurance proceeds of $75,000 and one time recognition of $69,000
        for
        check printing fees.
  For
        the
        six months ended June 30, 2006, noninterest income was $2.4 million, an increase
        of $394,000 from the same time period last year. Contributing to the increase
        was a loss the Company recognized last year, during the first quarter of
        2005,
        of $169,000 on the sale of securities available for sale that had been carried
        at $6.3 million prior to the sale. There were no sales of securities available
        for sale during the first half of 2006.
  NONINTEREST
        EXPENSE
  Noninterest
        expense for the quarter ended June 30, 2006 was $4,375,000, decreasing $982,000
        from the same quarter last year. The decrease was due to a one time write-down,
        totaling $1,067,000, of other real estate that occurred last year, during
        the
        second quarter of 2005, of other real estate owned to better reflect the
        market
        value of those properties.
  The
        Company’s efficiency ratio, noninterest expense divided by the sum of net
        interest income and noninterest income, was 77.8% for the second quarter
        of 2006
        as compared with 86.1% for the same quarter of 2005. The lower ratio for
        the
        second quarter of 2006 was reflects the decreased noninterest expenses in
        the
        second quarter of 2006 compared to the same time period last year.
  For
        the
        six months ended June 30, 2006, noninterest expense was $8.8 million, decreasing
        $901,000 from $9.7 million for the same period last year. Noninterest expense
        declined during the first half of 2006 primarily due to the $1,067,000
        write-down of other real estate owned last year, in the first half of 2005.
        If
        the one time write-down of other real estate owned is not considered,
        noninterest expenses increased only $85,000, less than 2%, during the first
        half
        of 2006 compared with the same period of 2005.
  FEDERAL
        AND STATE INCOME TAXES
  For
        the
        three months ended June 30, 2006, the Company’s income tax expense was $339,000
        compared with $205,000 for the same three months last year. As a percentage
        of
        pre-tax income, tax expense was 27.1% for the three months ended June 30,
        2006
        and 25.9% for the same period of 2005. As a percentage of pre-tax income,
        tax
        expense was 24.5% for the six months ended June 30, 2006 and 29.0% for the
        same
        period of 2005. Interest income on U.S. Treasury and U.S. government-sponsored
        entity securities not subject to state income tax was $1.9 million for the
        three
        months ended June 30, 2006 and $4.0 million for the six months ended June
        30,
        2006 which contributed to the lower tax rates for those time
        periods.
  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 June 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.
  19
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 **MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL**
 **CONDITION
        AND RESULTS OF OPERATIONS**
 
 TABLE
        3
 
 NORTHERN
        STATE FINANCIAL CORPORATION
 CONTRACTUAL
        OBLIGATIONS
 As
        of
        June 30, 2006
 ($
        000s)
 
 Contractual
                  obligations
              
              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.
              
              TotalLong-term
                  debtFederal
                  Home Loan Bank advance
              
              $
              0
              
              $
              6,500
              
              $
              0
              
              $
              0
              
              $
              6,500Subordinated
                  debentures
              
              
              0
              
              
              0
              
              
              0
              
              
              10,000
              
              
              10,000Time
                  deposits
              
              
              200,903
              
              
              68,127
              
              
              10,647
              
              
              0
              
              
              279,677Other
                  contractual obligationsStandby
                  letters of credit
              
              
              6,929
              
              
              0
              
              
              0
              
              
              0
              
              
              6,929Community
                  Reinvestment Act
                Investment
                  commitment
              
              
              118
              
              
              524
              
              
              0
              
              
              0
              
              
              642
 
 
 
 REGULATORY
        ISSUES
  As
        previously disclosed, following a joint examination by the Federal Deposit
        Insurance Corporation (“FDIC”) and the Illinois Department of Financial and
        Professional Regulation (“IDFPR”) the Board of Directors of the Bank approved
        and signed on May 17, 2005, a memorandum of understanding (“MOU”) in connection
        with certain deficiencies identified during the regulators’ examination of the
        Bank.
  The
        Bank’s Board of Directors received notification on May 30, 2006 from the Federal
        Deposit Insurance Corporation that the memorandum of understanding had been
        terminated on April 18, 2006.
  20
 *Table
            of Contents*
 **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 “shock” to net interest income of an assumed instantaneous decrease
        and increase in rates of 1% and 2% using computer simulation to show the
        effect
        of rate changes on the 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 in place sources of cash
        to
        meet short-term demands. These funds can 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
        June
        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 June 30, 2006, with prime rate
        estimated as rising from 8.25% during the third quarter of 2006 to 9.00%
        during
        the second quarter 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
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 
 
 
 **QUANTITATIVE
        AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**
  At
        June
        30, 2006 the projected net interest income increases $566,000 when rates
        are
        shocked downward 2% while projected net interest income decreases $1,484,000
        for
        a 2% upward rate shock. Projected net interest income increases when rates
        are
        shocked downward 2% as there more 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
        June 30, 2006 and December 31, 2005
 ($000s)
 
 Immediate
                  Change in Rates-2.00%
              
              -1.00%
              
              +1.00%
              
              +2.00%June
                  30, 2006:Dollar
                  Change from Base Forecast
              
              $
              566
              
              $
              316
              
              
              ($700
              )
              
              ($1,484
              )Percent
                  Change from Base Forecast
              
              
              2.61
              %
              
              1.45
              %
              
              -3.22
              %
              
              -6.83
              %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
 *Table
            of Contents*
 **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 six months ended June 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 litigations 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 June 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
 *Table
            of Contents*
 **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**
  The
        following table sets forth information in connection with purchases made
        by, or
        on behalf of, the Company of shares of the Company’s common stock during the
        quarterly period ended June 30, 2006.
  
 **Period**
              
              **Total
                  Number**
                **of
                  Shares**
                **Purchased**
              
              **Average**
                **Price
                  Paid**
                **per
                  Share**
              
              **Total
                  Number**
                **of
                  Shares Purchased**
                **as
                  Part of Publicly**
                **Announced
                  Plans**
              
              **Maximum
                  Number**
                **of
                  Shares that May**
                **Yet
                  be Purchased**
                **under
                  the Plans**April
                  1, 2006
                Through
                April
                  30, 2006
              
              
              0
              
              $
              0.00
              
              
              0
              
              
              222,850May
                  1, 2006
                Through
                May
                  31, 2006
              
              
              0
              
              
              0.00
              
              
              0
              
              
              222,850June
                  1, 2006
                Through
                June
                  30, 2006
              
              
              12,000
              
              
              20.98
              
              
              12,000
              
              
              210,850**Total**
              
              
              12,000
              
              $
              20.98
              
              
              12,000
              
              
              210,850
 
 
 
 **ITEM
        3. DEFAULTS UPON SENIOR
        SECURITIES**
  None
  24
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
  **ITEM
        4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
        HOLDERS**
  The
        annual meeting of stockholders of Northern States Financial Corporation was
        held
        on May 18, 2006 with the stockholders of record at April 3, 2006 voting in
        person or by proxy, with one vote for each share owned, to elect directors
        for a
        one year term each and to ratify Plante & Moran, PLLC as independent
        auditors of the Company for the year ending December 31, 2006. There were
        4,295,105 shares of stock as of April 3, 2006 that could be voted. Plante
&
Moran, PLLC was ratified as the Company’s independent auditors for the year
        ending December 31, 2006 by a vote of 3,685,615 for ratification, 11,123
        against, and 4,565 abstaining. The following directors were duly
        elected:
 
 Authority
                Granted
              
              Authority
                WithheldFred
                  Abdula
              
              
              3,628,023
              
              
              46,280Kenneth
                  W. Balza
              
              
              3,628,873
              
              
              45,930Theodore
                  A. Bertrand
              
              
              3,614,323
              
              
              59,980Jack
                  H. Blumberg
              
              
              3,590,116
              
              
              84,187Frank
                  Furlan
              
              
              3,628,323
              
              
              45,980Harry
                  S. Gaples
              
              
              3,622,008
              
              
              52,295James
                  A. Hollesteiner
              
              
              3,556,730
              
              
              117,573Allan
                  J. Jacobs
              
              
              3,606,543
              
              
              67,760Raymond
                  M. Mota
              
              
              3,630,911
              
              
              43,392Helen
                  Rumsa
              
              
              3,603,043
              
              
              71,260
 
 **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.
  25
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 **FORM
        10-Q**
 **June
        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 August
        2006.
  **NORTHERN
                    STATES FINANCIAL CORPORATION**
                  (Registrant)Date:     
                  August 7, 2006
                By:
                /s/
                  Fred Abdula
 Fred Abdula
 Chairman of the Board of
                    Directors
                      and President
  Date:     
                        August 7, 2006
                      By:
                      /s/
                        Thomas M. Nemeth
 Thomas M.
                        Nemeth
 Vice President and
                              Treasurer
 26
 *Table
            of Contents*
 **NORTHERN
        STATES FINANCIAL CORPORATION**
 **FORM
        10-Q**
 **June
        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.
  27