** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-K**

**(Mark One)**

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

**Forthe fiscal year ended December 31, 2006**

**or**

**o  TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the transition period from               to               **

**Commissionfile number:  0-5127**

**MERCANTILE BANKSHARES CORPORATION**

(Exact name ofregistrant as specified in its charter)

| **Maryland**                     |   | **52-0898572**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

**TwoHopkins Plaza**

**Baltimore, Maryland 21201**

(Address of principalexecutive offices) (Zip Code)

**(410) 237-5900**

(Registrant’s telephonenumber, including area code)

Securities registered pursuant to Section 12(b) of theAct:

| **Title of each class**                |   | **Name of  each exchange on which registered** |
|----------------------------------------|--------|------------------------------------------------|
| Common Stock ($2  par value per share) |   | The Nasdaq Stock  Market, Inc.                 |
| Stock Purchase  Rights                 |   |                                           |

 

Securitiesregistered pursuant to Section 12(g) of the Act:

**None**

(Title of class)

Indicate by check markif the registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.

Yes  x    No  o

Indicate by check markif the registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.

Yes  o    No  x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  x    No  o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. [X ]

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

Large accelerated filer  x      Acceleratedfiler  o     Non-acceleratedfiler  o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o    No  x

AtJune 30, 2006, the last business day of registrant’s most recently completedsecond fiscal quarter, the aggregate market value of shares of common stockheld by non-affiliates of registrant (1) (including fiduciary accountsadministered by affiliates) wasapproximately $4.3 billion based on the last sale price on the Nasdaq NationalMarket on June 30, 2006.

As of February 16, 2007, there were 125,730,716shares of common stock outstanding.

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(1)Excludes 2,119,115 shares of common stock held by directors, executiveofficers, and shares held in fiduciary accounts by the Registrant andsubsidiaries of the registrant with discretionary power to vote or dispose ofsuch shares as of June 30, 2006.  Exclusion of shares held by any personshould not be construed to indicate that such person possesses the power,direct or indirect, to direct or cause the direction of the management orpolicies of the registrant, or that such person is controlled by or undercommon control with the registrant.

 

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**2006ANNUAL REPORT ON FORM 10-K**

**TABLE OF CONTENTS**
| PART I     |
|------------|
|       |
| Item  1.   |   | Business |   |   |
| Item  1A.  |   | Risk  Factors |   |   |
| Item 1B.   |   | Unresolved  Staff Comments |   |   |
| Item  2.   |   | Properties |   |   |
| Item 3.    |   | Legal Proceedings |   |   |
| Item 4.    |   | Submission  of Matters to a Vote of Security Holders |   |   |
|       |   |   |   |   |
| PART II    |
|       |
| Item 5.    |   | Market for  the Registrant’s Common Stock, Related Stockholder Matters |   |   |
|       |   | and Issuer  Purchases of Equity Securities |   |   |
| Item 6.    |   | Selected Financial  Data |   |   |
| Item 7.    |   | Management’s  Discussion and Analysis of Financial Condition and |   |   |
|       |   | Results of  Operations |   |   |
| Item 7A.   |   | Quantitative  and Qualitative Disclosures About Market Risk |   |   |
| Item 8.    |   | Financial  Statements and Supplementary Data |   |   |
| Item 9.    |   | Changes in  and Disagreements with Accountants on Accounting and |   |   |
|       |   | Financial  Disclosure |   |   |
| Item 9A.   |   | Controls and  Procedures |   |   |
| Item 9B.   |   | Other Information |   |   |
|       |   |   |   |   |
| PART III   |
|       |
| Item 10.   |   | Directors,  Executive Officers and Corporate Governance |   |   |
| Item 11.   |   | Executive  Compensation |   |   |
| Item 12.   |   | Security  Ownership of Certain Beneficial Owners and Management |   |   |
|       |   | and Related  Stockholder Matters |   |   |
| Item 13.   |   | Certain  Relationships and Related Transactions, and Director Independence |   |   |
| Item 14.   |   | Principal  Accounting Fees and Services |   |   |
|       |   |   |   |   |
| PART IV    |
|       |
| Item 15.   |   | Exhibits and  Financial Statement Schedules |   |   |
|       |   |   |   |   |
| Signatures |   |   |   |   |

 

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**PART I**

**ITEM 1. BUSINESS.**

**General**

Mercantile Bankshares Corporation, with $17.7billion in assets at year-end December 31, 2006, is a regional multibankholding company with headquarters in Baltimore, Maryland.  It is comprised of 11 banks (the “Banks”) anda mortgage banking company.  Eight banksare headquartered in Maryland, two are in Virginia and one is in Delaware.  At December 31, 2006, Bankshares’ largestbank, Mercantile-Safe Deposit and Trust Company (“MSD&T”), representedapproximately 46% of total assets and operated 36 offices in Maryland, 21 inVirginia, 2 in Washington, D.C. and one in Pennsylvania.  MSD&T provides nearly all of Bankshares’substantial wealth management operations and specialized corporate bankingservices.  Mercantile BanksharesCorporation was incorporated under the laws of Maryland on May 27, 1969.  Mercantile Bankshares Corporation along withits consolidated subsidiaries is referred to in this report as “Bankshares,” “we”or “Registrant.”

OnOctober 8, 2006, Bankshares entered into an Agreement and Plan of Merger withThe PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshareswill merge with and into PNC, with PNC as the surviving corporation in themerger.  When the merger is completed,Bankshares’ stockholders will receive a combination of PNC common stock andcash in exchange for their Bankshares common stock.  Each share of Bankshares common stock will beconverted into the right to receive 0.4184 of a share of PNC common stock(including the related preferred stock purchase rights under PNC’s May 2000Rights Agreement) and $16.45 in cash, without interest.  Under the formula set forth in the mergeragreement, an aggregate of up to approximately 54.2 million shares of PNCcommon stock (and an equal number of related rights) may be issued and $2.13billion paid in the merger.  This mergerwas approved by Bankshares’ stockholders on February 27, 2007 and received substantiallyall of the required regulatory approvals. The merger is currently expected to close in March of 2007.  Pending the merger, Bankshares must complywith the covenants contained in the merger agreement, but is generallycontinuing to operate in the ordinary course of business.

Banksharesemphasizes long-term customer relationships founded on value-added service andfocuses on those traditional services it performs well.  This emphasis on relationship banking makesmoderate-sized and family-owned businesses a particularly important market forBankshares’ affiliate banks. Relationship-oriented banking is carried out through all our communitybanks, each of which has its own name, management, board of directors andhistorical ties to the families, businesses and institutions that make up itscommunity.  At the same time, communitybanks, through their association with Bankshares, are able to offer the moresophisticated services and financial strength of a major banking organization,as well as the conveniences of online banking and a large network of bankingoffices and ATMs.

Asa matter of policy, Bankshares’ affiliates lend almost exclusively within theirmarket areas.  Primary corporate objectives are to maintain capitalstrength, to achieve superior profitability and strong asset quality and toavoid undue risk. We believe that growth is a by-product of meeting theseobjectives.

On July 17, 2006, Bankshares completed itsacquisition of James Monroe Bancorp, Inc. (“James Monroe”), a bankheadquartered in Arlington, Virginia. Subsequent to its acquisition, James Monroe was merged intoMSD&T.  James Monroe operated sixfull-service branches and one loan production office in Northern Virginia andsuburban Washington, D.C. at the time of the acquisition.  The total consideration paid to James Monroeshareholders in connection with the acquisition was $71.4 million in cash and1.8 million shares of Bankshares’ common stock. The results of James Monroe’s operations have been included inBankshares’ results subsequent to July 17, 2006.  The assets and liabilities of James Monroewere recorded on the consolidated balance sheet at their respective fairvalues.  The transaction resulted in anincrease in total assets of $552 million, including $414 million in grossloans, and liabilities assumed of $507 million, including $434 million of totaldeposits.

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**Affiliate Bank Network**

Bankshares directly owns all of the outstandingstock of the Banks and directly or indirectly owns all of the outstanding stockof certain other affiliates.  Theprincipal components of our banking and nonbanking network are listed below.

*Lead Bank and Affiliates*

Mercantile-Safe Deposit andTrust Company

Mercantile Mortgage Corporation(“MMC”)

Mercantile Mortgage, LLC (49.9%owned by MMC)

West River LLC

HarborPoint Capital, GP LLC

HarborPoint Capital LP (74%owned by MMC)

Mercantile Brokerage ServicesHoldings, LLC

Mercantile Brokerage Services,Inc.

Mercantile Capital Advisors, Inc.

Mercantile/Cleveland, LLC

Boyd Watterson AssetManagement, LLC

MBC Agency, Inc.

Mercantile Life InsuranceCompany

Mercantile Real EstateAdvisors, Inc.

*Community Banks*
|   | The Annapolis Banking and  Trust Company  |   | Annapolis, Maryland       |
|--------|-------------------------------------------|--------|---------------------------|
|   | The Citizens  National Bank               |   | Laurel, Maryland          |
|   | Farmers &  Mechanics Bank             |   | Frederick, Maryland       |
|   | Keller  Stonebraker Insurance, Inc.       |   | Hagerstown, Maryland      |
|   | Potomac Basin  Group Associates, Inc.     |   | Beltsville, Maryland      |
|   | Marshall  National Bank and Trust Company |   | Marshall, Virginia        |
|   | Mercantile  County Bank                   |   | Elkton, Maryland          |
|   | Mercantile  Eastern Shore Bank            |   | Chestertown, Maryland     |
|   | Mercantile  Peninsula Bank                |   | Selbyville, Delaware      |
|   | Mercantile  Southern Maryland Bank        |   | Leonardtown, Maryland     |
|   | The National  Bank of Fredericksburg      |   | Fredericksburg,  Virginia |
|   | Westminster  Union Bank                   |   | Westminster, Maryland     |

 

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For purposes of segment reporting, two operatingcomponents have been identified:  BankingServices and Investment & Wealth Management.  For segment reporting information, see NoteNo. 16 - Segment Reporting in the Notes to the Consolidated Financial Statementsin Item 8 of this Annual Report.  Also,see information under the heading “Segment Reporting” in the sections captioned“Analysis of Operating Results for 2006 to 2005” and “Review of Earnings andBalance Sheet for 2005 to 2004,” in Item 7 of this Annual Report.

**Banking Services**

***Retail Banking***

The Banks offer numerous services to meet thechecking, savings, invest­ment and credit needs of individuals in theircommunities.  Retail banking servicesinclude checking, savings and money market accounts, Individual RetirementAccounts and time deposits.  The Banksoffer home equity loans and lines of credit, installment loans and lines ofcredit, and equipment and transportation (auto, marine, recreational vehicles,aircraft) loans to meet a variety of borrowing needs.

Through the affiliate bank network, customers haveno-fee access to their accounts at 255 Mercantile BANKING TWENTY-FOURSM ATMs, and they can perform many routinetransactions at any of the 240 affiliate-banking offices.  For added convenience, substantially all ofBankshares’ affiliates provide customers with toll-free telephone access to acentralized Customer Service Center and a voice-response account informationsystem.  BANKINGTWENTY-FOUR ONLINE® enables customers to access their personalaccounts online to pay bills, verify account balances, track recent accountactivity and perform selected transactions. BANKING TWENTY-FOURONLINE offers sole proprietorssimilar capabilities specifically tailored to meet small business needs.

***Small Business Banking***

The Banks offer numerous services to meet thedeposit, credit and service needs of businesses with annual****revenuesup to $3.0 million or credit needs up to $750 thousand.  Each Bank works closely with customers toprovide cash management services and extend credit for such purposes asreceivables and inventory financing, equipment leases and real estate financing.  Where appropriate, the Banks employ governmentguarantee programs, such as those available from the Small BusinessAdministration.

***Commercial Banking***

Commercial banking services include commercialdeposit, lending and commercial real estate solutions provided to businesseswith annual revenues between $4 million and $50 million.

Cash management services help business customerscollect, transfer and invest their cash. Through a variety of electronic payment and account management tools,customers are able to monitor and manage cash flows conveniently andefficiently.

With their local knowledge and focus, our Banksare well suited to meet the traditional credit needs of businesses in theirmarket areas.  Each Bank works closelywith customers to extend credit for general business pur­poses, such as workingcapital, plant expansion or equipment purchases, and for financing industrialand commercial real estate.  When localcommercial customers do not qualify for traditional financing, we can help themconvert the value of their accounts receivable, inventory and equipment intocash for operations.  Additionally, wecan arrange more sophisticated financing in the areas of acquisitions andmanagement buyouts.  We provide landacquisition and development, construction and interim financing to commercialreal estate investors and developers.

In addition to extending credit to businesses inits own market area, MSD&T works in collaboration with other bankaffiliates when their customers’ credit needs exceed the affiliate bank’slending limit or when there is a more specialized commercial banking need.  To supplement traditional credit products,the Banks offer capital market products such as municipal bond underwriting,interest rate risk management and financial advisory services through theMSD&T Capital Markets Group.

These services include underwriting andremarketing tax-exempt and taxable municipal variable-rate demand bonds fornonprofit organizations such as senior living and health care providers,private schools, health and social welfare organizations and culturalinstitutions.  By working directly withborrowers, we can evaluate and recommend financing and interest rate risk-management strategies, which include interest rate swaps, caps and collars.

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***Mortgage Banking***

Residential mortgages are provided throughMercantile Mortgage, LLC, a joint venture between Mercantile MortgageCorporation (“Mercantile Mortgage”), a sub­sidiary of MSD&T, and WellsFargo Ventures, LLC.  Through MercantileMortgage a wide variety of competitively priced fixed and variable-rateproducts are available, including jumbo loans. Residential mortgage loans also are available through the Banks.  Mercantile Mortgage also makes loans for landacquisition, development and construction of single-family and multifamilyhousing.

Risks associated with residential mortgage lendinginclude interest rate risk, which is mitigated through the sale of the majorityof all conforming fixed-rate loans, and default risk by the borrower, which ismitigated through underwriting procedures and credit quality standards, amongother things.

Permanent financing for multifamily projectsnationwide is provided through HarborPoint Capital, LP, a joint venture, themajority of which is owned by Mercantile Mortgage.  HarborPoint Capital, LP, headquartered inDallas, Texas, is one of the nation’s few Fannie Mae DUSTM (DelegatedUnderwriting and Servicing) lenders.

**Insurance Products**

Keller Stonebraker Insurance, Inc., anindependent, wholly owned subsidiary of Farmers & Mechanics Bank, arrangesa full line of consumer insurance products through offices in Hagerstown andCumberland, Maryland, and Keyser, West Virginia.  Consumer insurance products includeannuities, homeowners, automobile, life and personal umbrellas.

Potomac Basin Group Associates, Inc. operates asan independent, wholly owned subsidiary of Farmers & Mechanics Bank.  It is an independent insurance agencyspecializing in corporate employee benefit plans through its offices inBeltsville and Ellicott City, Maryland. Potomac Basin provides commercial products that include property andcasualty packages, workers’ compensation, professional liability and umbrellacoverage, bonds and 401(k) and other benefit plans.

MBC Agency, Inc. provides as agent, under grouppolicies, credit life insurance in connection with extensions of credit by theBanks.  Mercantile Life Insurance Companyreinsures the insurance provided by MBC Agency, Inc.

**Investment and Wealth ManagementServices**

Bankshares offers investment and wealth managementservices through the Investment & Wealth Management division (“IWM”) ofMSD&T.  IWM continues to build on amore than 140-year tradition of providing investment and wealth managementservices to private individuals, families and institutions.

Today, Bankshares provides a range of wealthmanagement services.  IWM has riskmanagement and asset allocation analyses to complement the investment advice weoffer.  An open architecture platformenables Bankshares to offer an array of proprietary investment products andcarefully selected outside managers in a range of asset classes, includingequity, fixed-income and alternative investment products.  Bankshares’ investment platform provides arange of investment vehicles, from separate account management to mutualfunds.  Investment and wealth managementservices are available through professional advisors at MSD&T, through theaffiliate bank network and through Baltimore-based Mercantile BrokerageServices, Inc. (“MBSI”).  Assetallocation and risk management capabilities, coupled with a range ofproprietary and nonproprietary investment alternatives and investment vehicles,enable Bankshares to provide high quality, advice-driven, risk-managedsolutions to meet clients’ investment objectives.  At December 31, 2006, Bankshares had $21.1billion of discretionary assets under management and $43.3 billion in assetsunder administration.

***Retail Brokerage Services***

Mercantile Brokerage Services, Inc., a generalsecurities broker-dealer, offers full-service, discount and online brokeragecapabilities and account services.  Ourcustomers can choose from investments in stocks, bonds, proprietary andnonproprietary mutual funds, and fixed or variable annuities.

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***Private Wealth Management Services***

When managing a client’s assets as part of aninvestment management or trustee relationship, Bankshares focuses on consistentinvestment performance and an asset allocation that is individually designed tomeet each client’s risk/return parameters and investment objectives.  Professional advisors, working in partnershipwith our clients, provide access to proprietary and third-party separateaccount management, the family of Mercantile Funds, nonproprietary mutual fundsand a variety of alternative investments. In addition, IWM provides a range of sophisticated fiduciary and clientadministrative services, including trust administration, protection andcontinuity of trust structures, estate settlement, estate advice and planning,tax advice and planning and charitable giving programs.  IWM also acts in a custodial capacity for itsclients, providing safekeeping of assets, transaction execution, incomecollection, preparation of tax returns and recordkeeping.

IWM also specializes in services designed to meetthe unique needs of families with substantial wealth.  We provide a full range of services requiredto manage seamlessly our client’s complex, multigenerational financialcircumstances.  We also provide guidancein more sophisticated investment strategies, incorporating nontraditional assetclasses such as private equity, real estate and hedge funds.

***Private Banking Services***

The Private Banking Group provides one point ofcontact for its clients’ deposit, investment and credit needs, ensuring thatthese services are delivered within an overall asset management plan.  Private bankers can coordinate cash flows;arrange investment of short- and long-term funds; and structure creditarrangements to meet short- to long-term needs.

***Institutional Investment Management***

Bankshares, through IWM and Boyd Watterson AssetManagement, LLC, works to provide businesses and charitable organizations withinvestment management and administrative services for their employee retirementplans, profit sharing plans and endowments. Clients include state and local government entities, unions, charitableorganizations and military institutions. IWM also can help nonprofit organizations, such as charitable andphilanthropic groups, with annual giving and capital campaigns, pooled incomefunds, gift annuities and charitable remainder trusts.  Bankshares offers corporations 401(k)programs tailored to their specific needs.

***Mercantile Funds***

We offer a full spectrum of mutual funds -from equity funds designed to grow clients’ money over time, to taxable andtax-exempt bond funds designed to offer regular income payments, to moneymarket funds designed to help clients build a cash reserve.  The Mercantile Funds help clients createwell-rounded portfolios around their goals - with the level of risk andpotential for return that makes the most sense for them.

Managed by Mercantile Capital Advisors, Inc., anaffiliate of MSD&T, Mercantile Funds utilize an investment foundation basedon risk management, in-depth fundamental research and a product line designedto meet clients’ needs.

***Real Estate***

IWM founded Mercantile Real Estate Advisors, Inc. in2006 to expand its longstanding commercial real estate investment andmanagement services to Taft-Hartley pension funds.  On behalf of its clients, Mercantile directlyinvests in properties across the country.

**Private Equity**

Bankshares, in partnership with MSD&T, began afocused private equity investment initiative in 2000 with two objectives: (1)provide an alternative method of funding to develop additional long-term clientrelationships with emerging companies in Bankshares’ market area and (2)provide an alternative use of capital to generate long-term returns.  The primary investments are private equitylimited partnerships located, or seeking investment opportunities, withinBankshares’ geographic trade area and, to a lesser extent, direct investmentsin privately held companies within the region. The private equity funds include small- and middle-market buyout funds,mezzanine funds and late-stage venture funds in which the target investments ofthe funds are or have the potential to become Bankshares’ customers.  For more information on private equityinvestments, see Notes No. 1, 6 and 10 in Notes to Consolidated FinancialStatements.

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**Statistical Information**

The statistical information required in this Item1 is set forth in Items 6, 7 and 8 of this Annual Report on Form 10-K, asfollows.

 
|        | ** ** | **Disclosure Required by Guide 3**                                                | ** ** | **Reference to Caption in Item 6  or 7, or Note in Item 8**                                         |
|--------|------------|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
|   |       |                                                                              |       |                                                                                                |
| (I)    |       | Distribution of Assets,  Liabilities and  Stockholders Equity; Interest Rates and |       | Analysis of Interest Rates and  Interest Differentials (Item 7)                                     |
|   |       | Interest Differentials                                                            |       | Rate/Volume Analysis (Item 7)                                                                       |
|   |       |                                                                              |       | Nonperforming Assets (Item 7)                                                                       |
|   |       |                                                                              |       |                                                                                                |
| (II)   |       | Investment Portfolio                                                              |       | Bond Investment Portfolio  (Item 7)                                                                 |
|   |       |                                                                              |       | Notes to Consolidated Financial  Statements, Note No. 3 - Investment Securities           |
|   |       |                                                                              |       |                                                                                                |
| (III)  |       | Loan Portfolio                                                                    |       | Year-End Loan Data (Item 6)                                                                         |
|   |       |                                                                              |       | Loan Maturity Schedule (Item  7)                                                                    |
|   |       |                                                                              |       | Interest Rate Risk (Item 7)                                                                         |
|   |       |                                                                              |       | Nonperforming Assets (Item 7)                                                                       |
|   |       |                                                                              |       |                                                                                                |
| (IV)   |       | Summary of Loan Loss  Experience                                                  |       | Allowance for Loan Losses  (Item 7)                                                                 |
|   |       |                                                                              |       | Credit Risk Analysis (Item 7)                                                                       |
|   |       |                                                                              |       | Allocation of Allowance for  Loan Losses (Item 7)                                                   |
|   |       |                                                                              |       |                                                                                                |
| (V)    |       | Deposits                                                                          |       | Analysis of Interest Rates and  Interest Differentials (Item 7)                                     |
|   |       |                                                                              |       | Notes to Consolidated Financial  Statements, Note No. 7 - Deposits              |
|   |       |                                                                              |       |                                                                                                |
| (VI)   |       | Return on Equity and Assets                                                       |       | Return on Equity and Assets  (Item 6)                                                               |
| (VII)  |       | Short-Term Borrowings                                                             |       | Notes to Consolidated Financial  Statements, Note No. 8 - Short-Term Borrowings |

 

**Employees**

At February 16, 2007,Bankshares and its affiliates had approximately 3,519 employees.

**Competition**

The banking business is highlycompetitive.  Within their service areas,the Banks compete with commercial banks (including local banks and branches oraffiliates of other larger banks), savings and loan associations and creditunions for loans and deposits, and with insurance companies and other financialinstitutions for various types of loans. There is also competition for commercial and retail banking businessfrom banks and financial institutions located outside our service areas.  Interstate banking is an established part ofthe competitive environment.  Banksharesis a financial holding company and is the largest independent bank holdingcompany headquartered in Maryland. Measured in terms of assets under management and administration,MSD&T believes it is one of the larger trust institutions in themid-Atlantic region of the United States. MSD&T and its subsidiaries (i.e., Boyd Watterson & MercantileCapital Advisors, Inc.) compete for various classes of fiduciary and investmentadvisory business with other banks and trust companies, insurance companies,investment counseling firms, mutual funds and others.  Mercantile Mortgage is one of manycompetitors in its area of activity.  MBCAgency, Inc. is limited to providing life, health and accident insurance inconnection with credit extended by the Banks.

The Banks ranged in asset size fromapproximately $200 million to $8 billion, at December 31, 2006.  They face competition in their own local serviceareas as well as from the larger competitors mentioned above.

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**Supervision and Regulation**

***Bankshares and the Banks***Bankshares, as a registered bank holding company, is subjectto regulation and examination by the Board of Governors of the Federal ReserveSystem (the “Federal Reserve Board”) under the Bank Holding Company Act of1956, as amended (the “BHC Act”) and is required to file with the FederalReserve Board quarterly and annual reports and such additional information asthe Federal Reserve Board may require pursuant to the BHC Act.  Among other provisions, the BHC Act andregulations promulgated thereunder require prior approval of the FederalReserve Board of the acquisition by Bankshares of more than five percent of anyclass of the voting shares of any bank holding company, bank or savingsassociation.

*CapitalAdequacy. *The Banksinclude seven banks chartered by the state of Maryland (two of which aremembers of the Federal Reserve System), a Delaware-chartered bank, and threenational banks (additional information about the chartering of the Banks iscontained in *The Banks,*below).  The Federal Reserve Board, regulator of bankholding companies and state-chartered banks that are members of the FederalReserve System; the Office of the Comptroller of the Currency (the “OCC”), thefederal regulator of national banks; and the Federal Deposit InsuranceCorporation (the “FDIC”), federal regulator of state-chartered banks that arenot members of the Federal Reserve System and insurer of the deposits of allU.S. commercial banks, have issued substantially similar risk-based andleverage capital guidelines applicable to United States bankingorganizations.  In addition, theseregulatory agencies may from time to time require that a banking organization maintaincapital above the minimum levels, whether because of its financial condition oractual or anticipated growth.

The Federal Deposit InsuranceCorporation Improvement Act of 1991 (“FDICIA”), among other things, identifiesfive capital categories for insured depository institutions (well capitalized,adequately capitalized, undercapitalized, significantly undercapitalized andcritically undercapitalized) and requires the respective federal regulatoryagencies to implement systems for “prompt corrective action” for insureddepository institutions that do not meet minimum capital requirements withinsuch categories.  FDICIA imposesprogressively more restrictive constraints on operations, management andcapital distributions, depending on the category in which an institution isclassified.  Failure to meet the capitalguidelines could also subject a banking institution to requirements to raisecapital.

The various regulatory agencieshave adopted substantially similar regulations that define the five capitalcategories identified by FDICIA, using the total risk-based capital, Tier 1risk-based capital and leverage capital ratios as the relevant capitalmeasures.  Such regulations establishvarious degrees of corrective action to be taken when an institution isconsidered undercapitalized.  Under theregulations, a “well capitalized” institution must have a Tier 1 risk-basedcapital ratio of at least six percent, a total risk-based capital ratio of atleast ten percent and a leverage ratio of at least five percent and not besubject to a capital directive order.  Asof December 31, 2006, the most recent notification from the primaryregulators for each of Bankshares’ subsidiary banks categorized them as “wellcapitalized” under the prompt corrective action regulations.

Changes to the risk-based capitalregime for banking organizations are proposed or implemented from time to time.The minimum risk-based capital requirements that are currently in effect forU.S. banking organizations follow the Capital Accord issued in 1988 by theBasel Committee on Banking Supervision, which is comprised of bank supervisorsand central banks from the major industrialized countries, including the UnitedStates.  The Basel Committee issued aproposed replacement for the 1988 Capital Accord in 2001 (“Basel II”), and workhas continued on the details of Basel II and the timing of its implementationsince that time.  In the United States,the Basel II framework will only apply to the largest financial institutions.  Following the approval of the Accord,non-Basel II institutions expressed concern that the larger bankingorganizations would gain unfair advantage through the potentially reducedcapital requirements that could be possible under the new framework.  In addition, the regulators recognized thatthe existing capital system applicable to smaller banks could be improved tobetter differentiate risk within asset classes. Therefore, in December 2006, the four federal banking agencies designeda proposal known as Basel I-A to address both of these concerns. The final formof Basel I-A, the timing of its implementation and the impact it might have onBankshares and its subsidiaries cannot be determined at this time.  Additional information regarding capitalrequirements for bank holding companies and tables reflecting Bankshares’regulatory capital position at December 31, 2006 is in Note No. 11 -Shareholders’ Equity of Notes to the Consolidated Financial Statements in Item8 of this Annual Report.

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*The Gramm-Leach-BlileyAct*.  TheGramm-Leach-Bliley Act of 1999 (the “GLB Act”) was adopted on November 12, 1999and amended several of the federal banking laws, including the BHC Act and theBanking Act of 1933 (generally known as “Glass-Steagall”), that affectBankshares and its subsidiaries.  Priorto the adoption of the GLB Act, the activities of bank holding companies andtheir subsidiaries were restricted to banking, the business of managing andcontrolling banks, and other activities that the Federal Reserve Board haddetermined were so closely related to banking or managing or controlling banksas to be a proper incident thereto.  Inparticular, Glass-Steagall and the BHC Act imposed important restrictions onthe ability of bank holding companies or their subsidiaries to engage in thesecurities or insurance business.

The GLB Act repealed the provisionsof Glass-Steagall and restrictions in the BHC Act that limited affiliationsamong, and overlapping business activities between the banking business and,respectively, the securities and insurance industries.  With the adoption of the GLB Act, a bankholding company that makes an effective election to become a “financial holdingcompany” may, within a holding company system, (a) engage in banking, ormanaging or controlling banks; (b) perform certain servicing activities forsubsidiaries; and (c) engage in any activity, or acquire and retain the sharesof any company engaged in any activity that is either (i) financial in natureor incidental to such financial activity, as determined by the Federal ReserveBoard in consultation with the Secretary of the Treasury or (ii) complementaryto a financial activity and that does not pose a substantial risk to the safetyand soundness of depository institutions or the financial system generally, asdetermined by the Federal Reserve Board. Activities that are “financial in nature” include activities specifiedin the GLB Act and those activities that the Federal Reserve Board haddetermined, by order or regulation in effect prior to enactment of the GLB Act,to be so closely related to banking or managing or controlling banks as to be aproper incident thereto.  Thus, afinancial holding company may engage in a full range of banking, securities andinsurance activities, including securities and insurance underwriting, as wellas, subject to certain restrictions, merchant banking activities.  The election to become a financial holdingcompany is only available to bank holding companies whose bank and thriftsubsidiaries are well capitalized, well managed, and have satisfactoryCommunity Reinvestment Act ratings.

With exceptions for insuranceunderwriting, merchant banking and real estate investment and development, theGLB Act also permits comparable expansion of national bank activities by banksmeeting similar criteria, together with certain additional firewalls and otherrequirements, through “financial subsidiaries” of national banks.  Similarly, as a matter of Federal law, butstill subject to State law, the GLB Act expands the potential financialactivities of subsidiaries of State banks. Bankshares filed an election and, on December 20, 2002, became afinancial holding company.

The GLB Act also imposed a generalscheme of functional regulation with respect to the activities of bank holdingcompanies and their bank and nonbank subsidiaries to ensure that bankingactivities are regulated by bank regulators, securities activities areregulated by securities regulators, and insurance activities are regulated byinsurance regulators, although the Federal Reserve Board retains its role asthe umbrella supervisor for bank holding companies.  Consequently, various securities activitiesof bank subsidiaries of Bankshares are now subject to regulation by theSecurities and Exchange Commission and the National Association of SecuritiesDealers, Inc.

As a result of the functionalregulation imposed by the GLB Act, the Banks have moved certain securitiesactivities that have become subject to Securities and Exchange Commissionregulation into separate securities subsidiaries or affiliates.  For example, MSD&T has two subsidiariesthat engage in securities activities: Mercantile Capital Advisors, Inc., a registered investment adviser thatadvises the Mercantile family of mutual funds and certain other institutionalaccounts; and Mercantile Brokerage Services, Inc., a registered broker-dealerthat facilitates the purchase of shares of mutual funds by bank customers andmay engage in certain other activities in the future.

The GLB Act also implements anumber of requirements designed to protect the privacy of customer information.  A financial institution must inform itscustomers at the outset of the customer relationship, and at least annuallythereafter, of the institution’s privacy policies and procedures with respectto the customer’s nonpublic personal financial information.  With certain exceptions, an institution maynot provide any nonpublic personal information to unaffiliated third partiesunless the customer has been informed that such information may be so providedand the customer has been given the opportunity to opt out.  Furthermore, the GLB Act limits a financialinstitution’s use of a customer’s account information for marketing purposesand imposes criminal penalties for the use of fraudulent or deceptive means toobtain personal customer financial information. The GLB Act permits states to adopt more rigorous laws with respect toprivacy of customer information.

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*The Fair CreditReporting Act and the Fair and Accurate Transactions Act of 2003*.  The Fair Credit Reporting Act (“FCRA”), amongother provisions, restricts any bank from sharing with its affiliates certaininformation relating to its individual customers’ creditworthiness and certainother matters with various exceptions.  FCRA preempts state laws that purport to restrict further suchinformation sharing among affiliated institutions.  The Fair and Accurate Transactions Act of2003 (the “FACT Act”), which was signed into law on December 4, 2003, amendedFCRA in various respects, including to enhance the ability of consumers tocombat identity theft, increase the accuracy of consumer credit reports, andallow consumers to exercise greater control over the type and amount ofmarketing solicitations that they receive. The new marketing restrictions, with some exceptions, would preventbanks from using certain information received from an affiliate for marketingto a consumer unless the consumer was given notice and an opportunity to optout.  The FACT Act also restricts thesharing of certain types of consumer medical information among affiliates.  These new restrictions on sharing or usinginformation shared among affiliates must be implemented by regulations, whichwere issued for public comment.  Certainprovisions are currently effective while other provisions have been issued, buthave not yet been finalized.  Moregenerally, the Federal Reserve Board and the Federal Trade Commission issuedjoint final rules establishing December 1, 2004 as the effective date for manyof the provisions of the FACT.

In December 2004, implementingsection 216 of the FACT Act, the federal bank regulatory agencies announcedinteragency final rules to require financial institutions to adopt measures forproperly disposing of “consumer information” derived from credit reports.  Federal banking law requires financialinstitutions to protect customer information by implementing informationsecurity programs.  The rules adopted bythe banking agencies require institutions to make certain adjustments to theirinformation security programs to include measures for the proper disposal ofconsumer information.  The rules define “consumerinformation” to mean “any record about an individual, whether in paper,electronic, or other form, that is a consumer report or is derived from aconsumer report and that is maintained or otherwise possessed by or on behalfof the [institution] for a business purpose,” and include a compilation of suchrecords, but exclude any record that does not identify an individual.  The rules took effect on July 1, 2005.  Federal regulators have pursued enforcementaction against U.S. banks and other entities for failing to properly safeguardcustomers’ information.

*The USA PATRIOTACT*.  Congress adopted theUSA PATRIOT ACT (the “Patriot Act”) on October 26, 2001 in response to theterrorist attacks that occurred on September 11, 2001.  Under the Patriot Act, banks are required tomaintain and prepare additional records and reports that are designed to assistthe government’s efforts to combat terrorism. The Patriot Act includes sweeping anti-money laundering and financialtransparency laws and required additional regulations, including, among otherthings, standards for verifying client identification when opening an accountand rules to promote cooperation among financial institutions, regulators andlaw enforcement entities in identifying parties that may be involved interrorism or money laundering. Specifically, the customer identification program (“CIP”) regulationissued under the Patriot Act requires each bank to implement a written CIPappropriate for its size and type of business that includes certain minimumrequirements. The CIP must be incorporated into the bank’s anti-moneylaundering compliance program, which is subject to approval by the bank’s boardof directors.  The regulation applies toall federally regulated banks and savings associations, credit unions, andnon-federally regulated private banks, trust companies, and credit unions. Allbanks were required to comply with the CIP regulation for all accountsestablished on or after October 1, 2003.

*InterstateBanking.  *Pursuantto the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the“Interstate Banking and Branching Act”), a bank holding company may acquirebanks located in states other than its home state without regard to thepermissibility of such acquisitions under state law, but subject to any staterequirement that the bank has been organized and operating for a minimum periodof time, not to exceed five years, and the requirement that the bank holdingcompany, after the proposed acquisition, controls no more than 10%  of the total amount of deposits of insureddepository institutions in the United States and no more than 30% or such lesseror greater amount set by state law of such deposits in that state.

Subject to certain restrictions,the Interstate Banking and Branching Act also authorizes banks to merge acrossstate lines to create interstate banks. The Interstate Banking and Branching Act also permits a bank to open newbranches in a state in which it does not already have banking operations ifsuch state enacts a law permitting de novo branching.

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*Other RegulatoryMatters*.  Bankshares isa separate and distinct legal entity from its subsidiaries.  It receives substantially all of its revenuefrom dividends from its subsidiaries and interest payments from the Banks onsubordinated debt. These dividends are the principal source of funds to paydividends on Bankshares’ common stock and interest on its debt. The payment ofdividends by a bank is subject to federal law restrictions as well as to thelaws of its state of incorporation in the case of a state-chartered bank. Also,a parent company’s right to participate in a distribution of assets upon asubsidiary’s liquidation or reorganization is subject to the prior claims ofthe subsidiary’s creditors.  It isFederal Reserve Board policy that a bank holding company should serve as asource of financial and managerial strength for, and commit resources tosupport each, of its subsidiary banks even in circumstances in which it mightnot do so (or may not legally be required or financially able to do so) absentsuch a policy.

In addition to the specific lawsand regulations discussed above, there are numerous federal and state laws andregulations which regulate the activities of Bankshares and the Banks,including requirements and limitations relating to reserves, permissibleinvestments and lines of business, transactions with officers, directors andaffiliates, loan limits, consumer protection laws, privacy of financialinformation, predatory lending, fair lending, mergers and acquisitions,issuances of securities, dividend payments, inter-affiliate liabilities,extensions of credit and branch banking. The BHC Act and the Federal Reserve Board’s regulations limit theability of bank subsidiaries of bank holding companies to engage in certaintie-in arrangements with bank holding companies and their nonbank subsidiariesin connection with any extension of credit or provision of any property orservices, subject to various exceptions.

The laws and regulations to whichBankshares is subject are constantly under review by Congress, regulatoryagencies and state legislatures.  Thelikelihood and timing of any bank-related proposals or legislation and theimpact they might have on Bankshares and its subsidiaries cannot be determinedat this time.

As a general matter, the recent regulatory environment for bankingorganizations has included significant enforcement actions by bankingregulators and other federal and state agencies, involving such matters asalleged shortcomings in anti-money laundering policies and procedures,inadequate protection of confidential customer information, and violations ofsecurities or other laws.  As a result ofthis regulatory environment, banking organizations may experience increases incompliance requirements and associated costs.

 

Changes in control of Bankshares and the Banks are regulated under theBHC Act, the Change in Bank Control Act of 1978 and various state laws.

***The Banks***

All the Banks, with the exceptionof The Citizens National Bank, The National Bank of Fredericksburg, MarshallNational Bank and Trust Company and Mercantile Peninsula Bank are Marylandbanks, subject to the banking laws of Maryland and to regulations issued by theCommissioner of Financial Regulation of the Maryland, Department of LaborLicensing and Regulation who is required by statute to make at least oneexamination in each calendar year (or at 18-month intervals if the Commissionerdetermines that an examination is unnecessary in a particular calendaryear).  Their deposits are insured by,and they are subject to certain provisions of federal law and regulations andexamination by, the FDIC.

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In addition, The Annapolis Bankingand Trust Company and Farmers & Mechanics Bank are members of the FederalReserve System and are thereby subject to regulation by the Federal ReserveBoard.

The Citizens National Bank, TheNational Bank of Fredericksburg and Marshall National Bank and Trust Companyare national banks subject to regulation and regular examination by the OCC inaddition to regulation and examination by the FDIC, which insures theirdeposits.

Mercantile Peninsula Bank is aDelaware bank, subject to the banking laws of Delaware and to regulation by theDelaware State Bank Commissioner, who is required by statute to make periodicexaminations.  Its deposits are insuredby, and it is subject to certain provisions of federal law and regulation andexamination by, the FDIC.

Bankshares and its affiliates are subject to the provisions of Section23A and Section 23B of the Federal Reserve Act and the Federal Reserve Board’sRegulation W, which implements Sections 23A and 23B.  Section 23A, among other things, limits theamount of loans or extensions of credit by the Banks to, and their investmentsin, Bankshares and the nonbank affiliates of the Banks, while Section 23Bgenerally requires that transactions between the Banks and Bankshares and itsnonbank affiliates be on terms and under****circumstancesthat are substantially the same as with non-affiliates.  Under the cross-guarantee provisions of theFederal Deposit Insurance Act, in the event of a loss suffered or anticipatedby the FDIC either as a result of default of a bank subsidiary or related toFDIC assistance provided to a bank subsidiary in danger of default theBanks may be assessed for the FDIC’s loss, subject to certain exceptions.

***Other Affiliates***

As affiliates of Bankshares, thenonbank affiliates are subject to examination by the Federal Reserve Board and,as affiliates of the Banks, they are subject to examination by the FDIC, theCommissioner of Financial Regulation of Maryland and the OCC, as the case maybe.  In addition, MBC Agency, Inc. andMercantile Life Insurance Company are subject to licensing and regulation bystate insurance authorities.  MercantileCapital Advisors, Inc., Boyd Watterson and Mercantile Brokerage Services, Inc.are subject to regulation by the Securities and Exchange Commission and statesecurities law authorities, and Mercantile Brokerage Services, Inc. is alsosubject to regulation by the National Association of Securities Dealers, Inc.  Retail sales of insurance and securitiesproducts by Mercantile Brokerage Services, Inc. are also subject to therequirements of the Interagency Statement on Retail Sales of NondepositInvestment Products promulgated in 1994 by the FDIC, the Federal Reserve Board,the Comptroller of the Currency and the Office of Thrift Supervision.

***Effects of Monetary Policy***

All commercial banking operationsare affected by the Federal Reserve System’s conduct of monetary policy and itspolicies change from time to time based on changing circumstances.  The Federal Reserve Board effectivelycontrols the supply of bank credit in order to achieve economic results itdeems appropriate, including efforts to combat unemployment, recession orinflationary pressures.  Among theinstruments of monetary policy used to advance these objectives are open marketoperations in the purchase and sale of U.S. Government securities, changes inthe discount rate charged on bank borrowings and changes in reserverequirements against bank deposits. These means are used in varying combinations to influence the generallevel of interest rates and the general availability of credit.  More specifically, actions by the FederalReserve Board influence the levels of interest rates paid on deposits and otherbank funding sources and charged on bank loans as well as the availability ofbank funds with which loans and investments can be made.

 

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**CautionaryStatement**

ThisAnnual Report on Form 10-K contains forward-looking statements, within themeaning of and pursuant to the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995.  Aforward-looking statement encompasses any estimate, prediction, opinion orstatement of belief contained in this report and the underlying managementassumptions.  These “forward-lookingstatements” include such words as “believes,” “expects,” “anticipates,” “intends,”“outlook,” “estimate,” “forecast,” “project” and similar expressions.  Examples of forward-looking statements inthis Annual Report on Form 10-K are statements concerning competitiveconditions, effects of monetary policy, the potential impact of legislation, identificationof trends, loan growth, customer borrowing trends, anticipated levels ofinterest rates, business strategies and services, continuation or developmentof specified lending and other activities, credit quality, predictions orassessments related to the determination and adequacy of loan loss allowances,monitored loans, internal controls, tax accounting, importance and effects ofcapital levels, effects of asset sensitivity and interest rates, earningssimulation model projections, efforts to mitigate market and liquidity risks,dividend payments and impact of Financial Accounting Standards Board (“FASB”)pronouncements.  These statements arebased on current expectations and assessments of potential developmentsaffecting market conditions, interest rates and other economic conditions, andresults may ultimately vary from the statements made in this report.  The following factors, among others, couldcause actual results to differ materially from the anticipated results or otherexpectations expressed in the forward-looking statements: (1) the interest rateenvironment may further compress margins and adversely affect net interestincome; (2) results may be adversely affected by continued diversification ofassets and adverse changes in credit quality; (3) economic slowdown couldadversely affect credit quality and loan originations; (4) loan growth may notimprove to a degree that would help offset continuing pressure on net interestmargin; (5) adverse governmental or regulatory policies may be enacted; (6)declines in equity and bond markets may adversely affect IWM revenues; (7) theinability to manage adequately the spread between yields on earning assets andcost of funds could adversely affect results; (8) the merger may be moreexpensive to complete than anticipated, including as a result of unexpectedfactors or events; and (9) the integration of Bankshares’ business andoperations with those of PNC may take longer than anticipated, may be morecostly than anticipated and may have unanticipated adverse results relating toBankshares’ or PNC’s existing businesses.

**WebsiteAccess to Information**

Bankshares’ annual reportson Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K andall amendments to those reports may be accessed through Bankshares’ website assoon as reasonably practicable after such material is electronically filedwith, or furnished to, the Securities and Exchange Commission.  Bankshares’ website is www.mercantile.com.

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ITEM 1A.      RISK FACTORS

Thefollowing is a summary of the risk factors that we believe are most relevant toour business.  These are factors that,individually or in the aggregate, we think could cause our actual results todiffer significantly from anticipated or historical results.  You should understand that it is not possibleto predict or identify all such factors. Consequently, you should not consider the following to be a completediscussion of all potential risks or uncertainties.  We undertake no obligation to publicly updateforward-looking statements, whether as a result of new information, futureevents, or otherwise.  You are advised,however, to consult any further disclosure we make on related subjects in ourreports on forms 10-Q and 8-K filed with the SEC.

***Bankshares isSubject to Interest Rate Risk***

Ourearnings depend largely on the relationship between the yield on ourinterest-earning assets and our cost of funds. This relationship, known as the interest rate spread, is subject tofluctuation and is affected by economic and competitive factors which influencemarket interest rates, the volume and mix of interest-earning assets andinterest-bearing liabilities, and the level of non-performing assets.  Fluctuations in market interest rates alsoaffect our customers’ demand for our products and services.  See the sections entitled “Net InterestIncome and Net Interest Margin” and “Interest Rate Risk” in Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”located elsewhere in this report for further discussion related to Bankshares’management of interest rate risk.

***Bankshares isSubject to Lending Risk***

Thereare inherent risks associated with Bankshares’ lending activities.  These risks include, among other things, theimpact of changes in interest rates and changes in the economic conditions inthe markets in which Bankshares operates. Increases in interest rates and/or weakening economic conditions couldadversely affect the ability of borrowers to repay outstanding loans or thevalue of the collateral securing these loans. Commercial loans, including commercial real estate loans are typicallysubject to a higher credit risk than other types of loans, includingresidential real estate or consumer loans, because they usually involve largerloan balances to a single borrower and are more susceptible to a risk ofdefault during an economic downturn. Because Bankshares’ loan portfolio contains a significant number ofcommercial and industrial, construction and commercial real estate loans withrelatively large balances, the deterioration of one or a few of these loanscould cause a significant increase in nonperforming loans.  These types of loans are also typicallylarger than residential real estate loans and consumer loans.   An increase in nonperforming loans couldresult in a net loss of earnings from these loans, an increase in the provisionfor possible loan losses and an increase in loan charge offs, all of whichcould have a material adverse effect on Bankshares’ financial condition andresults of operations.  See the sectioncaptioned “Loans” in Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations located elsewhere in this report forfurther discussion related to commercial and industrial, construction andcommercial real estate loans.

***Bankshares’ Allowancefor Possible Loan Losses and Reserve for Unfunded Commitments May BeInsufficient***

Inan attempt to provide for losses inherent in the loan portfolio, we estimate anallowance for loan and lease losses and reserve for unfunded commitments basedon, among other things, national and regional economic conditions, historicalloss experience and delinquency trends. However, we cannot predict loan and lease losses with certainty, and wecannot assure you that charge-offs in future periods will not exceed theallowance for loan and lease losses and reserve for unfunded commitments.  If our allowance for loan and lease lossesand reserve for unfunded commitments were not sufficient to cover actual loanand lease losses, our earnings would decrease. In addition, regulatory agencies, as an integral part of theirexamination process, review our allowance for loan and lease losses and reservefor unfunded commitments and may require additions to the allowance and/or thereserve based on their judgment about information available to them at the timeof their examination.  Factors thatrequire an increase in our allowance for loan and lease losses and reserve forunfunded commitments could reduce our earnings.

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***BanksharesOperates in a Highly Competitive Industry and Market Area***

Banksharesfaces substantial competition in all areas of its operations from a variety ofcompetitors, many of which are larger and may have more financialresources.  Such competitors primarilyinclude national, regional, and community banks within the various markets inwhich Bankshares operates.  Banksharesalso faces competition from many other types of financial institutions,including, without limitation, savings and loans, credit unions, finance companies,brokerage firms, insurance companies, factoring companies and other financialintermediaries.  The financial servicesindustry could become even more competitive resulting from legislative,regulatory and technological changes and continued consolidation.  Banks, securities firms and insurancecompanies can merge under the umbrella of a financial holding company, whichcan offer virtually any type of financial service, including banking,securities underwriting, insurance (both agency and underwriting) and merchantbanking.  Additionally, technology haslowered barriers to entry and made it possible for nonbanks to offer productsand services traditionally provided by banks, such as automatic funds transferand automatic payment systems.  Many of Bankshares’competitors have fewer regulatory constraints and may have lower coststructures. Additionally, due to their size, many competitors may be able toachieve economies of scale and, as a result, may offer a broader range ofproducts and services as well as better pricing for those products and servicesthan Bankshares can. Bankshares’ ability to compete successfully depends on anumber of factors, including, among other things:

·                  Theability to develop, maintain and build upon long-term customer relationshipsbased on top quality service, high ethical standards and safe, sound assets.

·                  Theability to expand Bankshares’ market position.

·                  Thescope, relevance and pricing of products and services offered to meet customerneeds and demands.

·                  Therate at which Bankshares introduces new products and services relative to itscompetitors.

·                  Customersatisfaction with Bankshares’ level of service.

·                  Industryand general economic trends.

Failureto perform in any of these areas could significantly weaken Bankshares’competitive position, which could adversely affect Bankshares’ growth andprofitability, which, in turn, could have a material adverse effect onBankshares’ financial condition and results of operations.

***Bankshares isSubject to Extensive Government Regulation and Supervision***

Financialinstitution regulation has been the subject of significant legislation inrecent years and may be the subject of further significant legislation in thefuture, none of which is within our control. Significant new laws or changes in, or repeals of, existing laws,including with respect to federal and state taxation, may cause our results ofoperations to differ materially. Further, federal monetary policy, particularly as implemented throughthe Federal Reserve, significantly affects credit conditions for our affiliatedbanks, primarily through open market operations in U.S. government securitiesand the discount rate for bank borrowings and reserve requirements.  A material change in any of these conditionswould have a material impact on our results of operations.  Furthermore, failure to comply with laws,regulations or policies could result in sanctions by regulatory agencies, civilmoney penalties and/or reputation damage, which could have a material adverseeffect on Bankshares’ business, financial condition and results ofoperations.  While Bankshares haspolicies and procedures designed to prevent any such violations, there can beno assurance that such violations will not occur.  See the section captioned “Supervision andRegulation” in Item 1 “Business” located elsewhere in this report.

***Bankshares’Controls and Procedures May Fail or Be Circumvented***

Managementregularly reviews and updates Bankshares’ internal controls, disclosurecontrols and procedures, and corporate governance policies and procedures.  Any system of controls, however well designedand operated, is based in part on certain assumptions and can provide onlyreasonable, not absolute, assurances that the objectives of the system will bemet.  Any failure or circumvention ofBankshares’ controls and procedures or failure to comply with regulationsrelated to controls and procedures could have a material adverse effect onBankshares’ business, results of operations and financial condition.

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***Bankshares MayNot Be Able To Attract and Retain Skilled People***

Bankshares’success depends, in large part, on its ability to attract and retain keypeople.  Competition for the best peoplein the business conducted byBankshares can be intense and Bankshares may not be able to hire people or toretain them. The unexpected loss of services of one or more of Bankshares’ keypersonnel could have a material adverse impact on Bankshares’ business becauseof their skills, knowledge of Bankshares’ market, years of industry experienceand the difficulty of promptly finding qualified replacement personnel.

***Bankshares’Information Systems May Experience an Interruption or Breach in Security***

Banksharesrelies heavily on communications and information systems to conduct itsbusiness.  Any failure, interruption orbreach in security of these systems could result in failures or disruptions inBankshares’ customer relationship management, general ledger, deposit, loan andother systems.  While Bankshares haspolicies and procedures designed to prevent or limit the effect of the failure,interruption or security breach of its information systems, there can be noassurance that any such failures, interruptions or security breaches will notoccur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptionsor security breaches of Bankshares’ information systems could damage Bankshares’reputation, result in a loss of business, subject Bankshares to additionalregulatory scrutiny, or expose Bankshares to civil litigation and possiblefinancial liability, any of which could have a material adverse effect onBankshares’ financial condition and results of operations.

***BanksharesContinually Encounters Technological Change***

Thefinancial services industry is continually undergoing rapid technologicalchange with frequent introductions of new technology driven products andservices.  The effective use oftechnology increases efficiency and enables financial institutions to servecustomers better and to reduce costs. Bankshares’ future success depends, in part, upon its ability to addressthe needs of its customers by using technology to provide products and servicesthat will satisfy customer demands, as well as to create additionalefficiencies in Bankshares’ operations. Many of Bankshares’ competitors have substantially greater resources toinvest in technological improvements. Bankshares may not be able to effectively implement new technologydriven products and services or be successful in marketing these products andservices to its customers.  Failure tokeep pace successfully with technological change affecting the financialservices industry could have a material adverse impact on Bankshares’ businessand, in turn, Bankshares’ financial condition and results of operations.

***Bankshares isSubject to Claims and Litigation Pertaining to Fiduciary Responsibility***

Fromtime to time, customers make claims and take legal action pertaining toBankshares’ performance of its fiduciary responsibilities.  Whether customer claims and legal actionrelated to Bankshares’ performance of its fiduciary responsibilities arefounded or unfounded, if such claims and legal actions are not resolved in amanner favorable to Bankshares they may result in significant financialliability and/or adversely affect the market perception of Bankshares and itsproducts and services as well as affect customer demand for those products andservices.  Any financial liability orreputation damage could have a material adverse effect on Bankshares’ business,which, in turn, could have a material adverse effect on Bankshares’ financialcondition and results of operations.

***BanksharesRelies on Dividends from Its Subsidiaries for Most of Its Revenue***

Weare a financial holding company and a bank holding company and as a result,much of our income consists of dividends received from our affiliatedbanks.  This means we rely primarily upondividends from our affiliated banks to pay dividends to Bankshares’ commonstockholders.  Federal and state bankregulations restrict the amounts when our affiliated banks pay dividendsdirectly or indirectly to us, when making any extensions of credit to us, whentransferring assets to us and when investing in our stock or securities.  These regulations also prevent us fromborrowing from our affiliated banks unless the loans are secured bycollateral.  In addition, we cannotassure that our affiliated banks will be able to continue to pay dividends tous at past levels, if at all.  If we donot receive sufficient cash dividends or borrowings from our affiliate banks,we may not have sufficient funds to pay dividends on common stock.

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***Bankshares May Not Be Able toRetain Skilled Personnel in Anticipation of the Planned Merger with PNC***

Individualemployees may experience uncertainty about their post-merger roles withPNC.  Issues relating to the uncertaintyand difficulty of integration or a desire not to remain with PNC after themerger may cause them to voluntarily leave Bankshares for other careeropportunities.  Loss of significantnumbers of employees, or employees in key positions, could have a detrimentalimpact on Bankshares’ ability to carry on certain routine businessactivities.  There are no assurances thatBankshares will be able to find adequate replacements if they do depart.

**ITEM 1B. UNRESOLVED STAFF COMMENTS.**

There were no unresolvedstaff comments as of December 31, 2006.

**ITEM 2. PROPERTIES.**

The main offices of Bankshares and MSD&T are locatedin a 21-story building at Two Hopkins Plaza in Baltimore, Maryland. Pursuant toa lease agreement, effective as of December 13, 2004, MSD&T agreed to leaseup to approximately 179,000 square feet of prime office space and approximately27,000 square feet of back-office and storage space at Two Hopkins Plaza, for aterm of ten years.  At December 31, 2006,MSD&T and Bankshares occupied approximately 206,000 square feet.  The lease agreement contains two five-yearrenewal options.  The lease agreementrequires aggregate annual rent of approximately $4.0 million in 2006.  At December 31, 2006, Bankshares alsooccupied approximately 132,000 square feet of space in a building located inLinthicum, Maryland, in which its operations and certain other departments arelocated, and a 7,000 square foot call center facility in Federalsburg,Maryland.  The Linthicum and Federalsburgproperties are owned by Bankshares.  Ofthe 240 banking offices, 110 are owned in fee, 33 are owned subject to groundleases and 97 are leased, with aggregate annual rentals, not including thebranch located at Two Hopkins Plaza, of approximately $13.9 million as ofDecember 31, 2006.

**ITEM 3. LEGAL PROCEEDINGS.**

Between 2001 and 2003, on behalf of either individualplaintiffs or a putative class of plaintiffs, eight separate actions were filedin state and federal court against Community Bank of Northern Virginia (“CBNV”)and other defendants challenging the validity of second mortgage loans thedefendants made to the plaintiffs.  Allof the cases were either filed in, or removed to, the federal district courtfor the Western District of Pennsylvania. In June 2003, the parties to the various actions informed the court thatthey had reached an agreement in principle to settle the various actions.  On July 17, 2003, the court conditionallycertified a class for settlement purposes, preliminarily approved the classsettlement, and directed the issuance of notice to the class.

Thereafter, certain plaintiffs who had initially optedout of the proposed settlement and other objectors challenged the validity ofthe settlement in the district court. The district court denied their arguments and approved thesettlement.  These “opt out” plaintiffsand other objectors appealed the district court’s approval of the settlement tothe Third Circuit Court of Appeals.

In August 2005, the Third Circuit reversed thedistrict court’s approval of the settlement and remanded the case to thedistrict court with instructions to consider and address certain specificissues when re-evaluating the settlement.  In July 2006, the settlingparties modified the original settlement agreement and submitted the modifiedsettlement agreement to the District Court.  See Note No. 10 -Commitments and Contingencies in Notes to the Consolidated Financial Statements. Certain individuals who were excluded from the settlement class have filed twoactions on behalf of a putative class of plaintiffs alleging claims similar tothose raised in the initial filing.  These actions were laterconsolidated in the Western District of Pennsylvania.

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

No matter wassubmitted during the fourth quarter of the fiscal year covered by this Reportto a vote of security holders, which is required to be disclosed pursuant tothe instructions contained in the form for this Report.

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**PART II**

**ITEM 5. MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES.**

For information regardingmarket prices, dividends on Bankshares common stock, and the number ofBankshares’ stockholders, see the information set forth under the captions “Dividends”and “Recent Common Stock Prices” in Item 7 of this Annual Report.

**Comparisonof Five-Year Cumulative Total Return**The following linegraph compares cumulative total stockholder return on our common stock with theStandard & Poor’s 500 Index and the Standard & Poor’s Banks CompositeIndex for the period December 31, 2001 through December 31, 2006.  The graph assumes $100 invested at theclosing price on December 31, 2001 and the reinvestment of all dividends.

** **
| ** **                    | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Bankshares                    |       | $        | 100.00     |     | $          | 92.37    |       | $        | 112.68     |     | $          | 132.91   |       | $ | 147.78 |   | $ | 188.94 |   |
| S&P 500                   |       | 100.00   |       | 77.90    |       | 100.25   |       | 111.15   |       | 116.61   |       | 135.03   |       |
| S&P Banks Composite Index |       | 100.00   |       | 98.97    |       | 129.45   |       | 148.81   |       | 151.11   |       | 174.74   |       |
|                               |            |          |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |  |

 
| ** **                      | ** ** | ** ** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|---------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Bankshares                      |       |       |       | -7.63    | %          | 21.99    | %          | 17.95    | %          | 11.19    | %          | 27.85    | %          |
| S&P 500                     |       |       |       | -22.10   | %          | 28.68    | %          | 10.88    | %          | 4.91     | %          | 15.79    | %          |
| S&P Banks Composite  Index* |       |       |       | -1.03    | %          | 30.80    | %          | 14.95    | %          | 1.55     | %          | 15.64    | %          |

 

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*S5CBNK Index TRA onBloomberg

17

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**ITEM 6. SELECTED FINANCIAL DATA.**

The following selectedfinancial data for 2006, 2005, 2004, 2003 and 2002 is qualified in its entiretyby, and should be read in conjunction with the more detailed informationcontained in, the Consolidated Financial Statements and Notes thereto andManagement’s Discussion and Analysis of Financial Condition and Results ofOperations included elsewhere in this Annual Report on Form 10-K.

Five-YearSelected Financial Data
| **Years Ended December 31,**                                        | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars in thousands, except per share data)**    | ** ** | **2006**       | ** **     | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
| **OPERATING  RESULTS**                                                             |       |           |           |       |       |       |       |       |       |       |       |
| Net interest  income                                                               | ** ** | **$**          | **655,787**    |       | $          | 617,126    |       | $          | 545,781    |       | $          | 472,349 |   | $ | 441,035 |   |
| Net interest  income - taxable equivalent                                          | ** ** | **663,158**    |           | 623,973    |       | 552,525    |       | 479,109    |       | 447,228    |       |
| Provision for  credit losses                                                       | ** ** | **—**     |           | 1,576      |       | 7,221      |       | 12,105     |       | 16,378     |       |
| Noninterest  income                                                                | ** ** | **254,734**    |           | 243,120    |       | 213,929    |       | 183,572    |       | 144,519    |       |
| Noninterest  expense                                                               | ** ** | **457,389**    |           | 420,821    |       | 391,958    |       | 337,447    |       | 272,608    |       |
| Net income                                                                         | ** ** | **288,286**    |           | 276,319    |       | 229,407    |       | 196,814    |       | 190,238    |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| **PER  COMMON SHARE DATA (1)**                                                     |       |           |           |       |       |       |       |       |       |       |       |
| Basic net income                                                                   | ** ** | **$**          | **2.32**       |       | $          | 2.28       |       | $          | 1.93       |       | $          | 1.80 |   | $ | 1.82 |   |
| Diluted net  income                                                                | ** ** | **2.30**       |           | 2.26       |       | 1.92       |       | 1.79       |       | 1.81       |       |
| Dividends paid                                                                     | ** ** | **1.10**       |           | 0.99       |       | 0.92       |       | 0.86       |       | 0.79       |       |
| Book value at  period end                                                          | ** ** | **19.25**      |           | 17.81      |       | 16.12      |       | 15.39      |       | 12.83      |       |
| Market value at  period end                                                        | ** ** | **46.79**      |           | 37.63      |       | 34.80      |       | 30.39      |       | 25.73      |       |
| Market range:                                                                      |       |           |           |       |       |       |       |       |       |       |       |
| High                                                                               | ** ** | **47.39**      |           | 40.09      |       | 35.39      |       | 30.63      |       | 30.24      |       |
| Low                                                                                | ** ** | **34.29**      |           | 32.27      |       | 26.87      |       | 20.11      |       | 21.38      |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| **BALANCE  SHEET DATA AT PERIOD END**                                              |       |           |           |       |       |       |       |       |       |       |       |
| Total loans                                                                        | ** ** | **$**          | **12,792,733** |       | $          | 11,607,845 |       | $          | 10,228,433 |       | $          | 9,272,160 |   | $ | 7,312,027 |   |
| Total investment  securities                                                       | ** ** | **3,123,552**  |           | 3,106,287  |       | 2,928,870  |       | 3,070,645  |       | 2,550,491  |       |
| Total assets                                                                       | ** ** | **17,716,025** |           | 16,421,729 |       | 14,425,690 |       | 13,695,472 |       | 10,790,376 |       |
| Total deposits                                                                     | ** ** | **12,773,891** |           | 12,077,350 |       | 10,799,199 |       | 10,262,553 |       | 8,260,940  |       |
| Shareholders’  equity                                                         | ** ** | **2,417,166**  |           | 2,194,722  |       | 1,917,683  |       | 1,841,441  |       | 1,324,358  |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| **PROFITABILITY  RATIOS**                                                          |       |           |           |       |       |       |       |       |       |       |       |
| Return on average  assets                                                          | ** ** | **1.69**       | **%**          | 1.78       | %          | 1.64       | %          | 1.64       | %          | 1.88       | %          |
| Return on average  equity                                                          | ** ** | **12.31**      |           | 13.18      |       | 12.26      |       | 13.15      |       | 15.12      |       |
| Return on average  tangible equity                                                 | ** ** | **18.40**      |           | 19.54      |       | 18.00      |       | 16.55      |       | 16.69      |       |
| Net interest rate  spread - taxable equivalent                                     | ** ** | **3.48**       |           | 3.88       |       | 3.99       |       | 3.92       |       | 4.05       |       |
| Net interest  margin on earning assets - taxable equivalent                        | ** ** | **4.31**       |           | 4.44       |       | 4.35       |       | 4.32       |       | 4.65       |       |
| Efficiency ratio                                                                   | ** ** | **49.83**      |           | 48.53      |       | 51.14      |       | 50.92      |       | 46.07      |       |
| Cash operating  efficiency ratio                                                   | ** ** | **47.32**      |           | 47.61      |       | 49.63      |       | 49.52      |       | 45.80      |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| **CAPITAL  RATIOS**                                                                |       |           |           |       |       |       |       |       |       |       |       |
| Average equity to  average assets                                                  | ** ** | **13.75**      | **%**          | 13.51      | %          | 13.38      | %          | 12.51      | %          | 12.43      | %          |
| Average tangible  equity to average tangible assets                                | ** ** | **9.82**       |           | 9.70       |       | 9.70       |       | 10.34      |       | 11.45      |       |
| Dividend payout  ratio (1)                                                         | ** ** | **47.41**      |           | 43.42      |       | 47.67      |       | 47.78      |       | 43.41      |       |
| Risk-based  capital:                                                               |       |           |           |       |       |       |       |       |       |       |       |
| Tier 1 capital ratio                                                               | ** ** | **12.02**      |           | 11.82      |       | 12.33      |       | 12.46      |       | 15.00      |       |
| Total capital ratio                                                                | ** ** | **15.31**      |           | 15.37      |       | 16.23      |       | 16.63      |       | 16.29      |       |
| Leverage ratio                                                                     | ** ** | **10.04**      |           | 9.81       |       | 10.02      |       | 9.60       |       | 11.20      |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| Bank offices                                                                       | ** ** | **240**        |           | 240        |       | 226        |       | 227        |       | 185        |       |
| Employees                                                                          | ** ** | **3,544**      |           | 3,606      |       | 3,479      |       | 3,565      |       | 2,885      |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| **CREDIT  QUALITY DATA AT PERIOD END**                                             |       |           |           |       |       |       |       |       |       |       |       |
| Net charge-offs                                                                    | ** ** | **$**          | **815**        |       | $          | 991        |       | $          | 13,556     |       | $          | 8,574 |   | $ | 19,240 |   |
| Nonaccrual loans                                                                   | ** ** | **30,960**     |           | 22,565     |       | 30,898     |       | 50,352     |       | 33,371     |       |
| Other real estate  owned, net                                                      | ** ** | **1,405**      |           | 667        |       | 212        |       | 191        |       | 132        |       |
| Total  nonperforming assets                                                        | ** ** | **32,365**     |           | 23,232     |       | 31,110     |       | 50,543     |       | 33,503     |       |
|                                                                               |       |           |           |       |       |       |       |       |       |       |       |
| **CREDIT  QUALITY RATIOS**                                                         |       |           |           |       |       |       |       |       |       |       |       |
| Net charge-offs  as a percent of period-end loans                                  | ** ** | **0.01**       | **%**          | 0.01       | %          | 0.13       | %          | 0.09       | %          | 0.26       | %          |
| Allowance for  loan losses as a percent of period-end loans                        |       | **1.12**       |           | 1.35       |       | 1.46       |       | 1.68       |       | 1.90       |       |
| Allowance for  loan losses as a percent of nonperforming loans                     |       | **461.98**     |           | 694.32     |       | 482.24     |       | 308.50     |       | 415.33     |       |
| Nonperforming assets as  a percent of period-end loans and other real estate owned |       | **0.25**       |           | 0.20       |       | 0.30       |       | 0.55       |       | 0.46       |       |

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(1)  OnJanuary 10, 2006, Bankshares announced a three-for-two stock split on itscommon stock.  Per share amounts andother applicable information have been adjusted to give effect to the split.

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Five-YearSummary of Consolidated Income
| **Years Ended December 31,**            | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars in thousands)**                   | ** ** | **2006**    | ** **  | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
| INTEREST INCOME                                        |       |        |        |       |       |       |       |       |       |       |       |
| Interest and  fees on loans                            | ** ** | **$**       | **863,563** |       | $          | 700,832    |       | $          | 546,531    |       | $          | 472,943 |   | $ | 468,678 |   |
| Interest on  securities                                | ** ** | **132,115** |        | 112,769    |       | 111,003    |       | 113,254    |       | 112,091    |       |
| Other interest  income                                 | ** ** | **3,044**   |        | 2,436      |       | 1,503      |       | 3,397      |       | 4,848      |       |
| Total interest income                                  | ** ** | **998,722** |        | 816,037    |       | 659,037    |       | 589,594    |       | 585,617    |       |
| INTEREST EXPENSE                                       |       |        |        |       |       |       |       |       |       |       |       |
| Interest on  deposits                                  | ** ** | **251,118** |        | 139,917    |       | 83,403     |       | 93,190     |       | 122,569    |       |
| Interest on  short-term borrowings                     | ** ** | **55,100**  |        | 26,266     |       | 7,844      |       | 5,604      |       | 11,259     |       |
| Interest on  long-term debt                            | ** ** | **36,717**  |        | 32,728     |       | 22,009     |       | 18,451     |       | 10,754     |       |
| Total interest expense                                 | ** ** | **342,935** |        | 198,911    |       | 113,256    |       | 117,245    |       | 144,582    |       |
| NET INTEREST  INCOME                                   | ** ** | **655,787** |        | 617,126    |       | 545,781    |       | 472,349    |       | 441,035    |       |
| Provision for  credit losses                           | ** ** | **—**  |        | 1,576      |       | 7,221      |       | 12,105     |       | 16,378     |       |
| NET INTEREST  INCOME AFTER PROVISION FOR CREDIT LOSSES |       | **655,787** |        | 615,550    |       | 538,560    |       | 460,244    |       | 424,657    |       |
| NONINTEREST  INCOME                                    |       |        |        |       |       |       |       |       |       |       |       |
| Investment and  wealth management                      | ** ** | **110,879** |        | 95,756     |       | 90,050     |       | 78,933     |       | 68,435     |       |
| Service charges  on deposit accounts                   | ** ** | **46,339**  |        | 43,885     |       | 44,263     |       | 39,194     |       | 33,539     |       |
| Other income                                           | ** ** | **97,516**  |        | 103,479    |       | 79,616     |       | 65,445     |       | 42,545     |       |
| Total noninterest income                               | ** ** | **254,734** |        | 243,120    |       | 213,929    |       | 183,572    |       | 144,519    |       |
| NONINTEREST  EXPENSES                                  |       |        |        |       |       |       |       |       |       |       |       |
| Salaries and  employee benefits                        | ** ** | **261,926** |        | 246,397    |       | 232,297    |       | 198,043    |       | 165,371    |       |
| Net occupancy  and equipment expenses                  | ** ** | **66,228**  |        | 60,255     |       | 55,746     |       | 52,366     |       | 40,368     |       |
| Other expenses                                         | ** ** | **129,235** |        | 114,169    |       | 103,915    |       | 87,038     |       | 66,869     |       |
| Total noninterest expenses                             | ** ** | **457,389** |        | 420,821    |       | 391,958    |       | 337,447    |       | 272,608    |       |
| Income before  income taxes                            | ** ** | **453,132** |        | 437,849    |       | 360,531    |       | 306,369    |       | 296,568    |       |
| Provision for  income taxes                            | ** ** | **164,846** |        | 161,530    |       | 131,124    |       | 109,555    |       | 106,330    |       |
| NET INCOME                                             | ** ** | **$**       | **288,286** |       | $          | 276,319    |       | $          | 229,407    |       | $          | 196,814 |   | $ | 190,238 |   |

 

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS.**

I.OVERVIEW

MercantileBankshares Corporation (“Bankshares”) is a regional multibank holding companyheadquartered in Baltimore, Maryland.  AtDecember 31, 2006, Bankshares had $17.7 billion in assets, $12.8 billion inloans and $12.8 billion in deposits.  Itis the largest bank holding company headquartered in the state ofMaryland.  The two principal lines ofbusiness are Banking and Investment & Wealth Management (“IWM”), deliveredthrough the lead bank, Mercantile-Safe Deposit and Trust Company (“MSD&T”),and 10 affiliated banks.  See SegmentReporting in “II. ANALYSIS OF OPERATING RESULTS FOR 2006 TO 2005” in this Item7 for more information.

On October 8, 2006, Bankshares entered into an Agreement and Plan of Merger with The PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshares will merge with and into PNC, with PNC as the surviving corporation in the merger.  When the merger is completed, Bankshares’ stockholders will receive a combination of PNC common stock and cash in exchange for their Bankshares common stock.  Each share of Bankshares common stock will be converted into the right to receive 0.4184 of a share of PNC common stock (including the related preferred stock purchase rights under PNC’s May 2000 Rights Agreement) and $16.45 in cash, without interest.  Under the formula set forth in the merger agreement, an aggregate of up to approximately 54.2 million shares of PNC common stock (and an equal number of related rights) may be issued and $2.13 billion paid in the merger.  This merger was approved by Bankshares’ stockholders on February 27, 2007 and received substantially all of the required regulatory approvals.  The merger is currently expected to close in March of 2007.  Pending the merger, Bankshares must comply with the covenants contained in the merger agreement, but is generally continuing to operate in the ordinary course of business.

During the year ended December 31, 2006, Bankshares expensed $13.1 million, or $9.2 million on an after-tax basis, of costs pursuant to the Merger Agreement with PNC.  These expenses were comprised of $6.8 million of investment banker and legal fees and $6.3 million of compensation-related expenses.

OnJanuary 10, 2006, Bankshares announced a three-for-two stock split on itscommon stock, payable in the form of a stock dividend on January 27, 2006 tostockholders of record as of the close of business on January 20, 2006.  Certain share, average share and per shareamounts have been adjusted to give effect to the split.

Banksharesrecorded its 31st consecutive year of increased net income in 2006.  Net income for Bankshares was $288.3 millionfor the year ended December 31, 2006, compared with $276.3 million for the year2005, representing a 4.3% increase. Diluted net income per common share for 2006 increased by 1.8% to $2.30compared with $2.26 for 2005.

OnJuly 17, 2006, Bankshares completed its acquisition of James Monroe, acommercial bank headquartered in Arlington, Virginia, which was merged intoMSD&T.  The consideration paid toJames Monroe shareholders in connection with the acquisition was comprised of$71.4 million in cash and 1.8 million shares of Bankshares’ common stock.  James Monroe transactions have been includedin Bankshares’ financial results subsequent to July 17, 2006.  The assets and liabilities of James Monroewere recorded on the consolidated balance sheet at their respective fairvalues.  The fair values were determinedas of July 17, 2006.  The transactionresulted in total assets acquired as of July 17, 2006 of $552 million,including $414 million in loans and liabilities assumed of $507 million,including $434 million in deposits. Bankshares recorded $95.4 million of goodwill and $7.8 million of coredeposit intangible (“CDI”).  CDI issubject to amortization and is being amortized on an accelerated basis.

TheBoard of Governors of the Federal Reserve System (“Federal Reserve Board”)increased short-term rates by 100 basis points in 2006 and 200 basis points in2005.  The net interest margin declined13 basis points to 4.31% for 2006 from 4.44% for 2005, which comparesunfavorably with the increase of nine basis points experienced during2005.  The net interest margin for 2004was 4.35%.  The 2006 net interest margindecrease was attributable to a 40 basis point decline in the spread between theyield on earnings assets and the cost of interest-bearing liabilities, whichwas partially offset by a 27 basis point increase in the benefit derived fromnoninterest-bearing sources of funds. Competition to gather deposits increased throughout the year andresulted in higher rates paid on these funds and a flat to inverted yield curveadversely affected the net interest spread. See “Analysis of Interest Rate and Interest Differentials” and thediscussions of “Net Interest Income” and “Interest Rate Risk” found in Item 7of this report.

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AtDecember 31, 2006, loans outstanding were $12.8 billion, an increase of 10.2%over the $11.6 billion outstanding at December 31, 2005.  Construction loans at December 31, 2006 were$2.0 billion, an increase of 25.1% from $1.6 billion at December 31, 2005.  Commercial real estate loans were $4.2billion at December 31, 2006, an increase of 14.5% from $3.7 billion atDecember 31, 2005.  Residential realestate loans grew by 11.7%.

Totaldeposits outstanding were $12.8 billion at December 31, 2006, up 5.8% from$12.1 billion outstanding at December 31, 2005. Average deposit growth was driven primarily by increases in timedeposits $100,000 and over, money market and other time deposits, which were up32.2%, 25.8% and 11.5%, respectively, from the year ended December 31,2005.  The James Monroe acquisitionprovided approximately 45.2% of the deposit growth from the year ended December31, 2005.

Nonperformingloans increased from $22.6 million at December 31, 2005 to $31.0 million atDecember 31, 2006.  Nonperforming loansas a percent of year-end loans were 0.24% at December 31, 2006.  The allowance for loan losses declined by$13.6 million to $143.0 million for the year ended December 31, 2006due to the reclassification of a portion of the allowance for loan losses to areserve for unfunded commitments.

Averageshareholders’ equity to average assets was 13.75% for 2006, an increase from13.51% for 2005.

Bankshares also reports cash operating earnings, definedas “GAAP”(Generally Accepted Accounting Principles) earnings excluding the amortizationof intangible assets associated with purchase accounting for businesscombinations; securities gains and losses; and other significant gains, lossesor expenses (such as those associated with integrating acquired entities’operations into Bankshares and expensesrelated to the PNC merger) unrelated to Bankshares’ core operations. We believe these non-GAAP measures provide information useful toinvestors in understanding our ongoing core business and operationalperformance trends.  These measuresshould not be viewed as a substitute for GAAP. Management believes presentations of financial measures excluding theimpact of certain items provide useful supplemental information and betterreflect its core operating activities. In order to arrive at core business operating results, the effects ofcertain noncore business transactions, such as gains and losses on the sale ofsecurities, amortization of intangibles, restructuring charges andmerger-related expenses, have been excluded. Management reviews these same measures internally.  For instance, the cash operating efficiencyratio, rather than the GAAP basis efficiency ratio, is used to measuremanagement’s success at controlling ongoing, core operating expenses.  We believe these measures are consistent withhow investors and analysts typically evaluate our industry and, by providingthese measures, we facilitate their analysis. Cash operating earnings totaled$302.9 million for 2006, an increase of 8.3% over $279.6 million for 2005.

Additionally,management believes that reporting several key measures based on tangibleassets (total assets less intangible assets) and tangible equity (total equityless intangible assets) is important, as this more closely approximates thebasis for measuring the adequacy of capital for regulatory purposes.  For the year 2006, the return on averagetangible assets was 1.81% compared with 1.89% for 2005.  The ratio of average tangible equity toaverage tangible assets was 9.82% for 2006 and 9.70% for 2005.  See “Reconciliation of Non-GAAP Measures” forthe reconciliation of GAAP measures to non-GAAP measures in the section captioned“II. ANALYSIS OF OPERATING RESULTS FOR 2006 TO 2005” in this Item 7.

Theremaining sections of Management’s Discussion and Analysis of FinancialCondition and Results of Operations will provide a more detailed explanation ofthe important trends and material changes in components of our consolidatedfinancial statements.  The discussionsuggests that sustaining future earnings growth comparable to our experience inpast years will require, among other things, efficient generation of loangrowth in a competitive market, while maintaining an adequate spread betweenyields on earning assets and the cost of funds. Our degree of success in meeting these goals depends on unpredictablefactors such as possible changes in prevailing interest rates, the mix ofdeposits, credit quality and general economic conditions and the impact of themerger with PNC during 2007.  Thisdiscussion and analysis should be read in conjunction with the consolidatedfinancial statements and other financial information presented in this Report.

21

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| NET INCOME                                   |   | DILUTED EARNINGS PER SHARE                        |
|----------------------------------------------|--------|---------------------------------------------------|
| (Dollars in millions)                        |   | (In dollars)                                      |
| Five —Year Compound Growth Rate: 9.7%   |   | Five-Year Compound Growth  Rate:  6.2%       |
| ****                                         |   |                                                   |
|                                         |   |                                              |
|                                         |   |                                              |
| TOTAL ASSETS                                 |   | INTEREST YIELDS AND RATES     |
| (Dollars in millions) December 31,           |   | (Tax-equivalent basis)                            |
| Five-Year Compound Growth Rate:   12.3% |   |                                              |
|                                              |   |                                                   |

 

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**CriticalAccounting Policies**Set forth below is adiscussion of the accounting policies and related estimates that managementbelieves are the most critical to understanding Bankshares’ consolidatedfinancial statements, financial condition and results of operations, and whichrequire complex management judgments, uncertainties and/or estimates.  Information regarding Bankshares’ otheraccounting policies is included in Note No. 1 - Significant Accounting Policiesin Notes to Consolidated Financial Statements.

*InvestmentSecurities*Investment securitiesclassified as “held-to-maturity” are acquired with the intent and ability tohold until maturity and are carried at amortized cost.  Investment securities classified as “available-for-sale”are acquired to be held for indefinite periods and may be sold in response tochanges in interest rates and/or prepayment risk or for liquidity managementpurposes.  These securities are carriedat fair value.  Securities may becomeimpaired on an other-than-temporary basis, which involves a degree ofjudgment.  Therefore, an assessment ismade at the end of each quarter to determine whether there have been any eventsor economic circumstances to indicate that a security is impaired on another-than-temporary basis.  Another-than-temporary impairment may develop if, based on all availableevidence, the carrying amount of the investment is not recoverable within areasonable period.  Factors considered inmaking this assessment include among others, the intent and ability to hold theinvestment for a period sufficient for a recovery in value, external creditratings and recent downgrades, market price fluctuations due to factors otherthan interest rates, and the probability of collection of contractual cashflows.  Securities on which there is anunrealized loss deemed to be other-than-temporary are written down to fairvalue, and the adjustment is recorded as a realized loss.

*Allowancefor Loan Losses and Reserve for Unfunded Commitments*Arriving at anappropriate level of allowance for loan losses and reserve for unfundedcommitments involves a high degree of judgment. Bankshares’ allowance for loan losses and reserve for unfundedcommitments provide for probable losses based on evaluations of inherent risksin the loan portfolio.  The allowance forloan losses and reserve for unfunded commitments are maintained at a levelconsidered by management to be adequate to absorb losses inherent in the loanportfolio as of the date of the consolidated financial statements.  We have developed appropriate policies andprocedures for assessing the adequacy of the allowance for loan losses that reflectmanagement’s careful evaluation of credit risk considering all availableinformation.  Management uses historicalquantitative information to assess the adequacy of the allowance for loanlosses and reserve for unfunded commitments as well as qualitative informationabout the prevailing economic and business environment, among other things. Indeveloping this assessment, management must rely on estimates and exercisejudgment in assigning credit risk. Depending on changing circumstances, future assessments of credit riskmay yield materially different results from the estimates, which may require anincrease or decrease in the allowance for loan losses and reserve for unfundedcommitments.

Weemploy modeling and estimation tools in developing the appropriate allowanceand reserve for unfunded commitments. Bankshares’ allowance consists of formula-based components for businessand retail loans, an allowance for impaired loans and an unallocatedcomponent.  The following provides adescription of each of these components of the allowance, the techniques usedand the estimates and judgments inherent in each.  In the first quarter of 2006, managementrefined the methodologies for the formula-based components to align moreappropriately the allowance methodology with our current framework for analyzingcredit losses.  Formula-based allowancecalculations for business and retail components permit us to addressspecifically the current trends and events affecting the credit risk in theloan portfolio.  The reserve for unfundedcommitments is estimated using the same methodology.

Businessloans are comprised of commercial, commercial real estate and constructionloans, which are evaluated separately for impairment.  For business loans, the formula-basedcomponent of the allowance for loan losses is based on statistical migrationestimates of the average losses observed for business loans classified bycredit grade. Average losses for each credit grade are computed using theannualized historical rate at which loans in each credit grade have defaulted(probability of default rates or “PD”) and the historical average lossesrealized for defaulted loans (loss-given-default or “LGD”).  We have developed default rates by analyzingfour years of our default experience and more than 14 years of comparable externaldata.  Default rates, which are validatedannually, are estimates derived from long-term averages and are not based onshort-term economic or environmental factors. LGD rates have been developed using industry benchmarks.

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

Forboth business and retail loans, the formula-based components include additionalqualitative amounts to establish reasonable ranges that consider observedhistorical variability in losses. Factors we may consider in setting these amounts include, but are notlimited to, industry-specific data, portfolio specific risks or concentrationand macroeconomic conditions. Including these variability components in themodel enables us to capture probable incurred losses that are not yet evidentin current default grades, delinquencies and other credit-risk measurementtools.

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

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

Inthe first quarter of 2006, we reclassified a portion of the allowance for loanlosses to a reserve for unfunded commitments, which is included in the otherliabilities section of the consolidated balance sheet.  The modeling process used in the firstquarter of 2006 for the determination of the reserve for unfunded lendingcommitments is consistent with the process described above for theformula-based component of the allowance for loan losses, also including as akey factor a benchmark average rate at which unfunded exposures have beenfunded at the time of default.  Thedevelopment of this modeling in 2006 enabled Bankshares to evaluatespecifically the risk inherent in unfunded commitments and make thereclassification discussed above.  As nomodel data existed in previous years, prior period data has not beenreclassified for comparability.  Duringthe year ended December 31, 2006, Bankshares reclassified $15.8 million of theallowance for loan losses to the reserve for unfunded commitments.

Fora full discussion of Bankshares’ methodology for assessing the adequacy of theallowance for loan losses, see “Allowance for Loan Losses” found elsewhere inItem 7 and Note No. 1 - Significant Accounting Policies in Notes toConsolidated Financial Statements and Note No. 4 — Loans and Allowance for LoanLosses and Reserve for Unfunded Commitments.

*Loansin Nonaccrual Status or Deemed to Be Impaired*A loan is placed intononaccrual status when the principal or interest payments on any loan (e.g.,commercial, mortgage and construction loans) are past due 90 days or more atthe end of a calendar quarter or the payment in full of principal or interestis not expected.  Any accrued butuncollected interest is reversed at that time. Consumer installment loans are charged off when they become 90 days pastdue at the end of the quarter.  Additionally,a loan may be put on nonaccrual status sooner than 90 days, if in management’sjudgment, the loan or portion thereof is deemed uncollectible.  Bankshares ceases to accrue interest incomeon such loans. Subsequent receipts on nonaccrual loans are recorded as areduction of principal, and interest income is recorded only once principalrecovery is reasonably assured. Generally, a loan may be restored to accrual status when all past dueprincipal, interest and late charges have been paid and the Bank expectsrepayment of the remaining contractual principal and interest.

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A loan is considered impaired, based on currentinformation and events, if it is probable that Bankshares will not collect allprincipal and interest payments according to the contractual terms of the loanagreement.  Impaired loans do not includelarge groups of smaller balance homogeneous loans that are evaluatedcollectively for impairment (e.g., residential mortgages and consumerinstallment loans).  The impairment of aloan is measured based on the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, or the fair value ofthe collateral if the repayment is expected to be provided predominantly by theunderlying collateral.  A majority ofBankshares’ impaired loans aremeasured by reference to the fair value of the collateral.

*IncomeTaxes*Banksharesrecognizes deferred income tax assets and liabilities for the future taxeffects of temporary differences, net operating loss carryovers and tax credits.  Deferred tax assets are subject to management’sjudgment, based on available evidence, that future realization is more likelythan not.  If management determines thatBankshares may be unable to realize all or part of net deferred tax assets inthe future, then Bankshares would be required to record a valuation allowanceagainst such deferred tax asset.  In suchan event, a direct charge to income tax expense may be required to reduce therecorded value of the net deferred tax asset to the expected realizableamount.  For more informationregarding Bankshares’ accounting for income taxes, see Note No. 12 - IncomeTaxes in Notes to Consolidated Financial Statements.

*Valuationof Goodwill/Intangible Assets and Analysis for Impairment*Bankshares has increasedits market share, in part, through the acquisition of entire financialinstitutions accounted for under the purchase method of accounting, as well asfrom the purchase of other financial institutions’ branches (not the entireinstitution). Bankshares is required to record assets acquired and liabilitiesassumed at their fair value, which involves an estimate determined by the useof internal or other valuation techniques. See Note No. 19 - Goodwill and Intangible Assets in Notes toConsolidated Financial Statements for further information on the accounting forgoodwill and other intangible assets.

II.ANALYSIS OF OPERATING RESULTS FOR 2006 TO 2005

##### **Segment Reporting**

Banksharesreports two distinct business segments, Banking Services and Investment &Wealth Management (“IWM”), for which financial information is segregated foruse in assessing performance and allocating resources when reporting to theBoard of Directors.  The Banking Servicessegment consists of the group of 11 affiliate banks and mortgage-bankingactivities.  A schedule disclosing thedetails of these operating segments can be found in Note No. 16 - SegmentReporting in Notes to the Consolidated Financial Statements.  Segment financial information is subjectiveand, unlike financial accounting, is not necessarily based on GAAP.  As a result, financial information of thereporting segments is not necessarily comparable with similar informationreported by others and may not be comparable with Bankshares’ consolidatedresults.  Certain expense amounts, suchas operations overhead, have been reclassified from internal financialreporting in order to provide for proper allocation of costs in the reporteddata.

Inthe fourth quarter of 2005, the Private Banking Group of MSD&T wasconsolidated into the Private Banking Group of IWM which is reflected in thesegment results below.  For loans anddeposits included in the IWM segment, a funds transfer-pricing model wasutilized to match the duration of the funding and investment of the IWM segment’sassets and liabilities.

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*BankingServices*

TheBanking Services segment includes the Retail, Small Business, Commercial andMortgage Banking lines of business. Banking products include:

·                  *RetailBanking*:  Checking, savings and money market accounts,time deposits and IRAs, insurance, equity lines and loans, lines of credit, andequipment and transportation (auto, recreational vehicle and marine) loans.

·                  *SmallBusiness Banking*:  Deposit and credit products and services tobusinesses with annual revenues up to $3.0 million or credit needs up to $750.0thousand, including receivables and inventory financing, equipment leases, andreal estate financing.

·                  *CommercialBanking*:  Commercial deposit, lending and commercialreal estate solutions to businesses typically with annual revenues between $4.0million and $50.0 million, and including commercial loans and lines of credit,letters of credit, asset-based lending, commercial real estate, constructionloans, capital market products and insurance.

·                  *MortgageBanking*:  Commercial, multifamily and residentialmortgage loan origination and servicing.

Thefollowing table presents selected Banking segment information for the threeyears ended December 31, 2006.
| **(Dollars in thousands)** | ** ** | **2006**       | ** **     | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|
| Net interest  income                 | ** ** | **$**          | **642,835**    |       | $          | 609,758    |       | $ | 534,468 |   |
| Provision for  loan losses           | ** ** | **—**     |           | (1,576     | )          | (7,221     | )          |
| Noninterest  income                  | ** ** | **120,017**    |           | 132,154    |       | 114,477    |       |
| Noninterest  expenses                | ** ** | **(352,092**   | **)**          | (341,543   | )          | (318,706   | )          |
| Adjustments                          | ** ** | **25,683**     |           | 17,610     |       | 18,098     |       |
| Income before  income taxes          | ** ** | **436,443**    |           | 416,403    |       | 341,116    |       |
| Income tax  expense                  | ** ** | **(152,899**   | **)**          | (145,044   | )          | (120,253   | )          |
| Net income                           | ** ** | **$**          | **283,544**    |       | $          | 271,359    |       | $ | 220,863 |   |
| Average loans                        | ** ** | **$**          | **11,975,089** |       | $          | 10,876,592 |       | $ | 9,591,510 |   |
| Average earning  assets              | ** ** | **15,309,149** |           | 13,917,161 |       | 12,576,465 |       |
| Average assets                       | ** ** | **16,785,770** |           | 15,235,634 |       | 13,413,992 |       |
| Average deposits                     | ** ** | **12,391,585** |           | 11,444,361 |       | 10,323,349 |       |
| Average equity                       | ** ** | **2,072,102**  |           | 1,891,834  |       | 1,449,355  |       |

 

TheBanking Services segment consists of 11 affiliate banks.  Mortgage banking activities are not viewed asa separate business line due to their insignificant impact on the core businessof Bankshares and, accordingly, are included in the Banking segment.

Inthe third quarter of 2006, Bankshares acquired James Monroe and merged it intothe Mercantile Potomac Division of MSD&T. This acquisition increased our presence in the northern Virginia andWashington, D.C. markets.

TheBanking Services segment, which contributed 83.8% of total revenue, continuedto experience strong loan and deposit growth. The Banking Services segment was the primary beneficiary of the JamesMonroe acquisition.  Net income forBanking Services for 2006 increased 4.5% to $283.5 million from $271.4 millionfor 2005.

TheBanking Services segment operating results improved over 2005, with revenuegrowth of 2.8% and an expense growth of 0.8%. Net interest income for Banking Services increased 5.4% to $642.8million for 2006 from $609.8 million for 2005. The growth in net interest income in 2006 was largely attributable to a10.1% increase in average loans outstanding. See the analysis of net interest income included in the sectioncaptioned “Net Interest Income and Net Interest Margin” included elsewhere inthis document.

Theallowance as a percentage of loans was 1.12% at year-end 2006 compared with1.35% at year-end 2005.  During 2006, wereclassified $15.8 million of the allowance for loan losses to a reserve forunfunded commitments, which is included in the other liabilities section of theconsolidated balance sheet.  Thedevelopment of this modeling in 2006 enabled Bankshares to evaluatespecifically the risk inherent in unfunded commitments and make thisreclassification discussed above.

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Averageloans outstanding increased $1.1 billion, or 10.1%, to $12.0 billion for2006.  The James Monroe acquisitionaccounted for 36.6% of the increase in average loans outstanding.  Construction loans increased 25.7% ascompared with the 2005 average, while commercial real estate increased 13.9%and residential real estate loans increased 8.9%.

Averagedeposits for Banking increased 8.3% to $12.4 billion in 2006. The James Monroeacquisition provided 45.2% of the deposit growth. Year-over-year averagedeposit growth was driven primarily by increases in money market, time deposits$100,000 and over and other time deposits, which were up 25.8%, 32.2% and11.5%, respectively.

Noninterest income decreased $12.1 million to $120.0million from 2005.  Mortgage banking feeswere $8.2 million lower than the prior year due principally to the sale ofColumbia National Real Estate Finance, LLC. Furthermore, gains on sales ofbank-owned premises declined $2.6 million from the year ended December 31,2005.

Noninterest expenses increased $10.5 million over2005 due primarily to operating expenses of $6.2 million from James Monroe and$9.0 million related to a full year of operating expenses from CBNV.  These increases were partially offset by a reduction of $3.3 million in operating expensesresulting from the sale of Columbia National Real Estate Finance, LLC in thethird quarter of 2006.

*Investment & Wealth Management*

IWMincludes Retail Brokerage Services, Private Wealth Management, InstitutionalInvestment Management, Private Banking and Mercantile Funds.  IWM providesa full line of investment products and retirement, tax and estate planningservices. IWM products include:

·                  *Retail Brokerage Services*: Stocks, bonds, proprietary andnonproprietary mutual funds, fixed and variable annuities.

·                  *Private Wealth Management Services*: Proprietary and nonproprietary mutualfunds, proprietary and nonproprietary separate account management, customizedwealth advisory services, defined benefit and defined contribution retirementservices, family office services, individual and institutional trust servicesand custody services.

·                  *Institutional Investment Management*:  Sophisticated investment managementand administrative services for employee retirement plans, profit-sharing plansand endowments.

·                  *Private Banking Services*: Deposits, loans, and mortgages.

·                  *Mercantile Funds*:  Proprietary stock, taxable and nontaxable fixed income, moneymarket mutual funds and registered hedge funds-of-funds.

Thefollowing table presents selected IWM segment information for the three yearsended December 31, 2006.
| **(Dollars in thousands)** | ** ** | **2006**    | ** **  | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|-------------|-------------|----------|------------|----------|------------|
| Net interest  income                 | ** ** | **$**       | **13,394**  |     | $          | 7,819    |       | $ | 10,172 |   |
| Provision for  loan losses           | ** ** | **—**  |        | —   |       | —   |       |
| Noninterest  income                  | ** ** | **111,412** |        | 95,958   |       | 90,516   |       |
| Noninterest  expenses                | ** ** | **(88,567** | **)**       | (72,929  | )          | (69,575  | )          |
| Adjustments                          | ** ** | **(3,616**  | **)**       | (3,885   | )          | (3,603   | )          |
| Income before  income taxes          | ** ** | **32,623**  |        | 26,963   |       | 27,510   |       |
| Income tax  expense                  | ** ** | **(13,049** | **)**       | (10,785  | )          | (11,004  | )          |
| Net income                           | ** ** | **$**       | **19,574**  |     | $          | 16,178   |       | $ | 16,506 |   |
| Average loans                        | ** ** | **$**       | **185,642** |     | $          | 152,572  |       | $ | 127,739 |   |
| Average earning  assets              | ** ** | **185,642** |        | 152,572  |       | 127,739  |       |
| Average assets                       | ** ** | **186,226** |        | 152,941  |       | 127,949  |       |
| Average deposits                     | ** ** | **316,367** |        | 199,159  |       | 175,096  |       |
| Average equity                       | ** ** | **38,997**  |        | 34,354   |       | 31,219   |       |

 

Inthe fourth quarter of 2005, the Private Banking Group of MSD&T wasconsolidated into the Private Banking Group of IWM which is reflected in thesegment results above.    Additionally, as loans and deposits are nowincluded in the IWM segment, a funds transfer-pricing model was utilized tomatch the duration of the funding and investment of the IWM’s segment assetsand liabilities.

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Duringthe second quarter of 2006, Bankshares’ IWM Real Estate Advisory Unitrestructured both its Real Estate Advisory Unit and a major advisoryrelationship within the unit.  As part ofthe restructuring, a new registered investment advisor (“RIA”) was formed andIWM’s direct real estate management activities were placed in the RIA.

Netincome in IWM increased to $19.6 million in 2006 from $16.2 million in 2005 andpre-tax income increased to $32.6 million in 2006 from $27.0 million in2005.  The increase was due primarily to the restructuring of a majorpension advisory relationship in the IWM Real Estate Advisory Unit and growthin average deposits of $117.2 million. Pre-tax income from the Real Estate Advisory Unit increased $3.0 millionover 2005 and net interest income from Private Banking increased $5.6 millionover 2005.  Pretax profit margins, prior to corporate overhead allocation,were 29.0% and 29.7% for 2006 and 2005, respectively.

While equity markets roseduring 2006, a slump in the second quarter was followed by a strong recovery inthe second half of 2006.  The S&P 500 Index ended 2006 at 1,418, up13.6% from 1,248 at the end of 2005. Between December 31, 2005 and December 31,2006, the Dow Jones Industrial Average increased 16.3% to 12,463 and the NASDAQrose 9.5% to 2,415.  The fixed income markets, as measured by the LehmanBrothers US Aggregate Bond Index, were down 1.0% in 2006. Bankshares’investment asset base is relatively balanced between equities (including realestate) and fixed income, cash and other securities.  As of December 31,2006, 43.3% of IWM managed assets were invested in equities, including realestate.  Approximately 37.2% were invested in fixed income securities and19.5% were invested in cash and other.
| ** **                                 | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|
| **Market Indices**                    | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dow Jones  Industrial Average              |       | 12,463                                |       | 10,717 |   | 10,783 |   |
| Year-over-Year %  Change                   |       | 16.3                                  |       | -0.6 |   | 3.1 |   |
| S&P 500  Index-period-end              |       | 1,418                                 |       | 1,248 |   | 1,214 |   |
| Year-over-Year %  Change                   |       | 13.6                                  |       | 2.8 |   | 9.0 |   |
| Nasdaq                                     |       | 2,415                                 |       | 2,205 |   | 2,175 |   |
| Year-over-Year %  Change                   |       | 9.5                                   |       | 1.4 |   | 8.6 |   |
| Lehman Brothers  U.S. Aggregate Bond Index |       | 101.0                                 |       | 101.9 |   | 104.6 |   |
| Year-over-Year % Change                    |       | -1.0                                  |       | -2.5 |   | -1.3 |   |

 

IWMtotal revenues increased $21.0 million, or 20.3%, to $124.8 million in 2006from $103.8 million in 2005. Year-over-year revenue growth exceeded 10.0% in Institutional Management(driven by the restructuring of a major advisory relationship in Bankshares’IWM Real Estate Advisory Unit), the Private Bank, in Hedge Funds and inBrokerage.

PrivateWealth Management benefited from the rise in equity markets during 2006 and afee increase on some accounts at the beginning of 2006.  Net new businesswas down from 2005 driven by higher terminations on small accounts due partlyto the fee increase.

InstitutionalInvestment Management benefited principally from the restructuring of a majorreal estate pension advisory relationship. The impact of this change was to increase revenues $10.2 millionyear-over-year.  Revenue declined in our Boyd Watterson Asset Managementsubsidiary primarily due to lower equity assets under management.  Higherterminations in our institutional business continued to impede non-real-estateinstitutional revenue growth in 2006, evidenced by the loss of a $6.5 billioninstitutional custody account in the third quarter of 2006.

TheMercantile Funds benefited from higher asset flows into the funds, improvedequity markets, and strong performance in the hedge funds-of-funds.  TheMercantile Funds’ assets increased $305 million, or 7.7 %, to $4.3 billion,driven by an 8.7% increase in personal trust assets at December 31, 2006compared with December 31, 2005.

Brokeragecommissions and income benefited from growth in the number of accounts andassets held in accounts. Brokerage assets increased $227 million, or 24%, to$1.2 billion at December 31, 2006 compared with December 31, 2005. In the tableon the following page, Mutual Fund assets and Brokerage assets have beenallocated to Personal and Institutional.

PrivateBanking revenues benefited from $33.1 million in loan growth and $117.2 millionin deposit growth during 2006.

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In2006, noninterest expenses increased 21.4%, or $15.6 million, to $88.6 million,compared with $72.9 million in 2005. The restructuring of a major real estatepension advisory relationship increased expenses by $6.1 million over 2005.
| ** **                                | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| **(Dollars in billions)**       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| *Personal*                                |       |                                       |       |   |   |   |   |
| Assets with  Investment Responsibility    | ** ** | **$**                                      | **9.4**    |   | $ | 8.7 |   | $ | 8.7 |   |
| Assets with No  Investment Responsibility | ** ** | **4.4**                                    |       | 3.8 |   | 3.6 |   |
| Total Personal                            | ** ** | **13.8**                                   |       | 12.5 |   | 12.3 |   |
| *Institutional*                           |       |                                       |       |   |   |   |   |
| Assets with  Investment Responsibility    | ** ** | **11.4**                                   |       | 11.6 |   | 12.2 |   |
| Assets with No  Investment Responsibility | ** ** | **17.8**                                   |       | 22.1 |   | 23.1 |   |
| Total Institutional                       | ** ** | **29.2**                                   |       | 33.7 |   | 35.3 |   |
| *Mutual  Funds Not included Above*        | ** ** | **0.3**                                    |       | 0.3 |   | 0.2 |   |
| *Total*                                   |       |                                       |       |   |   |   |   |
| Assets with  Investment Responsibility    | ** ** | **21.1**                                   |       | 20.6 |   | 21.1 |   |
| Assets with No  Investment Responsibility | ** ** | **22.2**                                   |       | 25.9 |   | 26.7 |   |
| Total Assets  Under Administration        | ** ** | **$**                                      | **43.3**   |   | $ | 46.5 |   | $ | 47.8 |   |

 

AtDecember 31, 2006, assets under administration by IWM were $43.3 billion, adecrease of $3.2 billion, or 6.9%, from the prior year due to the loss of a$6.5 billion institutional custody account in the third quarter of 2006. Bankshares had investment responsibility for $21.1 billion, an increase of $0.5billion, or 2.4%, compared with the prior year.

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Bankshares Earnings Performance

ANALYSIS OF INTEREST RATES AND INTERESTDIFFERENTIALS

Thefollowing table presents the distribution of the average consolidated balancesheets, interest income/expense and yields earned and rates paid.
| ** **                                         | ** ** | **2006**             | ** **     | **2005**                            | ** **  |
|----------------------------------------------------|------------|----------------------|----------------|-------------------------------------|-------------|
| **(Dollars in thousands)**               | ** ** | **Average  Balance** | ** **     | **Income (1)  / Expense** | ** **  | **Yield (1)  / Rate** | ** ** | **Average  Balance** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                     |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| Loans: (2),(4)                                     |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| Commercial                                         | ** ** | **$**                | **2,948,882**  | ** **                          | **$**       | **221,592** | ** ** | **7.51** | **%** | $ | 2,900,598 |   | $ | 186,462 |   | 6.43 | % |
| Commercial real  estate                            | ** ** | **3,922,356**        | ** **     | **277,957**                         | ** **  | **7.09** |   | 3,444,921 |   | 226,356 |   | 6.57 |   |
| Construction                                       | ** ** | **1,851,632**        | ** **     | **152,667**                         | ** **  | **8.24** |   | 1,473,353 |   | 102,484 |   | 6.96 |   |
| Residential real  estate                           | ** ** | **1,918,257**        | ** **     | **119,146**                         | ** **  | **6.21** |   | 1,761,955 |   | 105,312 |   | 5.98 |   |
| Home equity  lines                                 | ** ** | **480,747**          | ** **     | **37,349**                          | ** **  | **7.77** |   | 507,153 |   | 30,692 |   | 6.05 |   |
| Consumer                                           | ** ** | **1,039,138**        | ** **     | **60,254**                          | ** **  | **5.80** |   | 941,571 |   | 54,283 |   | 5.77 |   |
| Total loans                                        | ** ** | **12,161,012**       | ** **     | **868,965**                         | ** **  | **7.15** |   | 11,029,551 |   | 705,589 |   | 6.40 |   |
| Federal funds  sold, et al                         | ** ** | **54,274**           | ** **     | **3,041**                           | ** **  | **5.60** |   | 51,826 |   | 2,434 |   | 4.70 |   |
| Securities: (3)                                    |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| Taxable  securities                                |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| U.S. Treasury  securities                          | ** ** | **418,560**          | ** **     | **16,718**                          | ** **  | **3.99** |   | 494,763 |   | 17,906 |   | 3.62 |   |
| U.S. Government  agencies securities               | ** ** | **963,618**          | ** **     | **36,777**                          | ** **  | **3.82** |   | 922,597 |   | 30,143 |   | 3.27 |   |
| Mortgage-backed  securities                        | ** ** | **1,659,106**        | ** **     | **72,997**                          | ** **  | **4.40** |   | 1,418,144 |   | 59,084 |   | 4.17 |   |
| Other  investments                                 | ** ** | **63,024**           | ** **     | **2,682**                           | ** **  | **4.26** |   | 63,067 |   | 2,497 |   | 3.96 |   |
| Tax-exempt  securities                             |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| States and  political subdivisions                 | ** ** | **78,727**           | ** **     | **4,910**                           | ** **  | **6.24** |   | 87,992 |   | 5,229 |   | 5.94 |   |
| Total securities                                   | ** ** | **3,183,035**        | ** **     | **134,084**                         | ** **  | **4.21** |   | 2,986,563 |   | 114,859 |   | 3.85 |   |
| Interest-bearing  deposits in other banks          | ** ** | **200**              | ** **     | **3**                               | ** **  | **1.53** |   | 197 |   | 2 |   | 1.21 |   |
| Total earning  assets                              | ** ** | **15,398,521**       | ** **     | **1,006,093**                       | ** **  | **6.53** |   | 14,068,137 |   | 822,884 |   | 5.85 |   |
| Cash and due  from banks                           | ** ** | **310,843**          |           |                                |        |   |   | 309,646 |   |   |   |   |   |
| Bank premises  and equipment, net                  | ** ** | **140,659**          |           |                                |        |   |   | 143,177 |   |   |   |   |   |
| Other assets                                       | ** ** | **1,329,592**        |           |                                |        |   |   | 1,154,561 |   |   |   |   |   |
| Less: allowance  for loan losses                   | ** ** | **(147,352**         | **)**          |                                |        |   |   | (154,502 | ) |   |   |   |   |
| Total assets                                       | ** ** | **$**                | **17,032,263** |                                |        |   |   |   | $ | 15,521,019 |   |   |   |   |   |
| Interest-bearing  liabilities                      |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| Deposits:                                          |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| Savings                                            | ** ** | **$**                | **1,246,877**  | ** **                          | **6,339**   | ** ** | **0.51** |   | $ | 1,428,445 |   | 5,545 |   | 0.39 |   |
| Checking plus  interest accounts                   | ** ** | **1,272,953**        | ** **     | **2,655**                           | ** **  | **0.21** |   | 1,399,215 |   | 2,367 |   | 0.17 |   |
| Money market                                       | ** ** | **2,077,613**        | ** **     | **56,967**                          | ** **  | **2.74** |   | 1,651,513 |   | 23,036 |   | 1.39 |   |
| Time deposits  $100,000 and over                   | ** ** | **2,150,857**        | ** **     | **97,801**                          | ** **  | **4.55** |   | 1,627,194 |   | 51,714 |   | 3.18 |   |
| Other time  deposits                               | ** ** | **2,388,767**        | ** **     | **87,356**                          | ** **  | **3.66** |   | 2,142,068 |   | 57,255 |   | 2.67 |   |
| Total  interest-bearing deposits                   | ** ** | **9,137,067**        | ** **     | **251,118**                         | ** **  | **2.75** |   | 8,248,435 |   | 139,917 |   | 1.70 |   |
| Short-term  borrowings                             | ** ** | **1,435,082**        | ** **     | **55,100**                          | ** **  | **3.84** |   | 1,105,988 |   | 26,266 |   | 2.37 |   |
| Long-term debt                                     | ** ** | **682,324**          | ** **     | **36,717**                          | ** **  | **5.38** |   | 749,196 |   | 32,728 |   | 4.37 |   |
| Total  interest-bearing funds                      | ** ** | **11,254,473**       | ** **     | **342,935**                         | ** **  | **3.05** |   | 10,103,619 |   | 198,911 |   | 1.97 |   |
| Noninterest-bearing  deposits                      | ** ** | **3,236,404**        |           |                                |        |   |   | 3,165,320 |   |   |   |   |   |
| Other  liabilities and accrued expenses            | ** ** | **199,289**          |           |                                |        |   |   | 155,663 |   |   |   |   |   |
| Total  liabilities                                 | ** ** | **14,690,166**       |           |                                |        |   |   | 13,424,602 |   |   |   |   |   |
| Shareholders’  equity                         | ** ** | **2,342,097**        |           |                                |        |   |   | 2,096,417 |   |   |   |   |   |
| Total  liabilities & shareholders’ equity | ** ** | **$**                | **17,032,263** |                                |        |   |   |   | $ | 15,521,019 |   |   |   |   |   |
| Net interest  rate spread                          | ** ** | ** **           | ** **     | **$**                               | **663,158** |   | **3.48** | **%** |   |   | $ | 623,973 |   | 3.88 | % |
| Effect of  noninterest-bearing funds               | ** ** | ** **           |           |                                |        | **0.83** |   |   |   |   |   | 0.56 |   |
| Net interest  margin on earning assets             | ** ** | ** **           |           |                                |        | **4.31** | **%** |   |   |   |   | 4.44 | % |
| Tax-equivalent  adjustment included in:            |       |                 |           |                                |        |   |   |   |   |   |   |   |   |
| Loan income                                        | ** ** | ** **           |           | **$**                               | **5,402**   |   |   |   |   |   | $ | 4,757 |   |   |   |
| Investment  securities income                      | ** ** | ** **           |           | **1,969**                           |        |   |   |   |   | 2,090 |   |   |   |
| Total                                              | ** ** | ** **           |           | **$**                               | **7,371**   |   |   |   |   |   | $ | 6,847 |   |   |   |

 

30

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| ** **                                        | ** ** | **2004**             | ** ** | **2003**                            | ** ** |
|---------------------------------------------------|------------|----------------------|------------|-------------------------------------|------------|
| **(Dollars in thousands)**              | ** ** | **Average  Balance** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** | **Average  Balance** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                    |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| Loans: (2),(4)                                    |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| Commercial                                        |       | $                    | 2,725,452  |                                | $          | 145,170 |   | 5.33 | % | $ | 2,478,707 |   | $ | 135,186 |   | 5.45 | % |
| Commercial real estate                            |       | 2,927,968            |       | 173,626                             |       | 5.93 |   | 2,316,627 |   | 142,166 |   | 6.14 |   |
| Construction                                      |       | 1,144,044            |       | 62,508                              |       | 5.46 |   | 929,939 |   | 50,324 |   | 5.41 |   |
| Residential real estate                           |       | 1,643,504            |       | 98,596                              |       | 6.00 |   | 1,350,034 |   | 88,292 |   | 6.54 |   |
| Home equity lines                                 |       | 450,244              |       | 20,222                              |       | 4.49 |   | 311,037 |   | 13,899 |   | 4.47 |   |
| Consumer                                          |       | 828,197              |       | 50,940                              |       | 6.15 |   | 702,638 |   | 47,973 |   | 6.83 |   |
| Total loans                                       |       | 9,719,409            |       | 551,062                             |       | 5.67 |   | 8,088,982 |   | 477,840 |   | 5.91 |   |
| Federal funds sold, et al                         |       | 59,848               |       | 1,501                               |       | 2.51 |   | 250,462 |   | 3,337 |   | 1.33 |   |
| Securities: (3)                                   |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| Taxable securities                                |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury securities                          |       | 741,127              |       | 28,710                              |       | 3.87 |   | 1,021,513 |   | 41,233 |   | 4.04 |   |
| U.S. Government agencies securities               |       | 810,014              |       | 28,554                              |       | 3.53 |   | 709,519 |   | 32,399 |   | 4.57 |   |
| Mortgage-backed securities                        |       | 1,250,947            |       | 48,159                              |       | 3.85 |   | 927,235 |   | 36,135 |   | 3.90 |   |
| Other investments                                 |       | 57,193               |       | 2,389                               |       | 4.18 |   | 20,804 |   | 807 |   | 3.88 |   |
| Tax-exempt securities                             |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| States and political subdivisions                 |       | 94,308               |       | 5,404                               |       | 5.73 |   | 69,888 |   | 4,543 |   | 6.50 |   |
| Total securities                                  |       | 2,953,589            |       | 113,216                             |       | 3.83 |   | 2,748,959 |   | 115,117 |   | 4.19 |   |
| Interest-bearing deposits in other banks          |       | 158                  |       | 2                                   |       | 1.17 |   | 9,085 |   | 60 |   | 0.66 |   |
| Total earning assets                              |       | 12,733,004           |       | 665,781                             |       | 5.23 |   | 11,097,488 |   | 596,354 |   | 5.37 |   |
| Cash and due from banks                           |       | 291,540              |       |                                |       |   |   | 266,173 |   |   |   |   |   |
| Bank premises and equipment, net                  |       | 141,368              |       |                                |       |   |   | 118,071 |   |   |   |   |   |
| Other assets                                      |       | 985,222              |       |                                |       |   |   | 637,461 |   |   |   |   |   |
| Less: allowance for loan losses                   |       | (158,163             | )          |                                |       |   |   | (147,612 | ) |   |   |   |   |
| Total assets                                      |       | $                    | 13,992,971 |                                |       |   |   |   | $ | 11,971,581 |   |   |   |   |   |
| Interest-bearing  liabilities                     |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| Deposits:                                         |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| Savings                                           |       | $                    | 1,425,423  |                                | 4,197      |   | 0.29 |   | $ | 1,168,074 |   | 4,702 |   | 0.40 |   |
| Checking plus interest accounts                   |       | 1,289,295            |       | 1,899                               |       | 0.15 |   | 1,071,877 |   | 2,061 |   | 0.19 |   |
| Money market                                      |       | 1,571,462            |       | 9,584                               |       | 0.61 |   | 1,357,234 |   | 9,757 |   | 0.72 |   |
| Time deposits $100,000 and over                   |       | 1,314,423            |       | 26,101                              |       | 1.99 |   | 1,272,327 |   | 29,464 |   | 2.32 |   |
| Other time deposits                               |       | 1,933,799            |       | 41,622                              |       | 2.15 |   | 1,852,622 |   | 47,206 |   | 2.55 |   |
| Total interest-bearing deposits                   |       | 7,534,402            |       | 83,403                              |       | 1.11 |   | 6,722,134 |   | 93,190 |   | 1.39 |   |
| Short-term borrowings                             |       | 932,493              |       | 7,844                               |       | 0.84 |   | 851,348 |   | 5,604 |   | 0.66 |   |
| Long-term debt                                    |       | 645,375              |       | 22,009                              |       | 3.41 |   | 517,386 |   | 18,451 |   | 3.57 |   |
| Total interest-bearing funds                      |       | 9,112,270            |       | 113,256                             |       | 1.24 |   | 8,090,868 |   | 117,245 |   | 1.45 |   |
| Noninterest-bearing deposits                      |       | 2,879,290            |       |                                |       |   |   | 2,269,720 |   |   |   |   |   |
| Other liabilities and accrued expenses            |       | 129,741              |       |                                |       |   |   | 113,848 |   |   |   |   |   |
| Total liabilities                                 |       | 12,121,301           |       |                                |       |   |   | 10,474,436 |   |   |   |   |   |
| Shareholders’ equity                         |       | 1,871,670            |       |                                |       |   |   | 1,497,145 |   |   |   |   |   |
| Total liabilities & shareholders’ equity |       | $                    | 13,992,971 |                                |       |   |   |   | $ | 11,971,581 |   |   |   |   |   |
| Net interest rate spread                          |       |                 |       | $                                   | 552,525    |   | 3.99 | % |   |   | $ | 479,109 |   | 3.92 | % |
| Effect of noninterest-bearing funds               |       |                 |       |                                |       | 0.36 |   |   |   |   |   | 0.40 |   |
| Net interest margin on earning assets             |       |                 |       |                                |       | 4.35 | % |   |   |   |   | 4.32 | % |
| Tax-equivalent  adjustment included in:           |       |                 |       |                                |       |   |   |   |   |   |   |   |   |
| Loan income                                       |       |                 |       | $                                   | 4,531      |   |   |   |   |   | $ | 4,897 |   |   |   |
| Investment securities income                      |       |                 |       | 2,213                               |       |   |   |   |   | 1,863 |   |   |   |
| Total                                             |       |                 |       | $                                   | 6,744      |   |   |   |   |   | $ | 6,760 |   |   |   |

 

31

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| ** **                                        | ** ** | **2002**             | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| **(Dollars in thousands)**              | ** ** | **Average  Balance** | ** ** | **Income (1)  / Expense** | ** ** | **Yield (1)  / Rate** | ** ** |
| Earning assets                                    |       |                 |       |   |   |   |   |
| Loans: (2),(4)                                    |       |                 |       |   |   |   |   |
| Commercial                                        |       | $                    | 2,367,328  |   | $ | 148,380 |   | 6.27 | % |
| Commercial real estate                            |       | 1,915,994            |       | 130,995 |   | 6.84 |   |
| Construction                                      |       | 733,237              |       | 44,667 |   | 6.09 |   |
| Residential real estate                           |       | 1,247,859            |       | 91,592 |   | 7.34 |   |
| Home equity lines                                 |       | 215,411              |       | 11,122 |   | 5.16 |   |
| Consumer                                          |       | 609,015              |       | 46,744 |   | 7.68 |   |
| Total loans                                       |       | 7,088,844            |       | 473,500 |   | 6.68 |   |
| Federal funds sold, et al                         |       | 178,624              |       | 4,833 |   | 2.71 |   |
| Securities: (3)                                   |       |                 |       |   |   |   |   |
| Taxable securities                                |       |                 |       |   |   |   |   |
| U.S. Treasury securities                          |       | 1,478,387            |       | 67,531 |   | 4.57 |   |
| U.S. Government agencies securities               |       | 610,617              |       | 30,072 |   | 4.92 |   |
| Mortgage-backed securities                        |       | 216,391              |       | 12,096 |   | 5.59 |   |
| Other investments                                 |       | 9,131                |       | 628 |   | 6.88 |   |
| Tax-exempt securities                             |       |                 |       |   |   |   |   |
| States and political subdivisions                 |       | 38,799               |       | 3,135 |   | 8.08 |   |
| Total securities                                  |       | 2,353,325            |       | 113,462 |   | 4.82 |   |
| Interest-bearing deposits in other banks          |       | 358                  |       | 15 |   | 4.12 |   |
| Total earning assets                              |       | 9,621,151            |       | 591,810 |   | 6.15 |   |
| Cash and due from banks                           |       | 227,034              |       |   |   |   |   |
| Bank premises and equipment, net                  |       | 101,660              |       |   |   |   |   |
| Other assets                                      |       | 314,511              |       |   |   |   |   |
| Less: allowance for loan losses                   |       | (140,899             | )          |   |   |   |   |
| Total assets                                      |       | $                    | 10,123,457 |   |   |   |   |   |
| Interest-bearing  liabilities                     |       |                 |       |   |   |   |   |
| Deposits:                                         |       |                 |       |   |   |   |   |
| Savings                                           |       | $                    | 966,283    |   | 8,405 |   | 0.87 |   |
| Checking plus interest accounts                   |       | 873,497              |       | 2,908 |   | 0.33 |   |
| Money market                                      |       | 1,096,417            |       | 14,223 |   | 1.30 |   |
| Time deposits $100,000 and over                   |       | 1,080,347            |       | 34,671 |   | 3.21 |   |
| Other time deposits                               |       | 1,759,160            |       | 62,362 |   | 3.54 |   |
| Total interest-bearing deposits                   |       | 5,775,704            |       | 122,569 |   | 2.12 |   |
| Short-term borrowings                             |       | 845,938              |       | 11,259 |   | 1.33 |   |
| Long-term debt                                    |       | 279,471              |       | 10,754 |   | 3.85 |   |
| Total interest-bearing funds                      |       | 6,901,113            |       | 144,582 |   | 2.10 |   |
| Noninterest-bearing deposits                      |       | 1,856,706            |       |   |   |   |   |
| Other liabilities and accrued expenses            |       | 107,671              |       |   |   |   |   |
| Total liabilities                                 |       | 8,865,490            |       |   |   |   |   |
| Shareholders’ equity                         |       | 1,257,967            |       |   |   |   |   |
| Total liabilities & shareholders’ equity |       | $                    | 10,123,457 |   |   |   |   |   |
| Net interest rate spread                          |       |                 |       | $ | 447,228 |   | 4.05 | % |
| Effect of noninterest-bearing funds               |       |                 |       |   |   | 0.60 |   |
| Net interest margin on earning assets             |       |                 |       |   |   | 4.65 | % |
| Tax-equivalent  adjustment included in:           |       |                 |       |   |   |   |   |
| Loan income                                       |       |                 |       | $ | 4,822 |   |   |   |
| Investment securities income                      |       |                 |       | 1,371 |   |   |   |
| Total                                             |       |                 |       | $ | 6,193 |   |   |   |

----

(1) Presented on a tax-equivalent basis usingthe statutory federal corporate income tax rate of 35%.  See “Reconciliation of Non-GAAP Measures.”

(2) Nonaccrual loans are included in therespective average loan balances.

(3) Average investment securities are reportedat amortized cost and exclude unrealized gains (losses) on securitiesavailable-for-sale.

(4) Loan fees of $1.5 million, $12.4 million,$11.1 million, $9.3 million and $9.7 million for 2006, 2005, 2004, 2003 and2002, respectively, are included for rate calculation purposes. Loan feesdecreased in 2006 due primarily to increased amortization of deferred loanorigination costs.

 

32

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**NetInterest Income and Net Interest Margin**Net interest incomerepresents the largest source of Bankshares’ revenue.  Changes in both the level of interest ratesand the amount and composition of interest-earning assets and interest-bearingliabilities affect it.  Interest raterisk represents one of the more significant risks facing financial institutionslike Bankshares.  See additionaldiscussion under the caption “Interest Rate Risk” in section “III. ANALYSIS OFFINANCIAL CONDITION.”  It is measured interms of the effect changes in market interest rates have on net interestincome.  Bankshares is slightly assetsensitive, with assets repricing more quickly than liabilities in response tochanges in interest rates.  In a risingrate environment, Bankshares’ net interest margin (net interest incomeexpressed as a percent of average earning assets) generally expands, causingthe growth in net interest income to accelerate.  Net interest income, on a fullytax-equivalent basis, was $663.2 million for 2006.  This represents an increase of 6.3%, or $39.2million, over the prior year’s $624.0 million. In 2005, fully tax-equivalent net interest income increased by $71.4million, or 12.9%, over 2004.  Aspreviously noted, net interest income is affected by changes in the volume ofearning assets and the net interest margin earned thereon.  The “Rate/Volume Analysis” table presentsfurther details supporting this discussion.

The net interest margindecreased 13 basis points in 2006 to 4.31% from 4.44% in 2005.  The decrease was attributable to a 40 basispoint decline in the net interest spread, which was partially offset by a 27basis point increase in the benefit derived from noninterest bearing sources offunds.  The decline was due primarily togrowth in premium money market accounts and certificates of deposit ascustomers shifted to these higher rate products; increased competitionaffecting yields on new loans and the overall yield on interest earning assetslagging the increase in funding costs. Bankshares paid an average rate of 2.75% on interest-bearing depositsduring 2006, an increase of 105 basis points over 2005.  By contrast, the yield on average loans andinvestments increased by 75 basis points and 36 basis points, respectively,from 2005.

Averageearning assets increased by $1.3 billion, or 9.5%, in 2006, due primarily tothe acquisition of James Monroe.  Averagetotal loans grew $1.1 billion, or 10.3%, during 2006, compared with an increaseof $1.3 billion, or 13.5%, in 2005. Average securities, the other major component of earning assets,increased by $196.5 million, or 6.6%, in 2006 compared with an increase of$33.0 million, or 1.1%, in the prior year. See the following section “III. ANALYSIS OF FINANCIAL CONDITION” for amore in-depth discussion of balance sheet trends.  The overall growth in average earning assetsadded $51.9 million to net interest income in 2006.

During2006, the Federal Reserve Board raised rates four times, for a total increaseof 100 basis points and the yield curve flattened dramatically.  As of December 31, 2006, it is unclear whatthe direction of interest rates will be in 2007.  The Federal Reserve has left rates unchangedsince June 2006 and has stated a bias toward further rate increases in thefuture if growth is stronger than expected. Given the current rate environment, the inversion of the yield curve andthe competitive pressure on both loan and deposit pricing, we anticipate thatthe net interest margin will remain under pressure well into next year.  Management believes that Bankshares’ balancesheet is relatively well positioned with respect to Federal Reserve Boardinterest rate changes; however, competition for loans and deposits is expectedto remain intense.  For additionalinformation regarding interest rate sensitivity, see the discussion in the “InterestRate Risk” section in “III. ANALYSIS OF FINANCIAL CONDITION.”

33

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| SOURCES OF INCOME      |   |   |   |   |   | SOURCES OF INCOME     |   |   |   |   |
|------------------------|--------|--------|--------|--------|--------|-----------------------|--------|--------|--------|--------|
| (Dollars in  millions) |   |   |   |   |   | (Dollars in millions) |   |   |   |   |
|                   |   |   |   |   |   |                  |   |   |   |   |
|                   |   |   |   |   |   |                  |   |   |   |   |
|                        |   |        |

 

34

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RATE/VOLUMEANALYSIS

Arate/volume analysis, which demonstrates changes in tax-equivalent interestincome and expense for significant assets and liabilities, appears below.  The calculation of rate and volume variancesis based on a procedure established for banks by the Securities and ExchangeCommission.
| ** **                                | ** ** | **For the year ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                | ** ** | **2006 vs. 2005**                                  | ** ** | **2005 vs. 2004** | ** ** |
| ** **                                | ** ** | **Due to variances in**                       | ** ** | **Due to variances in** | ** ** |
| **(Dollars in thousands)**      | ** ** | **Total**                                                    | ** ** | **Rates (5),(6)** | ** ** | **Volumes (5),(6)** | ** ** | **Total** | ** ** | **Rates (5),(6)** | ** ** | **Volumes (5),(6)** | ** ** |
| Interest earned on:                       |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Loans:                                    |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Commercial (1)                            |       | $                                                            | 35,130     |   | $ | 31,502 |   | $ | 3,628 |   | $ | 41,292 |   | $ | 30,033 |   | $ | 11,259 |   |
| Commercial real  estate (2)               |       | 51,601                                                       |       | 17,768 |   | 33,833 |   | 52,730 |   | 18,762 |   | 33,968 |   |
| Construction (3)                          |       | 50,183                                                       |       | 18,994 |   | 31,189 |   | 39,976 |   | 17,070 |   | 22,906 |   |
| Residential real  estate                  |       | 13,834                                                       |       | 4,126 |   | 9,708 |   | 6,716 |   | (364 | ) | 7,080 |   |
| Home equity  lines                        |       | 6,657                                                        |       | 8,708 |   | (2,051 | ) | 10,470 |   | 7,026 |   | 3,444 |   |
| Consumer                                  |       | 5,971                                                        |       | 314 |   | 5,657 |   | 3,343 |   | (3,193 | ) | 6,536 |   |
| Taxable  securities                       |       | 19,544                                                       |       | 11,047 |   | 8,497 |   | 1,818 |   | 332 |   | 1,486 |   |
| Tax-exempt  securities (4)                |       | (319                                                         | )          | 259 |   | (578 | ) | (175 |   | 200 |   | (375 | ) |
| Federal funds  sold, et al                |       | 607                                                          |       | 470 |   | 137 |   | 933 |   | 1,310 |   | (377 | ) |
| Interest-bearing  deposits in other banks |       | 1                                                            |       | 1 |   | — |   | — |   | — |   | — |   |
| Total interest  income                    |       | 183,209                                                      |       | 96,286 |   | 86,923 |   | 157,103 |   | 79,007 |   | 78,096 |   |
|                                      |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest paid on:                         |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Savings deposits                          |       | 794                                                          |       | 1,717 |   | (923 | ) | 1,348 |   | 1,336 |   | 12 |   |
| Checking plus  interest deposits          |       | 288                                                          |       | 551 |   | (263 | ) | 468 |   | 282 |   | 186 |   |
| Money market  accounts                    |       | 33,931                                                       |       | 22,248 |   | 11,683 |   | 13,452 |   | 12,335 |   | 1,117 |   |
| Time deposits  $100,000 and over          |       | 46,087                                                       |       | 22,276 |   | 23,811 |   | 25,613 |   | 15,673 |   | 9,940 |   |
| Other time  deposits                      |       | 30,101                                                       |       | 21,079 |   | 9,022 |   | 15,633 |   | 10,066 |   | 5,567 |   |
| Short-term  borrowings                    |       | 28,834                                                       |       | 16,198 |   | 12,636 |   | 18,422 |   | 14,302 |   | 4,120 |   |
| Long-term debt                            |       | 3,989                                                        |       | 7,587 |   | (3,598 | ) | 10,719 |   | 6,184 |   | 4,535 |   |
| Total interest  expense                   |       | 144,024                                                      |       | 108,956 |   | 35,068 |   | 85,655 |   | 66,138 |   | 19,517 |   |
| Net interest earned                       |       | $                                                            | 39,185     |   | $ | (12,670 | ) | $ | 51,855 |   | $ | 71,448 |   | $ | 12,869 |   | $ | 58,579 |   |

 

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(1)Tax-equivalent adjustments of $3.2 million for 2006 and $3.1 million for 2005and 2004 are included in the calculation of commercial loan rate variances.

(2) Tax-equivalent adjustments of $0.9million for 2006, $0.6 million for 2005 and $0.5 million for 2004 are includedin the calculation of commercial real estate loan rate variances.

(3) Tax-equivalent adjustments of $1.3million for 2006, $1.0 million for 2005 and $0.9 million for 2004 are includedin the calculation of construction loan rate variances.

(4) Tax-equivalent adjustments of $1.9million for 2006, $2.1 million for 2005 and $2.2 million for 2004 are includedin the calculation of investment securities rate variances.

(5) Changes attributable to mix (rate andvolume) are included in the volume variance.

(6) Categories do not add due to the effectof changes in product mix.

35

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**Interest Income**Fully tax-equivalentinterest income amounted to $1.0 billion in 2006, an increase of $183.2million, or 22.3%, from $822.9 million in 2005. This compares favorably with the $157.1 million, or 19.1%, increase in2005 from 2004.  The increase in 2006 wasdue to a 68 basis point improvement in the yield on interest earning assets and$1.3 billion in additional loans and securities outstanding, which contributed$163.4 million and $19.2 million, respectively, in additional interestincome.  During 2005, the increase wasdue to growth in average loans and securities that contributed $85.9 million,and an increase in market interest rates, that resulted in a $71.2 millionincrease from the higher yield on interest-earning assets.

AtDecember 31, 2006, the prime rate was 8.25%, compared with 7.25% and 5.25% atyear-end 2005 and 2004, respectively. The average prime rate was 7.96% for 2006, compared with 6.19% for 2005,an increase of 177 basis points.  Theyield on average total loans in 2006 was 7.15%, a 75 basis point increase from6.40% in 2005.  The commercial,construction and home-equity loan portfolios are the most sensitive to changesin short-term interest rates.  Theaverage yield on the construction and home-equity loan portfolios increased 128basis points and 172 basis points, respectively, while the commercial loanportfolio yield increased 108 basis points over 2005.

Thecommercial real estate loan portfolio includes both fixed and variable-rateloans and the average portfolio yield increased 52 basis points.  The residential real estate and consumer loanportfolios are affected mostly by intermediate and long-term rates and do notmove with the prime rate.  The yields onthe consumer loan portfolio and the residential real estate portfoliosincreased by 3 basis points and 23 basis points, respectively.

Theyield on investment securities increased 36 basis points to 4.21% in 2006 from3.85% in 2005.  The yield on theportfolio increased two basis points in 2005 from 3.83% in 2004.  The investment portfolio was particularlyaffected by the flat yield curve. Securities are typically purchased in two-year to five-yearmaturities.  Market rates for two-year tofive-year terms only increased 22 to 30 basis points at December 31, 2006compared to the previous year.  During2006, Bankshares continued to follow a strategy to diversify the portfolio to amix of U.S. Treasury, U.S. Government agencies and mortgage-backedsecurities.  This has resulted in a mixof 13.2%, 30.3% and 52.1% of Treasury, agency and mortgage-backed securities,respectively, in 2006.  The other 4.4% ofthe investment securities was comprised of 2.4% municipals and 2.0% otherinvestments for 2006.

**InterestExpense**Total interestexpense in 2006 was $342.9 million, an increase of $144.0 million, or 72.4%,from $198.9 million in 2005.  Theincrease in interest expense for 2006 was attributable to an increase in therate paid on total interest-bearing funds of 108 basis points and an 11.4%growth in average balances.  Totalinterest expense in 2005 was $85.7 million greater than the $113.3 millionreported in 2004.  With the expectationthat the yield curve will remain flat to inverted in 2007, we anticipatedeposit customers will continue to migrate to short-term, high-yielding depositproducts.  See management’s discussionunder “Interest Rate Risk” in “III. ANALYSIS OF FINANCIAL CONDITION” forfurther information regarding Bankshares’ exposure to changes in interestrates.

Therate paid on total average interest-bearing deposits was 2.75% in 2006, anincrease of 105 basis points from 1.70% in 2005.  The rate paid on savings, checking plusinterest and money market accounts increased 12 basis points, 4 basis pointsand 135 basis points, respectively.  Timedeposits of $100,000 and over increased 137 basis points, while the rate paidon other time deposits increased 99 basis points in 2006.

Themost interest rate sensitive source of funds is short-term borrowings.  This category is comprised of federal fundspurchased, securities sold under agreements to repurchase and commercialpaper.  The duration of these funds isvery short, with most repricing daily. Reflecting the rate environment, the rate paid on short-term borrowingsincreased 147 basis points to 3.84% in 2006, after having increased by 153basis points in 2005 to 2.37%.  The ratepaid on long-term debt increased 101 basis points in 2006, following anincrease of 96 basis points in the prior year. The increase is related primarily to the increase in interest rate swapcosts on Bankshares’ long-term debt.  The$200.0 million of 10-year debt issued by MSD&T in the fourth quarter of2001, issued at a fixed rate of 5.70%, was converted to a floating rate throughan interest rate swap.  The notes repricequarterly and carried an effective cost of 6.02% during 2006 versus 4.24% in2005.  Additionally, Bankshares issued$300.0 million of subordinated debt in April 2003.  The notes were issued at a fixed rate of4.63%.  Subsequently, $150.0 million ofthis debt was converted to a floating rate through interest rate swaps.  The effect of the swaps increased the cost onthe $300.0 million debt to 5.30% during 2006 versus 4.37% in 2005.  Additionally, approximately $17.6 million inTrust Preferred Securities were acquired as part of the James Monroeacquisition at an average rate of 6.34%, which contributed to the increase.

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NONINTERESTINCOME

Aschedule of noninterest income over the past three years is presented below:
| ** **                            | ** ** | **Year ended December 31,** | ** **  | **% Change** | ** ** |
|---------------------------------------|------------|--------------------------------------------|-------------|-------------------|------------|
| **(Dollars in thousands)**  | ** ** | **2006**                                   | ** **  | **2005**          | ** ** | **2004** | ** ** | **2006/2005** | ** ** | **2005/2004** | ** ** |
| Investment and wealth  management     | ** ** | **$**                                      | **110,879** |              | $          | 95,756 |   | $ | 90,050 |   | 15.8 | % | 6.3 | % |
| Service charges on  deposit accounts  | ** ** | **46,339**                                 |        | 43,885            |       | 44,263 |   | 5.6 |   | (0.9 | ) |
| Mortgage  banking-related fees        | ** ** | **6,786**                                  |        | 15,019            |       | 11,495 |   | (54.8 | ) | 30.7 |   |
| Net investment  securities gains      | ** ** | **212**                                    |        | 405               |       | 1,239 |   | (47.7 | ) | (67.3 | ) |
| Nonmarketable  investments:           | ** ** | ** **                                 |        |              |       |   |   |   |   |   |   |
| Private equity and  other investments |       | **10,404**                                 | ** **  | 10,379            |       | 2,569 |   | 0.2 |   | 304.0 |   |
| Hedge funds                           |       | **6,241**                                  | ** **  | 4,720             |       | 5,529 |   | 32.2 |   | (14.6 | ) |
| Bank-owned life  insurance            |       | **6,875**                                  | ** **  | 4,783             |       | 3,324 |   | 43.7 |   | 43.9 |   |
| Total  nonmarketable investments      |       | **23,520**                                 |        | 19,882            |       | 11,422 |   | 18.3 |   | 74.1 |   |
| Other income:                         | ** ** | ** **                                 |        |              |       |   |   |   |   |   |   |
| Electronic  banking fees              |       | **25,696**                                 | ** **  | 23,969            |       | 21,766 |   | 7.2 |   | 10.1 |   |
| Charges and fees on  loans            |       | **11,988**                                 | ** **  | 12,664            |       | 10,833 |   | (5.3 | ) | 16.9 |   |
| Insurance                             |       | **16,039**                                 | ** **  | 15,017            |       | 13,358 |   | 6.8 |   | 12.4 |   |
| All other income                      |       | **13,275**                                 | ** **  | 16,523            |       | 9,503 |   | (19.7 | ) | 73.9 |   |
| Total other income                    |       | **66,998**                                 |        | 68,173            |       | 55,460 |   | (1.7 | ) | 22.9 |   |
| Total                                 |       | **$**                                      | **254,734** |              | $          | 243,120 |   | $ | 213,929 | ** ** | 4.8 |   | 13.6 |   |

 

##### **NoninterestIncome**Noninterest income for 2006 increased by $11.6million, or 4.8%, to $254.7 million from $243.1 million for 2005.  The table above shows the major components ofnoninterest income.  IWM revenue includespersonal and institutional fee income related primarily to trust, brokerage andcustody services.  IWM revenuerepresented the largest source of noninterest income at 43.5%.  Revenues increased 15.8% to $110.9 million in2006.  Growth in IWM revenue was dueprincipally to stronger equity markets, growth in Private Banking, increasedbrokerage activity, stronger performance in the hedge funds-of-funds (“hedgefunds”) and the restructuring of a major advisory relationship resulting in theformation of Mercantile Real Estate Advisors, Inc.  The restructuring of this relationshipresulted in increased real estate pension fees of $10.7 million in 2006 over2005.  See the preceding discussion in “SegmentReporting” for additional information relating to IWM.

Service charges on depositaccounts increased $2.5 million over 2005 due primarily to increases inbusiness overdraft fees.  Mortgagebanking-related fees were $8.2 million lower than the prior year dueprincipally to the sale of Columbia National Real Estate Finance, LLC.

Nonmarketable investment incomerepresents revenues derived from investing in private equities, hedge funds,Federal Reserve Bank and Federal Home Loan Bank securities acquired to meetvarious regulatory requirements and bank-owned life insurance (“BOLI”).  In 2006, nonmarketable investment incomeincreased $3.6 million, or 18.3%, over 2005 as a result of a $1.5 millionincrease in hedge funds revenue and higher income from bank-owned lifeinsurance.  The increase in BOLI revenuewas due to a full year of earnings from an investment of an additional $50million made in the third quarter of 2005.

Other income includes severalcategories.  Electronic banking feesconsist of merchant card processing fees, foreign ATM fees and check cardfees.  These fees increased by $1.7million, or 7.2%, from 2005 due to higher volumes.  Insurance revenues increased $1.0 million andare derived from fee income related to the sale and servicing of insuranceproducts.  All other income decreased$3.2 million from the prior year due primarily to gains on sales of bank-ownedpremises of $1.7 million for 2006, compared with $4.3 million for the year2005.

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NONINTEREST EXPENSES

Aschedule of noninterest expenses over the past three years is presented below.
| ** **                              | ** ** | **Year ended December 31,** | ** **  | **% Change** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|-------------|-------------------|------------|
| **(Dollars in thousands)**    | ** ** | **2006**                                   | ** **  | **2005**          | ** ** | **2004** | ** ** | **2006/2005** | ** ** | **2005/2004** | ** ** |
| Salaries                                | ** ** | **$**                                      | **205,826** |              | $          | 200,222 |   | $ | 187,621 |   | 2.8 | % | 6.7 | % |
| Employee benefits                       | ** ** | **56,100**                                 |        | 46,175            |       | 44,676 |   | 21.5 |   | 3.4 |   |
| Net occupancy expense  of bank premises | ** ** | **32,783**                                 |        | 28,596            |       | 24,307 |   | 14.6 |   | 17.6 |   |
| Furniture and equipment  expenses       | ** ** | **33,445**                                 |        | 31,659            |       | 31,439 |   | 5.6 |   | 0.7 |   |
| Communications and  supplies            | ** ** | **16,034**                                 |        | 16,406            |       | 16,904 |   | (2.3 | ) | (2.9 | ) |
| Professional services                   | ** ** | **31,483**                                 |        | 21,914            |       | 25,302 |   | 43.7 |   | (13.4 | ) |
| Advertising and  promotional expenses   | ** ** | **11,663**                                 |        | 9,103             |       | 8,418 |   | 28.1 |   | 8.1 |   |
| Other expenses:                         | ** ** | ** **                                 |        |              |       |   |   |   |   |   |   |
| Electronic  banking expenses            | ** ** | **14,073**                                 |        | 13,946            |       | 11,509 |   | 0.9 |   | 21.2 |   |
| Amortization of  intangible assets      | ** ** | **9,901**                                  |        | 8,773             |       | 8,142 |   | 12.9 |   | 7.7 |   |
| Outsourcing  expenses                   | ** ** | **11,062**                                 |        | 11,231            |       | 5,342 |   | (1.5 | ) | 110.2 |   |
| All other  expenses                     | ** ** | **35,019**                                 |        | 32,796            |       | 28,298 |   | 6.8 |   | 15.9 |   |
| Total other  expenses                   | ** ** | **70,055**                                 |        | 66,746            |       | 53,291 |   | 5.0 |   | 25.2 |   |
| Total                                   | ** ** | **$**                                      | **457,389** |              | $          | 420,822 |   | $ | 391,958 |   | 8.7 |   | 7.4 |   |

 

**NoninterestExpenses**Noninterest expensesincreased $36.6 million, or 8.7%, from 2005. The table above shows the major components of noninterest expenses.  The principal reasons for the year-over-yearincrease were expenses of $13.4 million related to the James Monroe acquisitionand the pending merger with PNC.  Excluding the $13.4 million of PNC and JamesMonroe merger-related expenses, noninterest expenses increased $23.2 millionfrom the prior year.  This increase wascomprised of $15.3 million in merit and staffing expenses; $6.1 million instock-based compensation; $0.6 million in directors’ fees; and $9.9 million inemployee benefits, due primarily to increased pension costs of $5.7 million andhigher health insurance expenses of $2.6 million.  Net occupancy expenses of bank premisesincreased $4.2 million due primarily to increased rent expenses and furnitureand equipment expenses increased $1.8 million. Also contributing to the overall increase in noninterest expenses were$2.8 million in professional fees, $2.6 million in promotional fees and a $2.1million increase in tax and licensing fees related to the restructuring of areal estate pension advisory relationship. These increases were partially offset by a reduction of $15.9 million insalaries expense due to an increase in the amount of loan origination costsdeferred and an $8.7 million decrease in incentive compensation.  Included in the $23.2 million increase innoninterest expenses was $6.2 million of operating expenses from James Monroe,which was acquired during the third quarter of 2006.

Controllingcosts and maintaining operational efficiencies remains a primary objective forBankshares.  A closely monitored keymeasure is Bankshares’ overall efficiency ratio.  It is computed by dividing noninterestexpenses by the sum of net interest income on a tax-equivalent basis andnoninterest income.  Bankshares’efficiency ratio was 49.83% for 2006 compared with 48.53% for 2005.  The cash operating efficiency ratio excludesamortization expense for intangibles and nonoperating income and expenses, suchas securities gains and losses and other significant gains, losses or expenses(such as those associated with integrating acquired entities’ operations intoBankshares or the merger with PNC) unrelated to Bankshares’ coreoperations.  When calculating certainperformance ratios, Bankshares believes that excluding these costs and incomehelps the investor to evaluate and compare the results of our core, ongoingbusiness operations.  Bankshares’ cashoperating efficiency ratio was 47.32% and 47.61% for 2006 and 2005,respectively.  See “Reconciliation ofNon-GAAP Measures” found in Item 7.

Salaries, which include basecompensation, commissions, incentive compensation and stock-based compensation,are the largest component of noninterest expenses at 45.0%.  Salaries increased $5.6 million, or 2.8%, over2005.  This increase was comprised of$15.3 million in merit and staffing expenses; $6.1 million in stock-basedcompensation; $6.3 million in compensation related to the merger with PNC and$1.6 million in directors’ fees; and $0.5 million in deferredcompensation.  These increases werepartially offset by a reduction of $15.9 million in salaries expense due to anincrease in the amount of loan origination costs deferred and an $8.7 milliondecrease in incentive compensation.

38

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Employee benefit expensesincreased $9.9 million, due primarily to increased pension costs of $5.7million, higher insurance expenses of $2.6 million and a $1.3 million increasein payroll taxes related to increased salary expenses.

Net occupancy expense, whichincludes premises depreciation, rents, maintenance and utilities increased $4.2million due primarily to increased rent expenses and higher utility costs.  Furniture and equipment expenses, whichinclude depreciation, rental and maintenance expense associated with the upkeepand improvement of hardware and computer software, increased $1.8 million.

Other expenses consist ofprofessional services, advertising and promotion, electronic banking,intangible amortization, outsourcing and all other expenses.  Other expenses increased $15.4 million, or15.8%, in 2006.  Professional servicesincreased $9.6 million of which $6.8 million was related to the PNCmerger.  Amortization of intangiblesincreased $1.1 million, from $8.8 million in 2005 to $9.9 million in 2006, themajority of which resulted from the James Monroe merger.  The remaining increase in other expenses wasdue primarily to an increase in promotional fees of $2.6 million and anincrease of $2.1 million in tax and licensing fees, which was primarily relatedto the restructuring of a real estate pension advisory relationship.

III.ANALYSIS OF FINANCIAL CONDITION

**InvestmentSecurities**Bankshares’investment securities portfolio is structured to manage liquidity, interestrate risk and regulatory capital and to take advantage of market conditionsthat create more economically attractive returns on investments.  The total investment securities portfolio was$3.1 billion at December 31, 2006 and 2005, with net unrealized losses of $39.2million and $51.7 million for the years ended December 31, 2006 and 2005,respectively.  The portfolio consists ofshort-term and intermediate-term U.S. Treasury and U.S. Government agencyobligations, adjustable-rate mortgage-backed securities (ARMs) and intermediateaverage-life agency collateralized mortgage obligations (CMOs).  More than 99.5% of the total investmentportfolio is classified as available-for-sale.

AtDecember 31, 2006, the weighted-average maturity of the debt securitiesavailable-for-sale portfolio was 2.0 years compared with 2.3 years at December31, 2005.  Since 58.6% of this portfoliowas mortgage-backed securities, the expected remaining maturity may differ fromcontractual maturity because borrowers may have the right to prepay obligationsbefore the underlying mortgages mature. The fair value of the debt securities available-for-sale portfolio atDecember 31, 2006 was 98.7% of amortized cost compared with 98.2% at December31, 2005.  The fair value and unrealizedloss on securities as of December 31, 2006, segregated by those securities thathave been in an unrealized loss position for a year or more, was $1.8 billionand $39.8 million, respectively.  Becausethe declines in fair value were due to changes in interest rates, not in estimatedcash flows or credit quality, no charge for an other-than-temporary impairmentwas required at December 31, 2006.  Thereference point for determining those securities in an unrealized loss positionis quarter-end.  As such, it is possiblethat a security had a market value that exceeded its amortized cost on otherdays during 2006.

Theestimated effects of a 200 basis point increase or decrease in interest rateson the fair value and the expected remaining maturity of the mortgage-backedsecurities available-for-sale portfolio are provided in the table below.
| **(Dollars in millions)** | ** ** | **Fair  Value** | ** ** | **Net  Unrealized  Gain (Loss)** | ** ** | **Remaining  Maturity  in Years** | ** ** |
|-------------------------------------|------------|-----------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| At December 31, 2006                |       | $               | 1,821.7    |                                  | $          | (31.3                                  | )          | 2.6 |   |
|                                |       |            |       |                                  |       |                                   |       |
| Assuming a 200 basis  point:        |       |            |       |                                  |       |                                   |       |
| Increase in  interest rates         |       | 1,674.9         |       | (146.8                                | )          | 4.2                                    |       |
| Decrease in interest  rates         |       | 1,838.3         |       | 16.6                                  |       | 1.1                                    |       |
|                                     |            |                 |            |                                       |            |                                        |            |  |  |

 

Moreinformation on the investment portfolio is provided in the following table andin Note No. 3 - Investment Securities in Notes to Consolidated FinancialStatements.

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DEBTINVESTMENT PORTFOLIO

Thefollowing summary shows the maturity distribution and average tax-equivalentyields for the bond investment portfolio at December 31, 2006.
| **(Dollars in  thousands)**          | ** ** | **Within 1   Year** | ** ** | **1-5  Years** | ** ** | **5-10  Years** | ** ** | **After 10  Years** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-------------------------------|------------|----------------|------------|-----------------|------------|--------------------------|------------|-----------|------------|
| Securities  available-for-sale (1)   |       |                          |       |           |       |            |       |                     |       |      |       |
| U.S. Treasuries                      |       |                          |       |           |       |            |       |                     |       |      |       |
| Fair Value                           |       | $                             | 140,764    |           | $          | 195,753         |       | $                        | —     |      | $          | — |   | $ | 336,517 |   |
| Yield                                |       | 3.81                          | %          | 4.50           | %          | —          | %          | —                   | %          | 4.21      | %          |
| U.S. Government  agencies            |       |                          |       |           |       |            |       |                     |       |      |       |
| Fair Value                           |       | $                             | 510,795    |           | $          | 326,930         |       | $                        | 12         |      | $          | — |   | $ | 837,737 |   |
| Yield                                |       | 3.86                          | %          | 4.46           | %          | 7.54            | %          | —                   | %          | 4.10      | %          |
| States and  political subdivisions   |       |                          |       |           |       |            |       |                     |       |      |       |
| Fair Value                           |       | $                             | 2,080      |           | $          | 27,551          |       | $                        | 27,068     |      | $          | — |   | $ | 56,699 |   |
| Yield                                |       | 5.39                          | %          | 5.45           | %          | 5.93            | %          | —                   | %          | 5.68      | %          |
| Mortgage-backed  securities (2)      |       |                          |       |           |       |            |       |                     |       |      |       |
| Fair Value                           |       | $                             | 99,742     |           | $          | 1,610,457       |       | $                        | 111,531    |      | $          | — |   | $ | 1,821,730 |   |
| Yield                                |       | 4.04                          | %          | 4.71           | %          | 4.58            | %          | —                   | %          | 4.67      | %          |
| Other bonds,  notes and debentures   |       |                          |       |           |       |            |       |                     |       |      |       |
| Fair Value                           |       | $                             | 3,984      |           | $          | 1,952           |       | $                        | —     |      | $          | — |   | $ | 5,936 |   |
| Yield                                |       | 2.72                          | %          | 4.28           | %          | —          | %          | —                   | %          | 3.23      | %          |
| Total securities  available-for-sale |       |                          |       |           |       |            |       |                     |       |      |       |
| Fair Value                           |       | $                             | 757,365    |           | $          | 2,162,643       |       | $                        | 138,611    |      | $          | — |   | $ | 3,058,619 |   |
| Yield                                |       | 3.87                          | %          | 4.66           | %          | 4.85            | %          | —                   | %          | 4.48      | %          |
| Securities  held-to-maturity         |       |                          |       |           |       |            |       |                     |       |      |       |
| States and  political subdivisions   |       |                          |       |           |       |            |       |                     |       |      |       |
| Amortized Cost                       |       | $                             | 1,990      |           | $          | 5,574           |       | $                        | 5,535      |      | $          | — |   | $ | 13,099 |   |
| Yield                                |       | 5.47                          | %          | 6.85           | %          | 7.85            | %          | —                   | %          | 7.07      | %          |

 

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(1)Investment securities available-for-sale are presented at estimated fairvalue.  Yields on such securities arebased on amortized cost.

(2)Maturities are reflected based on projected maturities at time of purchase.  Actual maturities will vary as a result ofthe level of loan prepayments in the underlying mortgage pools.

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LOANCOMPOSITION AND GROWTHAverage Loans(Dollars in millions)Five-Year Compound Growth Rate:  12.2%

**LoanPortfolio**A comparative chart ofaverage loan balances is included below; year-end balances are in Note No. 4 -Loans and Allowance for Loan Losses and Reserve for Unfunded Commitments inNotes to Consolidated Financial Statements.

Loanstotaled $12.8 billion for the year ended December 31, 2006, an increase of10.2% over the $11.6 billion for the year ended December 31, 2005.  Loans averaged $12.2 billion in 2006 comparedwith $11.0 billion in 2005, an increase of 10.3%.  On average in 2006, commercial real estategrew 13.9%; construction grew 25.7%; residential real estate loans grew 8.9%;and consumer loans increased 10.4% over 2005. The increases in the various loan categories resulted from both organicgrowth and the acquisition of James Monroe, which added $414 million inloans.  On an average basis, thepercentage of commercial real estate loans to total loans increased to 32.3% in2006 from 31.2% in 2005.  The shift inthe loan portfolio from commercial loans to commercial real estate loansreflected economic activity in our local market.

COMPOSITIONOF LOANS

|                                     | ** ** | **Average Balances** | ** **     |
|-------------------------------------|------------|---------------------------|----------------|
| **(Dollars in thousands** | ** ** | **2006**                  | ** **     | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Commercial                          | ** ** | **$**                     | **2,948,882**  | ** ** | **24.2** | **%** | $ | 2,900,598 |   | 26.3 | % | $ | 2,725,452 |   | 28.1 | % | $ | 2,478,707 |   | 30.6 | % | $ | 2,367,328 |   | 33.4 | % |
| Commercial real  estate             | ** ** | **3,922,356**             | ** **     | **32.3** |   | 3,444,921 |   | 31.2 |   | 2,927,968 |   | 30.1 |   | 2,316,627 |   | 28.6 |   | 1,915,994 |   | 27.0 |   |
| Construction                        | ** ** | **1,851,632**             | ** **     | **15.2** |   | 1,473,353 |   | 13.4 |   | 1,144,044 |   | 11.8 |   | 929,939 |   | 11.5 |   | 733,237 |   | 10.3 |   |
| Residential real  estate            | ** ** | **1,918,257**             | ** **     | **15.8** |   | 1,761,955 |   | 16.0 |   | 1,643,504 |   | 16.9 |   | 1,350,034 |   | 16.7 |   | 1,247,859 |   | 17.6 |   |
| Home equity  lines                  | ** ** | **480,747**               | ** **     | **4.0** |   | 507,153 |   | 4.6 |   | 450,244 |   | 4.6 |   | 311,037 |   | 3.9 |   | 215,411 |   | 3.0 |   |
| Consumer                            | ** ** | **1,039,138**             | ** **     | **8.5** |   | 941,571 |   | 8.5 |   | 828,197 |   | 8.5 |   | 702,638 |   | 8.7 |   | 609,015 |   | 8.7 |   |
| Total                               | ** ** | **$**                     | **12,161,012** | ** ** | **100.0** | **%** | $ | 11,029,551 |   | 100.0 | % | $ | 9,719,409 |   | 100.0 | % | $ | 8,088,982 |   | 100.0 | % | $ | 7,088,844 |   | 100.0 | % |

 

**Deposits**Bankshares’ primarysource of funding for its investing and lending activities is deposits gatheredby the 240 branches of its banking affiliates. Average total deposits in 2006 were $12.4 billion, representing anincrease of $959.7 million, or 8.4%, over the prior year average of $11.4billion.  For the year ended December 31,2006, 80.4% of the funding for average earning assets was derived from depositscompared with 81.1% for the year ended December 31, 2005.  The affiliate-banking model positionsBankshares to compete not only with the large national and regional bankingcompanies in the gathering of these funds, but also with local communitybanks.  Based on historical experience,management

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believesBankshares is well-positioned to retain this core customer base, althoughpricing pressure is expected to be intense. Bankshares continues to promote its cash management services to itscommercial customers in order to maintain and expand this key source offunding.  However, should there be anoutflow of deposits the investment portfolio should provide adequate liquidity.

In2006, interest-bearing deposits represented 73.8% of average total deposits andtotaled $9.1 billion, reflecting growth of 10.8% from 2005.  Growth in savings accounts slowed ascustomers demonstrated a stronger preference for higher yielding money marketand certificates of deposit accounts. Checking plus interest accounts decreased 9.0% from 2005 to $1.3billion.  Time deposits $100,000 and overand other time deposits increased 20.4% on average in 2006 over 2005.

DEPOSITMIX
| ** **                          | ** ** | **Average Balances** | ** **     |
|-------------------------------------|------------|---------------------------|----------------|
| **(Dollars in thousands** | ** ** | **2006**                  | ** **     | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Noninterest-bearing  deposits       | ** ** | **$**                     | **3,236,404**  | ** ** | **26.2** | **%** | $ | 3,165,320 |   | 27.7 | % | $ | 2,879,290 |   | 27.6 | % | $ | 2,269,720 |   | 25.2 | % | $ | 1,856,706 |   | 24.3 | % |
| Interest-bearing  deposits:         |       |                      |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                             | ** ** | **1,246,877**             | ** **     | **10.1** |   | 1,428,445 |   | 12.5 |   | 1,425,423 |   | 13.7 |   | 1,168,074 |   | 13.0 |   | 966,283 |   | 12.7 |   |
| Checking plus  interest             | ** ** | **1,272,953**             | ** **     | **10.2** |   | 1,399,215 |   | 12.2 |   | 1,289,295 |   | 12.4 |   | 1,071,877 |   | 11.9 |   | 873,497 |   | 11.4 |   |
| Money market                        | ** ** | **2,077,613**             | ** **     | **16.8** |   | 1,651,513 |   | 14.5 |   | 1,571,462 |   | 15.1 |   | 1,357,234 |   | 15.1 |   | 1,096,417 |   | 14.4 |   |
| Time deposits  $100,000 and over    | ** ** | **2,150,857**             | ** **     | **17.4** |   | 1,627,194 |   | 14.3 |   | 1,314,423 |   | 12.6 |   | 1,272,327 |   | 14.2 |   | 1,080,347 |   | 14.2 |   |
| Other time  deposits                | ** ** | **2,388,767**             | ** **     | **19.3** |   | 2,142,068 |   | 18.8 |   | 1,933,799 |   | 18.6 |   | 1,852,622 |   | 20.6 |   | 1,759,160 |   | 23.0 |   |
| Total                               | ** ** | **$**                     | **12,373,471** | ** ** | **100.0** | **%** | $ | 11,413,755 |   | 100.0 | % | $ | 10,413,692 |   | 100.0 | % | $ | 8,991,854 |   | 100.0 | % | $ | 7,632,410 |   | 100.0 | % |

**RiskManagement**Bankshares has established an integrated risk managementstructure in which senior management regularly identifies, measures and managesrisks.  The Chief Risk Officer coordinatesand directs the work of several standing management committees charged withmanaging the risks Bankshares faces and provides regular reports to the AuditCommittee.  These committees are listedbelow.

*CreditQuality Committee*The Credit QualityCommittee oversees the establishment of consistent credit quality policies and,among other responsibilities, works with management in determining importantfinancial reporting information, including the allowance for loan and leaseloss reserve.  A centralized loan reviewfunction is charged with analyzing the risks and quality of the lendingportfolios.  Among other things, LoanReview reaffirms or modifies individual loan-risk ratings in accordance withBankshares’ Loan Policy.  The Committeereports quarterly to the Audit Committee. The members of the Committee include the senior vice presidents of LoanReview, Chief Financial Officer, Chief Administrative/Risk Officer, ViceChairman/Chief Operating Officer and Chief Executive Officer of Bankshares, thesenior vice president of Credit Policy at MSD&T, the executive vicepresident of Affiliate Administration and Bankshares’ Treasurer.

*Assetand Liability Committee*The Asset andLiability Committee (“ALCO”) manages interest rate risk, market risk andliquidity risk.  These risks aredescribed in more detail in this Item 7.

*ComplianceCommittee*The ComplianceCommittee establishes compliance guidelines and ensures strict compliance withall relevant regulatory and statutory requirements for Bankshares and its affiliates.  In creating the Compliance Committee,management intended to foster a strong compliance function, which wouldestablish global compliance guidelines and ensure strict compliance forBankshares and its affiliates with relevant banking statutes and regulations,including the Bank Secrecy Act, anti-money laundering statutes and fair lendingstatutes.  A chief compliance officeroversees compliance with existing regulatory requirements and is responsiblefor developing a comprehensive training program.

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Compliancedeficiencies are reported to senior management through the General Counsel andthe Compliance Committee.  As part of itsmission, the Committee regularly assesses Bankshares’ compliance efforts andmaintains a high level of awareness about compliance and its effect on dailyactivities.  The chief compliance officerprepares a report, at least quarterly, that includes (1) the results ofcompliance monitoring activities and any compliance concerns identified withrecommended corrective action, (2) regulatory developments related to new andrevised regulations and proposed regulations, (3) compliance trainingactivities, (4) compliance initiatives, (5) regulatory exams, and (6) customercomplaints.  The Committee’s meetings arechaired by the General Counsel and are held quarterly.  In addition, the chief compliance officerpresents the compliance report to the Audit Committee quarterly.

*DisclosureCommittee*The DisclosureCommittee is comprised of senior representatives of all of Bankshares’ businesslines and is responsible for reviewing Bankshares’ periodic filings anddisclosures in order to ensure compliance with the requirements of U.S.securities laws.  In conjunction with theChief Executive Officer and the Chief Financial Officer, the DisclosureCommittee is charged with the design and oversight of internal controls overfinancial reporting.

TheCommittee conducts a systematic analysis of Bankshares’ annual and quarterlyfilings and reports filed on Form 8-K. It has established and evaluates the disclosure policies and proceduresrelating to the various certification requirements of the Chief ExecutiveOfficer and the Chief Financial Officer, as required by sections 302, 404, and906 of The Sarbanes-Oxley Act of 2002.

TheCommittee, at least annually, performs an analysis of the primary businessprocesses/cycles that support financial reporting.  The Committee reviews important changes inthe law related to disclosure requirements with Bankshares’ external andinternal legal counsel.  The ChiefFinancial Officer and his subordinates monitor important changes in accountingstandards and evaluate changes in the organization that may affect internalcontrols over financial reporting or that may require disclosure, and regularlyreport to the Committee on such developments. The Committee regularly reports to the Audit Committee.

*Technologyand Operations Committee*The Technology andOperations Committee evaluates operational risk on an ongoing basis.  The Committee has developed an Operational andIT Risk framework, including the evaluation of key risk indicators and theintegration with existing Bankshares internal control and risk-assessmentefforts.  Specifically, the Committeeensures that risk management is a responsibility of all layers of management,and it monitors the implementation of the various operational and informationtechnology risk policies of Bankshares. The Committee ensures that a structure and process exist for thecontinuous identification and evaluation, and subsequent remediation, ofoperational risk.  Membership includeseight individuals from the Operations & Technology Division.  Ad hoc members include representatives fromexecutive management, business units, Internal Audit, Financial Services andCompliance.   The President of MSD&Tand the Chief Risk Officer/Chief Administrative Officer are kept apprised ofthe Committee’s activities.  The Chair ofthe Committee, the executive vice president of Operations & TechnologyServices, reports to the Audit Committee at least annually**.**

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

Bankshares’ loan review function examines each affiliate bank at leastonce every five quarters.  Theseexaminations provide Bankshares’ management with an independent perspective asto overall loan portfolio quality, risk profile, risk trends and creditadministration processes at each affiliate. The Audit Committee receives quarterly reports on the findings.

ALLOWANCE AS APERCENT OF PERIOD-END LOANS; NONPERFORMING LOANS AS A PERCENT OF PERIOD-END LOANS

 

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ALLOWANCEFOR LOAN LOSSES and RESERVE FOR UNFUNDED COMMITMENTS
| ** **                                                                         | ** ** | **Year Ended December 31,** | ** **     |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|----------------|
| **Allowance for loan losses** (Dollars in thousands) | ** ** | **2006**                                   | ** **     | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Allowance for  loan losses, beginning of period                                    | ** ** | **$**                                      | **156,673**    |   | $ | 149,002 |   | $ | 155,337 |   | $ | 138,601 |   | $ | 141,463 |   |
| Allowance of  acquired bank                                                        | ** ** | **3,985**                                  |           | 7,086 |   | — |   | 13,205 |   | — |   |
| Charge-offs:                                                                       | ** ** | ** **                                 |           |   |   |   |   |   |   |   |   |
| Commercial                                                                         | ** ** | **(2,459**                                 | **)**          | (3,692 | ) | (13,433 | ) | (6,916 | ) | (18,193 | ) |
| Commercial real estate                                                             | ** ** | **(447**                                   | **)**          | (32 | ) | (67 | ) | (625 | ) | (471 | ) |
| Construction                                                                       | ** ** | **—**                                 |           | — |   | — |   | (170 | ) | — |   |
| Residential real estate                                                            | ** ** | **(54**                                    | **)**          | (202 | ) | (427 | ) | (246 | ) | (251 | ) |
| Home equity lines                                                                  | ** ** | **(35**                                    | **)**          | (91 | ) | (7 | ) | (29 | ) | (74 | ) |
| Consumer                                                                           | ** ** | **(3,292**                                 | **)**          | (3,585 | ) | (4,446 | ) | (4,338 | ) | (3,232 | ) |
| Total                                                                              | ** ** | **(6,287**                                 | **)**          | (7,602 | ) | (18,380 | ) | (12,324 | ) | (22,221 | ) |
| Recoveries:                                                                        | ** ** | ** **                                 |           |   |   |   |   |   |   |   |   |
| Commercial                                                                         | ** ** | **3,067**                                  |           | 3,545 |   | 1,768 |   | 1,345 |   | 896 |   |
| Commercial real estate                                                             | ** ** | **129**                                    |           | 158 |   | 118 |   | 174 |   | 161 |   |
| Construction                                                                       | ** ** | **2**                                      |           | 446 |   | 5 |   | 136 |   | 226 |   |
| Residential real estate                                                            | ** ** | **73**                                     |           | 238 |   | 442 |   | 125 |   | 128 |   |
| Home equity lines                                                                  | ** ** | **24**                                     |           | — |   | 38 |   | 44 |   | 83 |   |
| Consumer                                                                           | ** ** | **2,177**                                  |           | 2,224 |   | 2,453 |   | 1,926 |   | 1,487 |   |
| Total                                                                              | ** ** | **5,472**                                  |           | 6,611 |   | 4,824 |   | 3,750 |   | 2,981 |   |
| Net charge-offs                                                                    | ** ** | **(815**                                   | **)**          | (991 | ) | (13,556 | ) | (8,574 | ) | (19,240 | ) |
| Provision for  credit losses                                                       | ** ** | **(990**                                   | **)**          | 1,576 |   | 7,221 |   | 12,105 |   | 16,378 |   |
| Transfer to  reserve for unfunded commitments                                      | ** ** | **(15,824**                                | **)**          | — |   | — |   | — |   | — |   |
| Allowance for  loan losses, end of period                                          | ** ** | **$**                                      | **143,029**    |   | $ | 156,673 |   | $ | 149,002 |   | $ | 155,337 |   | $ | 138,601 |   |
|                                                                               | ** ** | ** **                                 |           |   |   |   |   |   |   |   |   |
| Average loans                                                                      | ** ** | **$**                                      | **12,161,012** |   | $ | 11,029,551 |   | $ | 9,719,409 |   | $ | 8,088,982 |   | $ | 7,088,844 |   |
| Period-end loans                                                                   | ** ** | **$**                                      | **12,792,733** |   | $ | 11,607,845 |   | $ | 10,228,433 |   | $ | 9,272,160 |   | $ | 7,312,027 |   |
|                                                                               | ** ** | ** **                                 |           |   |   |   |   |   |   |   |   |
| Percent of net  charge-offs to average loans                                       | ** ** | **0.01**                                   | **%**          | 0.01 | % | 0.14 | % | 0.11 | % | 0.27 | % |
| Percent of  allowance for loan losses to period-end loans                          | ** ** | **1.12**                                   | **%**          | 1.35 | % | 1.46 | % | 1.68 | % | 1.90 | % |

 

 
| ** **                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **Reserve for unfunded commitments** (Dollars in thousands) | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Reserve for unfunded  lending commitments, beginning of period                            | ** ** | **$**                                      | **—** |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Provision for credit losses                                                               | ** ** | **990**                                    |       | — |   | — |   | — |   | — |   |
| Transfer from allowance  for loan losses                                                  | ** ** | **15,824**                                 |       | — |   | — |   | — |   | — |   |
| Reserve for unfunded  lending commitments, end of period                                  | ** ** | **$**                                      | **16,814** |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |

 

Banksharesmaintains an allowance for loan losses at a level considered by management tobe adequate to absorb potential losses inherent in the loan portfolio.  Each Bankshares affiliate is required tomaintain an allowance for loan losses adequate to absorb losses inherent in itsindividual loan portfolio. Each affiliate’s reserve is dedicated to thataffiliate only and is not available to absorb losses from another affiliate.The allowance for loan losses is comprised of specific allocations to impairedloans and general allocations to pools of loans not deemed impaired.  It may also include an unallocatedamount.  The portfolio review and thecalculation of the allowance for loan losses are performed on a quarterly basisby Bankshares’ management.  Thecalculation is reviewed by the Bankshares Credit Quality Committee and eachaffiliate bank as to its allowance. Final approval rests with the Credit Quality Committee.  The final evaluation is reviewed with theBankshares Audit Committee.  All loanloss reserves are subject to annual bank regulatory examinations anddeterminations as to their methodology and adequacy.  Overall, the determinations of the allowancefor loan losses incorporate SFAS No. 114, “Accounting by Creditors forImpairment of a Loan - an amendment of FASB Statements No. 5 and 15,” and SFAS No. 118, “Accountingby Creditors for Impairment of a Loan - Income Recognition and Disclosure.”  Also incorporated in determination of theallowance is SFAS No. 5, “Accounting for Contingencies”; guidance contained inthe Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No.102, “Loan Loss Allowance Methodology and Documentation”; and the FederalFinancial Institutions Examination Council’s Policy Statement on Allowance forLoan and Lease Losses Methodologies and Documentation for Banks and SavingsInstitutions.

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ALLOCATIONOF ALLOWANCE FOR LOAN LOSSES

The following table presents the amount of allowance for loan lossesand the percentage distribution of loan amounts in each category, at the dateshown.
| ** **                           | ** ** | **Allowance amount allocated as of December 31,** | ** **  |
|--------------------------------------|------------|---------------------------------------------------------------------------------|-------------|
| ** **                           | ** ** | **2006**                                                                        | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **(Dollars in thousands)** | ** ** | **Amount**                                                                      | ** **  | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** | **Amount** | ** ** | **% of  Total  Loans** | ** ** |
| Allowance amount  allocated to:      |       |                                                                            |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                           | ** ** | **$**                                                                           | **37,290**  | ** ** | **23.9** | **%** | $ | 55,421 |   | 25.5 | % | $ | 58,915 |   | 28.0 | % | $ | 94,584 |   | 28.5 | % | $ | 97,472 |   | 32.8 | % |
| Commercial real  estate              | ** ** | **47,612**                                                                      | ** **  | **33.1** |   | 39,790 |   | 31.9 |   | 32,770 |   | 30.5 |   | 28,237 |   | 29.6 |   | 21,275 |   | 27.6 |   |
| Construction                         | ** ** | **35,980**                                                                      | ** **  | **15.7** |   | 16,163 |   | 13.8 |   | 11,080 |   | 12.4 |   | 10,806 |   | 11.5 |   | 9,644 |   | 11.1 |   |
| Residential real  estate             | ** ** | **7,221**                                                                       | ** **  | **15.7** |   | 12,371 |   | 15.5 |   | 10,303 |   | 16.4 |   | 7,263 |   | 16.6 |   | 3,645 |   | 16.9 |   |
| Home equity  lines                   | ** ** | **1,634**                                                                       | ** **  | **3.6** |   | 3,342 |   | 4.4 |   | 5,460 |   | 4.9 |   | 4,710 |   | 4.5 |   | 1,860 |   | 3.3 |   |
| Consumer                             | ** ** | **4,541**                                                                       | ** **  | **8.0** |   | 10,808 |   | 8.9 |   | 8,787 |   | 7.8 |   | 9,737 |   | 9.3 |   | 4,705 |   | 8.3 |   |
| Allowance amount not  allocated      | ** ** | **8,751**                                                                       |        |   |   | 18,778 |   |   |   | 21,687 |   |   |   | — |   |   |   | — |   |   |   |
| Total                                | ** ** | **$**                                                                           | **143,029** | ** ** | **100.0** | **%** | $ | 156,673 |   | 100.0 | % | $ | 149,002 |   | 100.0 | % | $ | 155,337 |   | 100.0 | % | $ | 138,601 |   | 100.0 | % |

 

**Allowancefor Loan Losses**The allowance forloan losses has been established through provisions for loan losses againstincome.  Loans deemed uncollectible arecharged against the allowance for loan losses and any subsequent recoveries arecredited to the allowance.  The totalallowance for loan losses decreased $13.6 million from year-end 2005 to $143.0million at December 31, 2006, which reflected the addition of $4.0 million ofJames Monroe’s allowance at consummation under SOP 03-3, “Accounting forCertain Loans or Debt Securities Acquired in a Transfer.”  The allowance for loan losses as a percent ofloans declined to 1.12% at December 31, 2006 compared with 1.35% at December31, 2005.  This reflects theestablishment of the reserve for unfunded commitments, the overall improvingcredit quality trends.  During 2006,there was no provision for loan loss expense compared with $1.6 million in2005.  Net charge-offs decreased to $815thousand during 2006 compared with $991 thousand during 2005.  The consumer portfolio represented thelargest net charge-off amount for 2006 at $1.1 million.  Net charge-offs as a percent of average loanswere 0.01%, 0.01% and 0.14% for the years ended December 31, 2006, 2005 and2004, respectively.  Intensive collectionefforts continue after a loan is charged off in order to maximize the recoveryof amounts previously charged off. Recoveries as a percent of loans charged off were 87.0% in 2006, 86.9%in 2005 and 26.3% in 2004.  Recoveries ina given year may not relate to loans charged off in that year.  Further details related to the allowance forloan losses are shown in the tables above and in Note No. 4 - Loans andAllowance for Loan Losses and Reserve for Unfunded Commitments in Notes toConsolidated Financial Statements.

Theallowance for loan losses is comprised of specific allocations to impairedloans, general allocations to pools of loans not deemed impaired and anunallocated amount.  Current trends andeconomic conditions that affect the collectibility of the loan portfolio areincorporated into the general allocation. These can include, but are not limited to, exposure to an industryexperiencing problems, changes in the nature or volume of the portfolio,delinquency and nonaccrual trends.

Thespecific allowance allocation is based on an analysis of the loan portfolio byeach affiliate bank and Loan Review. Each loan with an outstanding balance in excess of a specified thresholdthat is either on nonaccrual status or on the Watchlist is evaluated.  The Watchlist represents loans identified andclosely followed by management.  Theypossess certain qualities or characteristics that may lead to collection andloss issues.  Monitored loans, which areincluded in the Watchlist, display additional risk characteristics suggestingthat they may be classified as nonperforming loans in the near future.  The identified loans are evaluated forpotential loss in accordance with SFAS No. 114 and SFAS No. 118 by analyzingcurrent collateral values or present values of cash flows, as well as thecapacity of the guarantor, as applicable. The specific allocation resulting from this review increased to $6.6million at December 31, 2006 from $4.2 million at December 31, 2005 and wasrelated to specific loan balances of $14.7 million and $12.0 million atDecember 31, 2006 and 2005, respectively. See “Nonperforming Assets” in thefollowing section for more detail.

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We employ modeling andestimation tools in developing the appropriate allowance and reserve forunfunded commitments.  Bankshares’allowance consists of formula-based components for business and retail loans,an allowance for impaired loans and an unallocated component.  The following provides a description of eachof these components of the allowance, the techniques used and the estimates andjudgments inherent in each.  In the firstquarter of 2006, management refined the methodologies for the formula-basedcomponents to align more appropriately the allowance methodology with ourcurrent framework for analyzing credit losses. Formula-based allowance calculations for business and retail componentspermit us to address specifically the current trends and events affecting thecredit risk in the loan portfolio.  Thereserve for unfunded commitments is estimated using the same methodology.

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

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

Forboth business and retail loans, the formula-based components include additionalqualitative amounts to establish reasonable ranges that consider observedhistorical variability in losses. Factors we may consider in setting these amounts include, but are notlimited to, industry-specific data, portfolio specific risks or concentrations,and macroeconomic conditions. Including these variability components in themodel enables us to capture probable incurred losses that are not yet evidentin current default grades, delinquencies and other credit-risk measurementtools.

Thegeneral allowance was $127.7 million and $133.7 million at December 31, 2006and 2005, respectively.

Thecombination of specific and general allowance calculations resulted in $134.3million being allocated to loan portfolio segments at December 31, 2006compared with $137.9 million at December 31, 2005.  The decrease in the allocated allowance is primarilyattributable to improving credit quality over the past several years.

Theunallocated allowance represents the difference between the combined specificand general allocations and the actual allowance.  The unallocated allowance recognizes the imprecisioninherent in estimating and measuring loss when allocating the allowance toindividual, or pools of, loans.  It isdesigned to capture fully inherent losses in the loan portfolio after takinginto consideration these perspectives. It takes into consideration the allowance level deemed appropriate byeach affiliate based on its local knowledge and input from their regulators,including their view from the standpoint of safety and soundness, among otherfactors.  The amount of this componentand its relationship to the total allowance for loan losses may change from oneperiod to another.  At December 31, 2006,the unallocated component of the allowance for loan losses was $8.8 million, or6.1%, of the allowance for loan losses.

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NONPERFORMINGASSETS

Afive-year comparison of nonperforming assets is presented below.
| ** **                                                                         | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| **(Dollars in thousands)**                                               | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Nonaccrual loans (1)                                                               | ** ** | ** **                            |       |   |   |   |   |   |   |   |   |
| Commercial                                                                         | ** ** | **$**                                 | **5,336**  |   | $ | 15,771 |   | $ | 25,510 |   | $ | 37,393 |   | $ | 19,944 |   |
| Commercial real estate                                                             | ** ** | **4,777**                             |       | 4,451 |   | 1,959 |   | 7,363 |   | 9,322 |   |
| Construction                                                                       | ** ** | **15,690**                            |       | 376 |   | 9 |   | 651 |   | 1,365 |   |
| Residential real estate                                                            | ** ** | **4,583**                             |       | 1,505 |   | 2,748 |   | 3,721 |   | 2,479 |   |
| Home equity lines                                                                  | ** ** | **123**                               |       | 88 |   | 300 |   | 78 |   | 105 |   |
| Consumer                                                                           | ** ** | **451**                               |       | 374 |   | 372 |   | 1,146 |   | 156 |   |
| Total                                                                              | ** ** | **30,960**                            |       | 22,565 |   | 30,898 |   | 50,352 |   | 33,371 |   |
| Renegotiated  loans (1)                                                            | ** ** | **—**                            |       | — |   | — |   | — |   | — |   |
| Loans  contractually past due 90 days or more and still accruing interest          | ** ** | —                                |       | — |   | — |   | — |   | — |   |
| Total nonperforming loans                                                          | ** ** | **30,960**                            |       | 22,565 |   | 30,898 |   | 50,352 |   | 33,371 |   |
| Other real  estate owned                                                           | ** ** | **1,405**                             |       | 667 |   | 212 |   | 191 |   | 132 |   |
| Total nonperforming assets                                                         | ** ** | **$**                                 | **32,365** |   | $ | 23,232 |   | $ | 31,110 |   | $ | 50,543 |   | $ | 33,503 |   |
| Nonperforming  loans as a percent of period-end loans                              | ** ** | **0.24**                              | **%**      | 0.19 | % | 0.30 | % | 0.54 | % | 0.46 | % |
| Nonperforming  assets as a percent of period-end loans and other real estate owned | ** ** | **0.25**                              | **%**      | 0.20 | % | 0.30 | % | 0.55 | % | 0.46 | % |

 

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(1)Aggregate gross interest income of $2.7 million and $2.1 million in 2006 and2005, respectively, on nonaccrual and renegotiated loans would have beenrecorded if these loans had been accruing on their original terms throughoutthe period or since origination if held for part of the period.  The amount of interest income on thenonaccrual and renegotiated loans that was recorded totaled $0.7 millionand $0.5 million in 2006 and 2005, respectively.

**NonperformingAssets**Nonperforming assetsconsist of nonaccrual loans, renegotiated loans and other real estate owned(i.e., real estate acquired in foreclosure or in lieu of foreclosure).  With respect to nonaccrual loans, our policyis that, regardless of the value of the underlying collateral and/orguarantees, no interest is accrued on the entire balance once either principalor interest payments on any loan are 90 days past due at the end of a calendarquarter.  All accrued and uncollectedinterest on such loans is reversed out of interest income and is recognizedonly as it is collected.  If a loan isimpaired and has a specific loss allocation based on an analysis under SFAS No.114, “Accounting by Creditors for Impairment of a Loan — an amendment of FASBStatements No. 5 and 15,” all payments are applied against the loan’sprincipal.  A loan may be placed onnonaccrual status sooner than this standard if, in management’s judgment, suchaction is warranted.

Nonperformingassets as a percentage of period-end loans and other real estate owned were0.25% at December 31, 2006 compared with 0.20% in the preceding year.  At year-end 2006, nonperforming assets were$32.4 million compared with $23.2 million at year-end 2005.  Nonperforming loans totaled $31.0 million atDecember 31, 2006 compared with $22.6 million at December 31, 2005.  This increase was primarily due to oneconstruction relationship.

Thelevel of monitored loans, or loans with characteristics suggesting that theymay be classified as nonperforming in the near future were $2.3 million atDecember 31, 2006 compared with $2.2 million a year before.  The amount of loans past due 30-89 daysincreased from $65.2 million at December 31, 2005 to $78.6 million at December31, 2006.  The increase was primarilyreflected in the categories:  commercial,commercial real estate and residential real estate.  In general, the increase was in loans pastdue 30 days; however, Bankshares has seen a growing delinquency trend inresidential real estate loans during the second half of 2006.

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Otherreal estate owned was $1.4 million at December 31, 2006 compared with $667thousand at December 31, 2005.  Theseproperties generally are sold within a short period; therefore, regardless ofthe amount, the properties generally will have changed from year to year.  Other real estate owned is carried at thelower of cost or fair market value. Refer to the data in the “Nonperforming Assets” table on the precedingpage, which shows the changes in the amounts of various categories ofnonperforming assets over the last five years and sets forth the relationshipbetween nonperforming loans and total loans.

LOANMATURITY SCHEDULE

Thefollowing table illustrates loan diversity by maturity distribution forcommercial (including commercial real estate and lease financing) andconstruction loans as of December 31, 2006.
| ** **                           | ** ** | **Maturing**                  | ** ** |
|--------------------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **1 year  or less** | ** ** | **Over 1  through  5 years** | ** ** | **Over 5  years** | ** ** | **Total** | ** ** |
| Commercial                           |       | $                             | 2,371,038  |   | $ | 3,799,876 |   | $ | 1,123,221 |   | $ | 7,294,135 |   |
| Construction                         |       | 888,250                       |       | 999,706 |   | 121,881 |   | 2,009,837 |   |
| Total                                |       | $                             | 3,259,288  |   | $ | 4,799,582 |   | $ | 1,245,102 |   | $ | 9,303,972 |   |

 

Ofthe $6.0 billion in loans maturing after one year, $3.0 billion, or 50.1%, havefixed interest rates, and $3.0 billion, or 49.9%, have variable interest rates.

**Asset/Liabilityand Market Risk Management**Asset/liabilitymanagement involves the evaluation, monitoring and management of interest raterisk, market risk, liquidity and funding. The Asset/Liability Management Committee (“ALCO”) oversees policyguidelines and reports periodically to the Board of Directors.  This Committee consists of senior financialand business executives.  Treasurydivision management and other finance personnel monitor the day-to-day exposureto interest rates in response to loan and deposit flows.

**InterestRate Risk**Interest rate risk,which potentially can have a significant earnings impact, is an integral partof being a financial intermediary. Bankshares is subject to interest rate riskdue to a variety of factors including:

·                  Assetsand liabilities may mature or reprice at different times (for example,currently our assets reprice slightly faster than our liabilities and ifinterest rates fall, earnings will initially decline);

·                  Assetsand liabilities may reprice at the same time but by different amounts (forexample, when the market level of interest rates is falling, we may reducerates paid on checking and savings deposit accounts by an amount that is lessthan the general decline in market interest rates);

·                  Short-termand long-term market interest rates may change by different amounts (i.e., theshape of the yield curve may affect new loan and investment yields and fundingcosts differently); or

·                  Theremaining maturity of various assets or liabilities may shorten or lengthen asinterest rates change (for example, if long-term mortgage rates fall,mortgage-backed securities may prepay significantly earlier than anticipated,which could reduce portfolio income). In addition, interest rate changes havean indirect impact on loan demand, credit losses, mortgage originations, thevalue of mortgage servicing rights and other sources of earnings.

Abalance sheet is considered asset-sensitive when its assets (loans andsecurities) reprice faster or to a greater extent than liabilities (depositsand borrowings).  An asset-sensitivebalance sheet will produce more net interest income when rates rise and lessnet interest income when rates fall.  Abalance sheet is described as liability-sensitive when its liabilities(deposits or borrowings) reprice more frequently or to a greater degree thanits assets (loans and securities).  Aliability-sensitive balance sheet will produce a lower level of net interestincome when interest rates rise and more net interest income when ratesfall.  Bankshares’ largenoninterest-bearing deposit and equity base funds a loan portfolio with a large

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percentageof floating-rate commercial and consumer loans, which creates a bias towardsasset sensitivity.  

Tomanage this asset sensitivity in our balance sheet, we maintain a largeportfolio of fixed-rate, although short-duration, investments. Periodically, weelect to use derivatives to protect assets and liabilities from changes ininterest rates.  When deciding whether touse derivatives instead of cash market instruments to achieve the same goal, weconsider a number of factors, such as cost, efficiency, the effect on ourliquidity and capital and our overall strategy. The derivatives we use for interest rate risk management purposes areprimarily interest rate swaps.  We fullyincorporate the market risk associated with interest rate risk managementderivatives into our earnings simulation model in the same manner as otheron-balance-sheet financial instruments. The credit risk amount and estimated net fair value of these derivativesas of December 31, 2006 and 2005 are presented in Note No. 18 - DerivativeInstruments and Hedging Activities in Notes to the Consolidated FinancialStatements.   Derivatives are used forasset/liability management in three ways: (1) to convert long-term fixed-rate debt to floating-rate payments byentering into receive-fixed swaps at issuance; (2) to convert the cash flowsfrom selected asset and/or liability instruments/portfolios from fixed tofloating payments or vice versa; and (3) to hedge the mortgage originationpipeline by utilizing forward commitments for loans held-for-sale.

Weassess interest rate risk by comparing projected net interest income in thecurrent rate environment with various interest rate scenarios that differ inthe direction of interest rate changes, the degree of change over time, thespeed of the change and the projected shape of the yield curve.  This analysis incorporated substantially allof Bankshares’ assets and liabilities and off-balance sheet instruments as ofDecember 31, 2006.  Through thesesimulations, management estimates the impact on net interest income of a 200basis point upward and a 200 basis point downward change in interest rates.  In analyzing interest rate sensitivity forpolicy measurement, we compare our forecasted net interest income in both “highrate” and “low rate” scenarios to our most likely earnings estimate utilizing a“flat rate” scenario.  The policymeasurement period is 12 months in length, beginning with the first month ofthe forecast.  Our objective is to manageprudently the interest-bearing assets and liabilities on our balance sheet inways that minimize our exposure to changes in interest rates.  Our “high rate” and “low rate” scenariosassume gradual 100 and 200 basis point increases or decreases in the federalfunds rate relative to the “flat rate” scenario.  Our standard approach evaluates expected netinterest income in a 200 basis point range both above and below the “flat rate”scenario.  To capture the impact of yieldcurve-related risk, we simultaneously measure the impact of nonparallel shiftsin rates.  A parallel shift would moveall points on the yield curve by the same increments.  A nonparallel shift would consist of a 100basis point increase in short-term rates, while long-term rates would increaseby a different amount.  A rate shift inwhich short-term rates rise to a greater extent than long-term rates isreferred to as a “flattening” of the yield curve.  Conversely, long-term rates rising to agreater extent than short-term rates leads to a “steepening” of the yieldcurve.

EARNINGSSENSITIVITY

Thefollowing table summarizes the effect a positive 100 and 200 basis point changeand a negative 100 and 200 basis point change in interest rates would have onBankshares’ net interest income over the next 12 months.
| ** **                                                           | ** ** | **Calculated increase / (decrease) in   projected net interest income** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **As of December 31,**                                                                           | ** ** |
| **Change in interest rates (basis points)** | ** ** | **2006**                                                                                                        | ** ** | **2005** | ** ** |
| +200                                                                 |       | 0.1                                                                                                             | %          | 2.3 | % |
| +100                                                                 |       | 0.1                                                                                                             | %          | 1.3 | % |
| -100                                                                 |       | (0.5                                                                                                            | )%         | (1.8 | )% |
| -200                                                                 |       | (2.0                                                                                                            | )%         | (4.6 | )% |

 

Asseen in the “Earnings Sensitivity” table above, within a one-year horizon, theearnings sensitivity model forecasts that, compared with the net interest incomeprojection under stable rates, net interest income remains basically unchangedif interest rates increased by 100 and 200 basis points, respectively.  Conversely, if interest rates decreased by100 and 200 basis points, net interest income would decrease by 0.5% and 2.0%,respectively.  Bankshares manages theinterest rate risk profile within policy limits of +/- 5.0% change in netinterest income on a +/- 200 basis point change in interest rates and atDecember 31, 2006 was within the risk limits established.  These results are not necessarily indicativeof future actual results, nor do they take into account certain actions thatmanagement may undertake in response to future changes in interest rates.

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MARKET VALUE OF EQUITYMODELING

Banksharesalso utilizes the market value of equity as a measurement tool in managinginterest rate sensitivity.  The marketvalue of equity measures the degree to which the market values of Bankshares’assets and liabilities and off-balance sheet instruments will change given achange in interest rates.  ALCOguidelines limit the change in market value of equity in a 200 basis pointparallel rate shock to 12.5% of the market value of equity assuming interestrates at December 31, 2006.  The up 200basis point scenario resulted in a 4.6% decrease at December 31, 2006 and a2.9% decrease at December 31, 2005.  Thedown 200 basis point scenario resulted in a 1.7% decrease at December 31, 2006and a 3.9% decrease at December 31, 2005. At December 31, 2006 and 2005, Bankshares was within its policyguidelines.

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

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

*TradingActivities*Bankshares providescapital market products to its customers. From a market risk perspective, Bankshares’ net income is exposed tochanges in interest rates, credit spreads, and equities and their impliedvolatilities.  The primary purpose ofBankshares’ trading business is to accommodate customers in the management oftheir market price risks.  Derivativetransactions executed with customers are simultaneously hedged in the capitalmarkets.  All derivatives transacted withcustomers used to hedge capital market transactions with customers are carriedat fair value.  The ALCO establishes andmonitors counterparty risk limits.  Thenotional amount, exposure amount and estimated net fair value of all customeraccommodation derivatives at December 31, 2006 are included in Note No. 18 -Derivative Instruments and Hedging Activities in Notes to the ConsolidatedFinancial Statements.

*Equity Markets*Bankshares is directly and indirectly affected by changes inthe equity markets.  Bankshares has madeinvestments in private equities and hedge funds.  These private equity investments are madewithin capital allocations approved by Bankshares’ management. Managementreviews these investments at least quarterly and assesses them for possibleother-than-temporary impairment.  Fornonmarketable investments, the analysis is based on the facts and circumstancesof each individual investment and the expectations for that investment’s cashflows and capital needs, the viability of the business model and an appropriateexit strategy.  Private equityinvestments totaled $25.4 million at December 31, 2006 and $20.7 million atDecember 31, 2005.  Hedge fundinvestments totaled $68.8 million at December 31, 2006 and $62.8 million atDecember 31, 2005.

Changesin equity market prices may also indirectly affect Bankshares’ net income (1)by affecting the value of third-party assets under management or administrationwithin IWM and, hence, fee income; (2) by affecting particular borrowers, whoseability to repay principal and/or interest may be affected by the stock market;or (3) by affecting brokerage activity, related commission income and otherbusiness activities.

Bankshares’maintenance of capital ratios well above regulatory requirements (see “CapitalResources and Adequacy”) provides management with the flexibility to utilizethe available-for-sale portfolio for liquidity and interest rate riskmanagement needs, even during a period when valuations are depressed.  Maintaining a fairly short duration in theportfolio also mitigates market risk.

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**Liquidity Risk**Liquidity risk is the possibility that Bankshares will not beable to fund present and future financial obligations.  The objective of liquidity management is tomaintain the ability to meet commitments to fund loans, purchase securities andrepay deposits and other liabilities in accordance with their terms.  To achieve this objective, the ALCOestablishes and monitors liquidity guidelines that require sufficient asset-basedliquidity to cover potential funding requirements and to avoid over-reliance onvolatile, less reliable funding markets. Debt securities in the available-for-sale portfolio provide liquidity,in addition to the immediately liquid resources of cash and due from banks andfederal funds sold and securities purchased under resale agreements.  By limiting the maturity of securities andmaintaining a conservative investment posture, management can rely on theinvestment portfolio to help meet any short-term funding needs. U.S. Treasuryand agency securities, which provide the greatest liquidity, averaged $1.4billion in 2006 and 2005.

Corecustomer deposits historically have provided a substantial source of relativelystable, low-cost funds.  During 2006,core deposits (total deposits less time deposits of $100,000 and over),averaged $10.2 billion compared with $9.8 billion during 2005.  Although not viewed as core deposits, asubstantial portion of short-term borrowings comprised of securities sold underagreements to repurchase and commercial paper originate from core depositrelationships tied to the overnight cash management program offered tocustomers.  Short-term borrowingsaveraged $1.4 billion during 2006, a 29.8% increase from 2005.

Inaddition to these sources, Bankshares has access to national markets forcertificates of deposit, commercial paper and debt financing.  Should Bankshares need to supplement itsliquidity, it also has $3.2 billion in lines with the Federal Home Loan Banksof Atlanta and Pittsburgh (“FHLB”) and back-up commercial paper lines of $40.0million with commercial banks. Bankshares is required to obtain approval from holders of Bankshares’6.80% unsecured senior notes if Bankshares incrementally borrows in excess of4% of Average Total Assets under the FHLB lines.

Long-termdebt decreased to $659.0 million at December 31, 2006 from $742.2 million atDecember 31, 2005.  Approximately $17.6million in Trust Preferred Securities were acquired as part of the James Monroeacquisition.  During 2006, $95.8 millionwas repaid on long-term debt.  Banksharescan access the capital markets for long-term funding by issuing registered debtand private placements.  In October 2006,Moody’s Investors Service affirmed Mercantile Bankshares Corporation’scommercial paper rating of “P-1” and Bankshares’ subordinated debt rating of “A2.”  Also in October 2006, Standard & Poor’sRatings Service revised Bankshares’ rating to “A+/Watch Negative/A-1” andcounterparty rating of “A+/Watch Negative/A-1.” Rating agencies base their ratings on many quantitative and qualitativefactors, including capital adequacy, liquidity, asset quality, quality of themanagement team, business mix and the level and quality of earnings.
| TIER I CAPITAL RATIO*                                                        |   | DIVIDENDS PER SHARE                  |
|------------------------------------------------------------------------------|--------|--------------------------------------|
| Regulatory Tier  I Minimum: 4.0%                                             |   | Five-Year Compound Growth Rate: 8.5% |
| *Tier I equity  as percentages of risk-adjusted total assets at December 31, |   |                                 |
|                                                                              |   |                                      |

 

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**CapitalResources and Adequacy**Bankshares hasconsistently maintained a capital to asset ratio higher than its peers asreported in data furnished by its regulators. Shareholders’ equity averaged $2.3 billion during 2006, whichrepresented an increase of $245.7 million, or 11.7%, over the prior year’saverage.  A significant portion of theincrease was caused by the shares issued in the James Monroe acquisition thatwere valued at $63.1 million, plus net earnings retention.

Maintenanceof capital strength has long been a guiding principle of Bankshares.  Ample capital is necessary to sustain growth,to provide a measure of protection against unanticipated declines in assetvalues and to safeguard the funds of depositors.  Capital also provides a source of funds tomeet loan demand and enables Bankshares to manage its assets and liabilitieseffectively.

Shareholders’equity increased 10.1% to $2.4 billion at year-end 2006 from $2.2 billion atyear-end 2005.  The increase wasattributable primarily to earnings growth and the shares issued in connectionwith the James Monroe acquisition partially offset by increased cash dividendpayments.  In addition, at December 31,2006, Bankshares implemented SFAS No. 158, “Employers’ Accounting for DefinedBenefit Pension and Other Postretirement Plans-an amendment of FASB StatementsNo. 87, 88, 106, and 132(R).”  Theinitial application of SFAS 158 did not affect Bankshares’ results ofoperations; however, shareholders’ equity was reduced by $23.1 million.  See Note No. 14 — Pension and OtherPostretirement Benefit Plans in Notes to Consolidated Financial Statements.

Bookvalue per share was $19.25 at December 31, 2006 compared with $17.81 atDecember 31, 2005.  The ratio of averageequity to average assets was 13.75% in 2006 and 13.51% in 2005, rankingBankshares among the most strongly capitalized banks in the industry.  Excluding intangible assets average tangibleequity to average tangible assets was 9.82% and 9.70% in 2006 and 2005,respectively.  Bankshares believes thatexcluding intangible assets helps the investor understand the effects ofacquisition activities on its results and more closely approximates the basisfor measuring the adequacy of capital for regulatory purposes.

Whilemaintaining exceptional capital strength Bankshares also has a share repurchaseprogram.  On June 13, 2006, Bankshares’Board of Directors authorized the repurchase of two million shares of commonstock, in addition to the remaining shares authorized by the Board of Directorsin 2001.  At December 31, 2006, thereremained 2.7 million shares of common stock authorized for repurchase.  The share repurchase program has supportedmanagement’s strategy to enhance shareholder value.  Management has repurchased shares in openmarket and privately negotiated transactions during periods when capitalaccumulates at a rate in excess of that required to support the growth ofearning assets.  See Note No. 11 -Shareholders’ Equity in Notes to Consolidated Financial Statements and the “Statementsof Changes in Consolidated Shareholders’ Equity” found elsewhere in this documentfor details related to the share repurchase program.  The repurchase programs have been suspendedas a condition of the merger agreement with PNC.

Variousbank regulatory agencies have implemented capital guidelines, which aredirectly related to a bank’s risk-based capital ratios.  By regulatory definition, a well capitalizedinstitution, such as Bankshares, faces fewer regulatory constraints on itsoperations than institutions classified as undercapitalized.  For example, only well capitalized banks canaccept brokered deposits without advance regulatory approval.  In addition, FDIC deposit insurance premiumrates are significantly lower for banks with higher capital levels.  The “Tier I Capital Ratio” graph above showsthat Bankshares has maintained capital levels well in excess of the regulatoryminimum over each of the last five years. For a further discussion of the regulatory capital requirements thatapply to Bankshares, see Note No. 11 - Shareholders’ Equity in Notes toConsolidated Financial Statements.  Bankregulatory agencies also impose certain restrictions on transactions among andbetween subsidiaries of bank holding companies, including extensions of credit,transfers of assets and payments of dividends. Historically, the dividend restrictions have not limited dividendpayments at Bankshares and it is not anticipated that they will have aconstraining effect in the future.  Inaddition to dividend restrictions, Capital requirements also are affected byoff-balance sheet risks.  These includesuch items as letters of credit and commitments to extend credit.  Refer to Note No. 10 - Commitments andContingencies in Notes to Consolidated Financial Statements for informationregarding Bankshares’ commitments.

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DIVIDENDS
| ** **       | ** ** | **2006** | ** ** | **2005**   | ** ** |
|------------------|------------|----------|------------|------------|------------|
| **Quarter**      | ** ** | **4th**  | ** ** | **3rd**    | ** ** | **2nd** | ** ** | **1st** | ** ** | **4th** | ** ** | **3rd** | ** ** | **2nd** | ** ** | **1st** | ** ** |
| Common dividends |       | **$**    | **0.28**   | ** ** | **$**      | **0.28** | ** ** | **$** | **0.28** | ** ** | **$** | **0.26** | ** ** | $ | 0.25 |   | $ | 0.25 |   | $ | 0.25 |   | $ | 0.23 |   |
|                  |            |          |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Bankshareshas paid quarterly cash dividends on its common stock since September 1970 whensuch stock was first issued. Bankshares intends to consider quarterly paymentof dividends on its common stock, but such payment is necessarily dependent onmany factors, including the future earnings and financial requirements ofBankshares and its affiliates.

OnJanuary 10, 2006, Bankshares’ Board of Directors announced a three-for-twostock split on its common stock.   Inaddition, the Board stated its intention to raise the indicated quarterly pershare dividend rate, adjusted for the stock split, to $0.26 per share.

Forthe 30th consecutive year, the annual dividend paid on common stock exceededthe prior year’s level.  Effective withthe June 2006 dividend, the quarterly cash dividend was increased 7.7% to $0.28from $0.26 per share.  Over the last fiveyears, dividends have increased at a compound growth rate of 8.5%.  Management periodically will evaluate thedividend rate in light of Bankshares’ capital strength, profitability andconditions prevailing in the economy in general and the banking industry inparticular.  The annual dividends paidper common share were $1.10 in 2006 and $0.99 in 2005.  Total cash dividends paid were $136.7 millionin 2006 and $120.2 million in 2005.  The “Dividends”table above presents quarterly dividends paid over the last two years.

On February 6, 2007, Bankshares’ Board of Directors declareda quarterly dividend of $0.28 per share on the common stock, payable February28, 2007, to stockholders of record as of February 21, 2007.

RECENT COMMON STOCK PRICESMarket Prices (1)
| ** **  | ** ** | **2006**  | ** ** | **2005**   | ** ** |
|-------------|------------|-----------|------------|------------|------------|
| **Quarter** | ** ** | **4th**   | ** ** | **3rd**    | ** ** | **2nd** | ** ** | **1st** | ** ** | **4th** | ** ** | **3rd** | ** ** | **2nd** | ** ** | **1st** | ** ** |
| High        | ** ** | **$**     | **47.39**  | ** ** | **$**      | **37.96** | ** ** | **$** | **39.53** | ** ** | **$** | **39.82** |   | $ | 40.09 |   | $ | 37.46 |   | $ | 35.20 |   | $ | 34.90 |   |
| Low         | ** ** | **36.04** | ** ** | **34.29**  | ** ** | **35.00** | ** ** | **36.88** |   | 34.11 |   | 34.13 |   | 32.39 |   | 32.27 |   |
|             |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)The stock of Mercantile Bankshares Corporation is traded on the Nasdaq GlobalSelect Market under the symbol MRBK.  Thequotations represent actual transactions.

Asof February 16, 2007, there were 10,811 shareholders of record.

**Off-BalanceSheet Arrangements and Contractual Obligations**

*Off-BalanceSheet Arrangements*Banksharesconsolidates majority-owned subsidiaries that it controls.  Other affiliates, including certain jointventures in which there is less than 20% ownership, generally are carried atthe lower of cost or fair market value.  Banksharesdoes not dispose of troubled loans or problem assets by means of unconsolidatedspecial purpose entities.

Bankshares’mortgage banking subsidiary, as a Fannie Mae Delegated Underwriting andServicing lender, has a loss sharing arrangement for loans originated on behalfof and sold to Fannie Mae.  In theordinary course of business, Bankshares routinely originates and sells mortgageloans in the secondary market.  Typically,these loans are sold under forward commitments. Refer to Note No. 10 - Commitments and Contingencies in Notes toConsolidated Financial Statements for additional information regardingcommitments relating to mortgage banking.

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*ContractualObligations and Other Commitments*Through the normalcourse of business, Bankshares enters into certain contractual obligations andother commitments.  Such obligationsgenerally relate to funding operations through debt arrangements as well asleases of premises and equipment.  Forfurther information on commitments, see Notes No. 5, 9 and 10 in Notes toConsolidated Financial Statements.

Asa financial services provider, Bankshares routinely enters into commitments toextend credit, including loan commitments, standby letters of credit andfinancial guarantees.  Guarantees arecontracts that contingently require us to make payments to a guaranteed partybased on an event or changes in an underlying asset, liability, rate orindex.  While contractual obligationsrepresent future cash requirements of Bankshares, a significant portion ofcommitments to extend credit are likely to expire without being drawnupon.  Such commitments are subject tothe same credit policies and approval processes accorded to loans made byBankshares.

Additionally,Bankshares has committed to invest funds in third-party private equityinvestments.

The table below summarizes significant contractual obligations andother commitments.
| **(Dollars in thousands)**                | ** ** | **1 Year  or less** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **After 5  years** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|------------|-------------------------------|------------|----------------|------------|----------------|------------|-------------------------|------------|-----------|------------|
| Contractual  obligations                            |       |                          |       |           |       |           |       |                    |       |      |       |
| Long-term debt (1)                                  |       | $                             | 18,999     |           | $          | 50,950         |       | $                       | 237,585    |      | $          | 351,486 |   | $ | 659,020 |   |
| Operating leases                                    |       | 18,594                        |       | 27,316         |       | 17,070         |       | 46,814                  |       | 109,794   |       |
| Purchase  obligations                               |       | 5,000                         |       | 10,000         |       | 10,000         |       | —                  |       | 25,000    |       |
| Total  contractual obligations by period            |       | $                             | 42,593     |           | $          | 88,266         |       | $                       | 264,655    |      | $          | 398,300 |   | $ | 793,814 |   |
| Other  commitments                                  |       |                          |       |           |       |           |       |                    |       |      |       |
| Commitments to  extend credit                       |       |                          |       |           |       |           |       |                    |       | $         | 5,024,880  |   |
| Standby letters  of credit and financial guarantees |       |                          |       |           |       |           |       |                    |       | 596,879   |       |
| Unfunded  third-party private equity investments    |       |                          |       |           |       |           |       |                    |       | 30,552    |       |
| Total other commitments                             |       |                          |       |           |       |           |       |                    |       | $         | 5,652,311  |   |

 

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##### (1) Includes $47.2 millionin financing resulting from the sale of the Hopkins Plaza Building. Includesprincipal payments only.

REVIEWOF EARNINGS AND BALANCE SHEET FOR 2005 TO 2004

**Performance& Operating Analysis**

On May 18, 2005, Bankshares completed itsacquisition of Community Bank of Northern Virginia (“CBNV”), a bankheadquartered in Sterling, Virginia, which was merged into MSD&T and becamepart of MSD&T’s Mercantile Potomac Bank. CBNV operated 14 branch offices in the Northern Virginia metropolitanmarket at the time of the acquisition. The primary reason for the merger with CBNV was to expand Bankshares’distribution network in Northern Virginia, a higher growth market.  The total consideration paid to CBNVshareholders in connection with the acquisition was $82.9 million in cash and3.7 million shares of Bankshares common stock, which reflects the adjustmentfor the three-for-two stock split announced by Bankshares on January 10,2006.  CBNV transactions have beenincluded in Bankshares’ financial results subsequent to May 18, 2005.  The assets and liabilities of CBNV wererecorded on the Consolidated Balance Sheet at their respective fair values. Thefair values were determined as of May 18, 2005. The transaction resulted in total assets acquired as of May 18, 2005 of$888.2 million, including $671.0 million of loans and leases; liabilitiesassumed were $842.3 million, including $626.9 million of deposits.  Bankshares recorded $162.1 million ofgoodwill and $4.6 million of core deposit intangible.

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Net income in 2005 was $276.3 million compared with $229.4 million in2004, a 20.4% increase.  Diluted netincome per common share was $2.26 in 2005 compared with $1.92 in 2004, anincrease of 17.7%.  Return on averageassets was 1.78% and return on average equity was 13.18% in 2005 compared with1.64% and 12.26%, respectively, in 2004. Average assets increased 10.9% to $15.5 billion; average depositsincreased 9.6% to $11.4 billion; and average loans increased 13.5% to $11.0billion for the year ended December 31, 2005 compared with the prior year.

Netinterest income, on a fully tax-equivalent basis, was $624.0 million in 2005compared with $552.5 million in 2004. Both changes in the level of interest rates and changes in the amountand composition of interest-earning assets and interest-bearing liabilitiesaffected net interest income.  The netinterest margin improved nine basis points to 4.44% for 2005 from 4.35% for2004.

Noninterestincome for 2005 increased by $29.2 million, or 13.6%, to $243.1 millioncompared with $213.9 million for 2004. IWM revenues increased 6.3% to $95.8 million in 2005, which was dueprincipally to stronger equity markets, increased new sales in Private Wealth Managementand increased brokerage activity. Mortgage banking fees increased $3.5 million, or 30.7%, over 2004 due tostrong performance in the commercial sector. Residential mortgage banking fees for 2005 were nearly flat whencompared with 2004.  Nonmarketableinvestment income increased $8.5 million, or 74.1%, over 2004 resulting frombetter private equity investment performance and higher income from bank-ownedlife insurance (“BOLI”) of which Bankshares purchased an additional $50.0million in the third quarter of 2005.

Noninterestexpenses for 2005 increased $28.9 million, or 7.4%, from 2004.  Year-over-year expenses increased due toapproximately $8.0 million related to the acquisition of CBNV; $8.3 million inhigher incentive compensation due to improved operating performance; and $6.3 millionin merit and staffing increases. Partially offsetting these increases was a reduction in salaries expenseby $2.5 million based on the deferral of loan origination costs.  Professional fees decreased $3.4 million dueto reduction in fees for the implementation of compliance with TheSarbanes-Oxley Act of 2002 and for a litigation matter in 2004.  Outsourcing fees increased $5.9 million in2005 over 2004 due to the outsourcing of IWM back-office functions.

Netoccupancy expense increased by $4.3 million, or 17.6%, during 2005 due to 14net additional branch locations and the loss of outside tenant income from theDecember 2004 sale of Bankshares’ headquarters building.

**SegmentReporting**

Inthe fourth quarter of 2005, the Private Banking Group of MSD&T wasconsolidated into the Private Banking Group of IWM.  The segment results were reclassified toconform to current presentation for comparability.  Additionally, as loans and deposits werereflected in the IWM segment, a funds transfer-pricing model was utilized tomatch the duration of the funding and investment of the IWM segment’s assetsand liabilities.

*Banking*Net income in 2005was $271.4 million compared with $220.9 million in 2004, a 22.9% increase.  For the year ended December 31, 2005, averageassets increased 13.6% to $15.2 billion; average deposits increased 10.9% to$11.4 billion; and average loans increased 13.4% to $10.9 billion.

Netinterest income increased 14.1% to $609.8 million in 2005 over $534.5 millionin 2004.  The growth in net interestincome was largely attributable to a 13.4% increase in average loansoutstanding with CBNV contributing approximately 32.1%.   Average loans outstanding increased 13.4% to$10.9 billion for 2005 with the majority of growth in commercial real estate(19.0%), construction loans (28.7%) and consumer loans (13.0%) in 2005 over2004.

Averagedeposits for Banking were $11.4 billion in 2005, an increase of 10.9% over2004.  The strongest year-over-yeargrowth was in certificates of deposit (19.9%), noninterest-bearing deposits(9.3%) and money market deposit accounts(8.5%). The CBNV acquisition contributed approximately 34.8% of this depositgrowth.

Theyear-over-year increases in noninterest income and noninterest expenses from2004 were attributable primarily to the CBNV acquisition, increased depositactivity and branch expansion. Noninterest income increased to $132.2 million in 2005 from $114.5million in 2004 with gains on sales of bank premises increasing $2.7 million,mortgage-banking fees increasing $3.5 million, nonmarketable investmentsincreasing $2.6 million, insurance fees increasing $1.8 million and

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electronicbanking fees increasing by $2.2 million. Partially offsetting these gains was a decrease of $0.6 million indeposit service charges.  Noninterestexpenses increased to $341.5 million in 2005 from $318.7 million in 2004.  The increase was partially attributable to$8.2 million in additional operating expenses related to the CBNV acquisitionand $11.2 million, in salaries and benefits. Incentive compensation linked to improved operating performanceincreased $7.7 million and pension expense increased $1.3 million.  Occupancy expense increased by $3.6 millionand electronic banking costs increased $2.4 million.

*IWM*Net income in 2005was $16.2 million compared with $16.5 million in 2004.  Excluding the Private Banking Group, IWM netincome increased $1.3 million, or 11.5%, in 2005 compared with 2004.  Pretax profit margins, prior to corporateoverhead allocations, were 29.9% and 31.1% for 2005 and 2004,respectively.  At December 31, 2005,assets under administration by IWM were $46.5 billion, a decrease of $1.3billion from the prior year.  Bankshareshad investment management responsibility for $20.6 billion and $21.1billion at December 31, 2005 and 2004, respectively.

Thedecrease in net income resulted primarily from a reduction in net interestincome in the Private Banking Group. This decline was due to lower earnings attributed to noninterest-bearingdemand deposit accounts due to greater volatility in customer balances during2005.

Revenuesincreased $3.1 million, or 3.1%, to $103.8 million in 2005 from $100.7 millionin 2004.  Revenue increases were achievedin Private Wealth Management, Institutional Investment Management, MercantileFunds and Brokerage.  Revenues declinedin Private Banking despite strong loan and deposit growth.  IWM revenues increased principally due tostronger equity and real estate markets during 2005 compared with 2004,increased new sales in Private Wealth Management and increased brokerageactivity.

Expensesincreased 4.8% to $72.9 million in 2005 compared with $69.6 million in2004.  Increases in personnel-related,technology and occupancy expenses were offset by decreases in professionalservices, travel and marketing expense.

**CreditQuality Measures**Provision for loanlosses was $1.6 million in 2005 compared with $7.2 million in 2004.  Net charge-offs in 2005 were $1.0 million, or0.01% of average total loans compared with $13.6 million, or 0.14%, in 2004.  The allowance for loan losses was $156.7million, or 1.35% of total loans, at December 31, 2005 compared with $149.0million, or 1.46%, at December 31, 2004.

AtDecember 31, 2005, total nonperforming assets were $23.2 million, or 0.20% ofperiod-end loans and other real estate owned, compared with $31.1 million, or0.30%, at December 31, 2004.  Thedecrease in nonperforming loans was due primarily to an improvement in creditquality at MSD&T, the lead bank.

**CapitalRatios**The ratio of averageshareholders’ equity to average total assets was 13.51% for 2005 and 13.38% for2004.  Bankshares’ total risk-basedcapital ratio at December 31, 2005 was 15.37%, and Tier I capital ratio was11.82%, exceeding the minimum regulatory guidelines of 8.0% and 4.0%, respectively.  Bankshares’ leverage ratios were 9.81% and10.02% at December 31, 2005 and 2004, respectively, exceeding the minimumregulatory guideline of 4.0%.  As ofDecember 31, 2005, all of Bankshares’ bank affiliates exceeded all capitaladequacy requirements necessary to be considered “well capitalized.”  For additional information on Bankshares’risk-based capital ratios, see Note No. 11 - Shareholders’ Equity in Notes toConsolidated Financial Statements.

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QUARTERLYRESULTS OF OPERATIONS (unaudited)

Thefollowing is a summary of the quarterly results of operations.
| ** **                                                                                | ** ** | **Three months ended** | ** **  |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|
| **2006 (Dollars in thousands, except per share data)** | ** ** | **Dec. 31**                 | ** **  | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| Interest income                                                                           | ** ** | **$**                            | **270,160** | ** ** | **$** | **258,856** | ** ** | **$** | **241,793** | ** ** | **$** | **227,913** | ** ** |
| Interest expense                                                                          | ** ** | **100,165**                      | ** **  | **92,787** | ** ** | **80,383** | ** ** | **69,600** | ** ** |
| Net interest  income                                                                      | ** ** | **169,995**                      | ** **  | **166,069** | ** ** | **161,410** | ** ** | **158,313** | ** ** |
| Provision for  loan losses                                                                | ** ** | **—**                       | ** **  | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Investment  securities gains (losses)                                                     | ** ** | **7**                            | ** **  | **218** | ** ** | **—** | ** ** | **(13** | **)** |
| Net income                                                                                | ** ** | **72,862**                       | ** **  | **71,573** | ** ** | **73,092** | ** ** | **70,759** | ** ** |
| Per share of  common stock:                                                               | ** ** | ** **                       | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                     | ** ** | **0.58**                         | ** **  | **0.57** | ** ** | **0.59** | ** ** | **0.58** | ** ** |
| Diluted                                                                                   | ** ** | **0.57**                         | ** **  | **0.57** | ** ** | **0.59** | ** ** | **0.57** | ** ** |
|                                                                                           |            |                                  |             |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                                | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **2005 (Dollars in thousands, except per share data)** | ** ** | **Dec. 31**                 | ** ** | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| Interest income                                                                           |       | $                                | 225,203    |   | $ | 214,525 |   | $ | 197,064 |   | $ | 179,245 |   |
| Interest expense                                                                          |       | 62,769                           |       | 55,283 |   | 44,697 |   | 36,162 |   |
| Net interest  income                                                                      |       | 162,434                          |       | 159,242 |   | 152,367 |   | 143,083 |   |
| Provision for  loan losses                                                                |       | —                           |       | 820 |   | — |   | 756 |   |
| Investment  securities gains (losses)                                                     |       | (53                              | )          | (32 | ) | 76 |   | 414 |   |
| Net income                                                                                |       | 74,863                           |       | 70,956 |   | 67,873 |   | 62,627 |   |
| Per share of  common stock:                                                               |       |                             |       |   |   |   |   |   |   |
| Basic                                                                                     |       | 0.61                             |       | 0.58 |   | 0.56 |   | 0.53 |   |
| Diluted                                                                                   |       | 0.60                             |       | 0.57 |   | 0.56 |   | 0.52 |   |
|                                                                                           |            |                                  |            |  |  |  |  |  |  |  |  |  |  |

 

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RECONCILIATION OFNON-GAAP MEASURES

We believe the non-GAAPmeasures we use provide information useful to investors in understanding ourongoing core business and operational performance trends.  These measures should not be viewed as asubstitute for GAAP.  Management believespresentations of financial measures excluding the impact of certain itemsprovide useful supplemental information and better reflect its core operatingactivities.  In order to arrive at corebusiness operating results, the effects of certain non-core businesstransactions such as gains and losses on the sales of securities, amortization ofintangibles, restructuring charges and merger-related expenses, have beenexcluded.  Management reviews these samemeasures internally.  For instance, thecash operating efficiency ratio, rather than the GAAP basis efficiency ratio,is used to measure management’s success at controlling ongoing, core operatingexpenses.  Additionally, managementbelieves that reporting several key measures based on tangible assets (totalassets less intangible assets) and tangible equity (total equity lessintangible assets) is important as this more closely approximates the basis formeasuring the adequacy of capital for regulatory purposes.

|        | ** ** | **For the twelve months ended  December 31,** | ** ** | ** ** | ** ** | **For the three months  December 31,** | ** ** |
|--------|------------|------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------|------------|
|   |       | **2006**                                                               |       |       |       | 2005                                                       |       |   |   | **2006** | ** ** |   |   | 2005 | ** ** |
|        |            |                                                                        |            |            |            |                                                            |            |  |  |  |  |  |  |  |  |

 

(1)The net interest margin and efficiency ratios are presented on afully taxable-equivalent (FTE) and annualized basis.  The FTE basis adjusts for the tax-favoredstatus of income from certain loans and investments.  Management believes this measure to be thepreferred industry measurement of net interest income and provides a relevantcomparison between taxable and nontaxable investments.

 

|  Net interest income (GAAP basis)         | ** ** | **$**     | **655,787** |   |   |   | $      | 617,126 |       |      | ** ** | **$**  | **169,995** |   |   |   | $ | 162,434 |   |
|------------------------------------------------|------------|-----------|-------------|--------|--------|--------|--------|---------|------------|-----------|------------|--------|-------------|--------|--------|--------|---|---------|--------|
|  Taxable-equivalent adjustment            | ** ** | **7,371** |        |   |   | 6,847  |   |    | ** ** | **1,847** |       |   |        | 1,833  |   |
|  Net interest income - taxable equivalent | ** ** | **$**     | **663,158** |   |   |   | $      | 623,973 |       |      | ** ** | **$**  | **171,842** |   |   |   | $ | 164,267 |   |

 

(2) Management excludes the balance of intangible assets and theirrelated amortization expense from its calculation of return on average tangibleequity and average tangible equity to average tangible assets.  This adjustment allows management to reviewthe core operating results and core capital position of Bankshares.  This is consistent with the treatment by thebank regulatory agencies that excludes goodwill and other intangible assetsfrom their calculation of risk-based capital ratios.

 

|  Return on average equity (GAAP basis)                           | ** ** | **12.31** | **%**  |   |   | 13.18  | %      |   | ** ** | **11.78** | **%**  |   |   | 13.44  | %      |
|-----------------------------------------------------------------------|------------|-----------|--------|--------|--------|--------|--------|--------|------------|-----------|--------|--------|--------|--------|--------|
|  Impact of excluding average intangible  assets and amortization | ** ** | **6.09**  |   |   |   | 6.36   |   |   | ** ** | **6.23**  |   |   |   | 6.82   |   |
|  Return on average tangible equity                               | ** ** | **18.40** | **%**  |   |   | 19.54  | %      |   | ** ** | **18.01** | **%**  |   |   | 20.26  | %      |
|                                                                  |       |      |   |   |   |   |   |   |       |      |   |   |   |   |   |
|                                                                  |       |      |   |   |   |   |   |   |       |      |   |   |   |   |   |
|  Average equity to average assets (GAAP  basis)                  | ** ** | **13.75** | **%**  |   |   | 13.51  | %      |   | ** ** | **13.95** | **%**  |   |   | 13.59  | %      |
|  Impact of excluding average intangible  assets and amortization | ** ** | **(3.93** | **)**  |   |   | (3.81  | )      |   | ** ** | **(4.15** | **)**  |   |   | (3.98  | )      |
|  Average tangible equity to average tangible  assets             | ** ** | **9.82**  | **%**  |   |   | 9.70   | %      |   | ** ** | **9.80**  | **%**  |   |   | 9.61   | %      |

 

(3) The efficiency ratio is measured by dividing noninterest expensesby the sum of net interest income on an FTE basis and noninterest income.  When computing the cash operating efficiencyratio and cash operating earnings, management excludes the amortization ofintangible assets, restructuring charges, merger-related expenses, and gainsand losses on sales of premises and from the sales of investment securities inorder to assess the core operating results of Bankshares and because of theuncertainty as to timing and amount of gain or loss to be recognized.

 

|  Efficiency ratio (GAAP basis)   | ** ** | **49.83**  | **%**  |   |   | 48.53  | %      |   | ** ** | **53.29**  | **%**  |   |   | 47.87  | %      |
|---------------------------------------|------------|------------|--------|--------|--------|--------|--------|--------|------------|------------|--------|--------|--------|--------|--------|
|  Impact of excluding:            | ** ** | ** ** |   |   |   |   |   |   | ** ** | ** ** |   |   |   |   |   |
| Securities gains and  (losses)        | ** ** | **0.01**   |   |   |   | 0.03   |   |   | ** ** | **—** |   |   |   | (0.01  | )      |
| Gains on sales of premises            | ** ** | **0.10**   |   |   |   | 0.24   |   |   | ** ** | **0.37**   |   |   |   | — |   |
| Amortization of deposit intangibles   | ** ** | **(0.75**  | **)**  |   |   | (0.67  | )      |   | ** ** | **(0.91**  | **)**  |   |   | (0.66  | )      |
| Amortization of other intangibles     | ** ** | **(0.33**  | **)**  |   |   | (0.35  | )      |   | ** ** | **(0.26**  | **)**  |   |   | (0.35  | )      |
| Restructuring charges                 | ** ** | **—** |   |   |   | — |   |   | ** ** | **—** |   |   |   | — |   |
| Merger-related expenses               | ** ** | **(1.54**  | **)**  |   |   | (0.17  | )      |   | ** ** | **(5.58**  | **)**  |   |   | (0.16  | )      |
|  Cash operating efficiency ratio | ** ** | **47.32**  | **%**  |   |   | 47.61  | %      |   | ** ** | **46.91**  | **%**  |   |   | 46.69  | %      |

 

(4) Bankshares presents cash operating earnings in order to assess itscore operating results.

 

|  Net income (GAAP basis)                   | ** ** | **$**      | **288,286** |   |   |   | $      | 276,319 |       |       | ** ** | **$**  | **72,862** |   |   |   | $ | 74,863 |   |
|-------------------------------------------------|------------|------------|-------------|--------|--------|--------|--------|---------|------------|------------|------------|--------|------------|--------|--------|--------|---|--------|--------|
| Less:                                           | ** ** | ** ** | ** **  |   |   |   |   |    | ** ** | ** ** | ** ** |   |       |   |   |
| Securities (gains) and losses, net of tax       | ** ** | **(128**   | **)**       |   |   | (245   | )      |    | ** ** | **(4**     | **)**      |   |       | 32     |   |
| Gains on sales of premises, net of tax          | ** ** | **(1,054** | **)**       |   |   | (2,624 | )      |    | ** ** | **(992**   | **)**      |   |       | — |   |
| Plus:                                           | ** ** | ** ** |        |   |   |   |   |    | ** ** | ** ** |       |   |       |   |   |
| Amortization of deposit intangibles, net of tax | ** ** | **4,140**  |        |   |   | 3,492  |   |    | ** ** | **1,327**  |       |   |       | 899    |   |
| Amortization of other intangibles, net of tax   | ** ** | **1,845**  |        |   |   | 1,812  |   |    | ** ** | **388**    |       |   |       | 486    |   |
| Restructuring charges, net of tax               | ** ** | **—** |        |   |   | — |   |    | ** ** | **—** |       |   |       | — |   |
| Merger-related expenses, net of tax             | ** ** | **9,797**  |        |   |   | 877    |   |    | ** ** | **9,386**  |       |   |       | 216    |   |
| Cash operating earnings                         | ** ** | **$**      | **302,886** |   |   |   | $      | 279,631 |       |       | ** ** | **$**  | **82,967** |   |   |   | $ | 76,496 |   |

 

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RECENT ACCOUNTING PRONOUNCEMENTS

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

InMarch 2006, the FASB issued SFAS No. 156, “Accounting for Servicing ofFinancial Assets-An Amendment of FASB Statement No. 140.”  This standard amends the guidance in SFASNo.140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.”  Amongother requirements, SFAS No. 156 requires an entity to recognize a servicingasset or servicing liability each time it undertakes an obligation to service afinancial asset by entering into a servicing contract.  The standardrequires initial measurement of all newly purchased or issued separatelyrecognized servicing assets and servicing liabilities at fair value, ifpracticable.  Subsequent measurements maybe made using either the fair value or amortization method.  SFAS No. 156 is effective as of thebeginning of an entity’s first fiscal year that begins after September 15, 2006with early adoption permitted in the quarter-ended March 31, 2006.  Bankshares does not anticipate this statementwill have a material effect on its results of operations or financialcondition.

# On July 13, 2006, the FASBissued FASB Interpretation No. 48 (“FIN 48”).  FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, “Accounting for IncomeTaxes”.  FIN 48 prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  An enterprise shall disclose thecumulative effect of the change on retained earnings in the statement offinancial position as of the date of adoption and such disclosure is requiredonly in the year of adoption. Bankshares expects that the effect of adoptingFIN 48 will result in an immaterial adjustment to 2007 opening retainedearnings.

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

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

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

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**ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Marketrisk refers to the risk of loss arising from adverse changes in interest rates,foreign currency exchange rates, commodity prices, and other relevant marketrates and prices, such as equity prices. The risk of loss can be assessed fromthe perspective of adverse changes in fair values, cash flows, and futureearnings.  Due to the nature of itsoperations, Bankshares is primarily exposed to interest rate risk and, to alesser extent, liquidity risk.

Referto Item 1A. Risk Factors and Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, of this report, along with thecautionary statements set forth elsewhere in this report for additionalinformation.

**ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**
|                                                                                                                   |
|-------------------------------------------------------------------------------------------------------------------|
| Report of Independent Registered Public Accounting  Firm on Consolidated Financial Statements           |
|                                                                                                              |
| Management’s Report on Internal Control Over Financial  Reporting                                  |
|                                                                                                              |
| Report of Independent Registered Public Accounting  Firm on Internal Control Over Financial Reporting   |
|                                                                                                              |
| Report of Independent Registered Public Accounting  Firm on Consolidated Financial Statements           |

 

ConsolidatedFinancial Statements
| Consolidated Balance Sheets,  December 31, 2006 and 2005                                                               |
|------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                   |
| Statements of  Consolidated Income for the years ended December 31, 2006, 2005 and 2004                                |
|                                                                                                                   |
| Statements of  Changes in Consolidated Shareholders’ Equity for the years ended December 31,  2006, 2005 and 2004 |
|                                                                                                                   |
| Statements of  Consolidated Cash Flows for the years ended December 31, 2006, 2005 and 2004                            |
|                                                                                                                   |
| Notes to  Consolidated Financial Statements                                                                            |

** **

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**Report ofIndependent Registered Public Accounting Firm**

**The Board of Directors andShareholders of Mercantile Bankshares Corporation:**

We have audited the accompanying consolidated balancesheet of Mercantile Bankshares Corporation as of December 31, 2006, and therelated consolidated statements of income, shareholders’ equity, and cash flowsfor the year then ended.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting amounts and disclosures in the financial statements.  An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation.  We believe that our audit provides areasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Mercantile Bankshares Corporation at December 31, 2006, and theconsolidated results of their operations and their cash flows for the year thenended, in conformity of U.S. generally accepted accounting principles.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Mercantile Bankshares Corporation’sinternal control over financial reporting as of December 31, 2006, based on thecriteria established in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated February 27, 2007, expressed an unqualified opinion thereon.
| /s/ Ernst & Young LLP |   |   |
|---------------------------|--------|--------|
| McLean, Virginia          |   |   |
| February 27,  2007        |   |   |

 

62

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**Management’s Report on Internal Control over Financial Reporting**

Management of Mercantile BanksharesCorporation, (together with its consolidated subsidiaries, we, us orBankshares), is responsible for establishing and maintaining adequate internalcontrol over financial reporting as defined in Rules 13a-15(f) and 15d-15(f)under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. Our internal control over financial reporting includes those policiesand procedures that:

(i)            pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of Bankshares;

(ii)           providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of Bankshares arebeing made only in accordance with authorization of management and directors ofBankshares; and

(iii)          providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of our assets that could have a material effecton the financial statements.

Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of ourinternal control over financial reporting as of December 31, 2006. In makingthis assessment, management used the criteria described in the “InternalControl-Integrated Framework” set forth by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

Based on our assessment and those criteria,management has concluded that, as of December 31, 2006, Bankshares’ internalcontrol over financial reporting was effective. Our independently registered public accounting firm has auditedmanagement’s assessment of the effectiveness of Bankshares’ internal controlover financial reporting as of December 31, 2006 as stated in their report thatappears on the following page.
| /s/ Edward J. Kelly, III                              |   |
|-------------------------------------------------------|--------|
| Edward J. Kelly,  III                                 |   |
| Chairman,  President and Chief Executive Officer      |   |
|                                                  |   |
| /s/ Terry L.  Troupe                                  |   |
| Terry L. Troupe                                       |   |
| Executive Vice  President and Chief Financial Officer |   |
|                                                  |   |
| Mercantile  Bankshares Corporation                    |   |
| March 1, 2007                                         |   |

** **

63

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**Report ofIndependent Registered Public Accounting Firm**

**The Board of Directors andShareholders of Mercantile Bankshares Corporation:**

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over FinancialReporting, that Mercantile Bankshares Corporation maintained effective internalcontrol over financial reporting as of December 31, 2006, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (the COSO criteria).Mercantile Bankshares Corporation’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit. 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment thatMercantile Bankshares Corporation maintained effective internal control overfinancial reporting as of December 31, 2006, is fairly stated, in all materialrespects, based on the COSO criteria. Also, in our opinion, Mercantile Bankshares Corporation maintained, inall material respects, effective internal control over financial reporting asof December 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheet of Mercantile Bankshares Corporation as of December31, 2006 and the related consolidated statements of income, shareholders’equity, and cash flows for the year then ended and our report dated February27, 2007, expressed an unqualified opinion thereon.

 
| /s/ Ernst & Young LLP |   |   |
|---------------------------|--------|--------|
| McLean, Virginia          |   |   |
| February 27,  2007        |   |   |

 

64

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**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors and Shareholders ofMercantile Bankshares Corporation:

In our opinion, theconsolidated balance sheet as of December 31, 2005 and the related consolidatedstatements of income, changes in shareholders’ equity and cash flows for eachof two years in the period ended December 31, 2005 present fairly, in all materialrespects, the financial position of Mercantile Bankshares Corporation and itssubsidiaries at December 31, 2005, and the results of their operations andtheir cash flows for each of the two years in the period ended December 31,2005, in conformity with accounting principles generally accepted in the UnitedStates of America.  These financialstatements are the responsibility of the Company's management.  Our responsibility is to express an opinionon these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.  

 
| /s/ PricewaterhouseCoopers  LLP |   |   |
|---------------------------------|--------|--------|
| Baltimore, MD                   |   |   |
| March 10, 2006                  |   |   |

 

65

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Consolidated Balance Sheets
| **DECEMBER 31,**                                                                                                 | ** ** | ** **     | ** **     | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|
| **(Dollars in thousands, except per share data)**                                       | ** ** | **2006**       | ** **     | **2005**   | ** ** |
| **ASSETS**                                                                                                            |       |           |           |       |       |
| Cash and due from banks                                                                                               | ** ** | **$**          | **347,246**    |       | $          | 369,536 |   |
| Interest-bearing  deposits in other banks                                                                             | ** ** | **200**        |           | 200        |       |
| Federal funds sold                                                                                                    | ** ** | **2,609**      |           | 25,104     |       |
| Total cash and  cash equivalents                                                                                      | ** ** | **350,055**    |           | 394,840    |       |
|                                                                                                                  |       |           |           |       |       |
| Trading account  securities at fair value                                                                             | ** ** | **3,605**      |           | —     |       |
|                                                                                                                  |       |           |           |       |       |
| Investment securities  available-for-sale amortized cost of $3,148,953 (2006) and $3,141,858 (2005)                   | ** ** | **3,110,453**  |           | 3,089,628  |       |
| Investment securities  held-to-maturity fair value of $13,462 (2006) and $17,181 (2005)                               |       | **13,099**     |           | 16,659     |       |
|                                                                                                                  |       |           |           |       |       |
| Loans held-for-sale                                                                                                   | ** ** | **—**     |           | 26,263     |       |
|                                                                                                                  |       |           |           |       |       |
| Loans                                                                                                                 | ** ** | **12,792,733** |           | 11,607,845 |       |
| Less: allowance for  loan losses                                                                                      | ** ** | **(143,029**   | **)**          | (156,673   | )          |
| Loans, net                                                                                                            | ** ** | **12,649,704** |           | 11,451,172 |       |
|                                                                                                                  |       |           |           |       |       |
| Bank premises and  equipment, net                                                                                     | ** ** | **141,464**    |           | 137,419    |       |
| Other real estate  owned, net                                                                                         | ** ** | **1,405**      |           | 667        |       |
| Goodwill, net                                                                                                         | ** ** | **768,686**    |           | 670,028    |       |
| Other intangible  assets, net                                                                                         | ** ** | **45,736**     |           | 46,653     |       |
| Other assets                                                                                                          | ** ** | **631,818**    |           | 588,400    |       |
| Total assets                                                                                                          | ** ** | **$**          | **17,716,025** |       | $          | 16,421,729 |   |
|                                                                                                                  |       |           |           |       |       |
| **LIABILITIES**                                                                                                       |       |           |           |       |       |
| Deposits:                                                                                                             |       |           |           |       |       |
| Noninterest-bearing  deposits                                                                                         | ** ** | **$**          | **3,271,286**  |       | $          | 3,324,650 |   |
| Interest-bearing  deposits                                                                                            | ** ** | **9,502,605**  |           | 8,752,700  |       |
| Total deposits                                                                                                        | ** ** | **12,773,891** |           | 12,077,350 |       |
| Short-term borrowings                                                                                                 | ** ** | **1,652,196**  |           | 1,237,714  |       |
| Accrued expenses and  other liabilities                                                                               | ** ** | **213,752**    |           | 169,780    |       |
| Long-term debt                                                                                                        | ** ** | **659,020**    |           | 742,163    |       |
| Total  liabilities                                                                                                    | ** ** | **15,298,859** |           | 14,227,007 |       |
|                                                                                                                  |       |           |           |       |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                     |       |           |           |       |       |
| ** **                                                                                                            |       |           |           |       |       |
| **SHAREHOLDERS’ EQUITY**                                                                                         |       |           |           |       |       |
| Preferred stock, no par  value; authorized 2,000,000 shares; issued and outstanding - None                            |       |           |           |       |       |
| Common stock, $2 par  value; authorized 200,000,000 shares; issued shares - 125,581,400 (2006) and  82,165,414 (2005) |       | **251,163**    |           | 164,331    |       |
| Capital surplus                                                                                                       | ** ** | **672,698**    |           | 676,830    |       |
| Retained earnings                                                                                                     | ** ** | **1,540,836**  |           | 1,386,405  |       |
| Accumulated other  comprehensive loss                                                                                 | ** ** | **(47,531**    | **)**          | (32,844    | )          |
| Total  shareholders’ equity                                                                                      | ** ** | **2,417,166**  |           | 2,194,722  |       |
| Total liabilities and  shareholders’ equity                                                                      | ** ** | **$**          | **17,716,025** |       | $          | 16,421,729 |   |

 

SeeNotes to Consolidated Financial Statements.

 

66

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Statements of Consolidated Income
| **For the years ended December 31,**                   | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **2006**    | ** **  | **2005**   | ** ** | **2004**   | ** ** |
| **INTEREST INCOME**                                                             |       |        |        |       |       |       |       |
| Interest and fees on  loans                                                     | ** ** | **$**       | **863,563** |       | $          | 700,832    |       | $ | 546,531 |   |
| Interest and dividends  on investment securities:                               |       |        |        |       |       |       |       |
| Taxable interest  income                                                        | ** ** | **126,492** |        | 107,133    |       | 105,423    |       |
| Tax-exempt  interest income                                                     | ** ** | **2,968**   |        | 3,161      |       | 3,266      |       |
| Other investment  income                                                        | ** ** | **2,655**   |        | 2,475      |       | 2,314      |       |
| Total interest  and dividends on investment securities                          | ** ** | **132,115** |        | 112,769    |       | 111,003    |       |
| Other interest income                                                           | ** ** | **3,044**   |        | 2,436      |       | 1,503      |       |
| Total interest  income                                                          | ** ** | **998,722** |        | 816,037    |       | 659,037    |       |
| **INTEREST EXPENSE**                                                            |       |        |        |       |       |       |       |
| Interest on deposits                                                            | ** ** | **251,118** |        | 139,917    |       | 83,403     |       |
| Interest on short-term  borrowings                                              | ** ** | **55,100**  |        | 26,266     |       | 7,844      |       |
| Interest on long-term  debt                                                     | ** ** | **36,717**  |        | 32,728     |       | 22,009     |       |
| Total interest  expense                                                         | ** ** | **342,935** |        | 198,911    |       | 113,256    |       |
| **NET INTEREST INCOME**                                                         | ** ** | **655,787** |        | 617,126    |       | 545,781    |       |
| Provision for credit  losses                                                    | ** ** | **—**  |        | 1,576      |       | 7,221      |       |
| **NET INTEREST INCOME AFTER  PROVISION FOR CREDIT LOSSES**                      | ** ** | **655,787** |        | 615,550    |       | 538,560    |       |
| **NONINTEREST INCOME**                                                          |       |        |        |       |       |       |       |
| Investment and wealth  management                                               | ** ** | **110,879** |        | 95,756     |       | 90,050     |       |
| Service charges on  deposit accounts                                            | ** ** | **46,339**  |        | 43,885     |       | 44,263     |       |
| Mortgage banking  related fees                                                  | ** ** | **6,786**   |        | 15,019     |       | 11,495     |       |
| Investment securities  gains                                                    | ** ** | **212**     |        | 405        |       | 1,239      |       |
| Nonmarketable  investments                                                      | ** ** | **23,520**  |        | 19,882     |       | 11,422     |       |
| Other income                                                                    | ** ** | **66,998**  |        | 68,173     |       | 55,460     |       |
| Total  noninterest income                                                       | ** ** | **254,734** |        | 243,120    |       | 213,929    |       |
| **NONINTEREST EXPENSES**                                                        |       |        |        |       |       |       |       |
| Salaries                                                                        | ** ** | **205,826** |        | 200,222    |       | 187,621    |       |
| Employee benefits                                                               | ** ** | **56,100**  |        | 46,175     |       | 44,676     |       |
| Net occupancy expense  of bank premises                                         | ** ** | **32,783**  |        | 28,596     |       | 24,307     |       |
| Furniture and equipment  expenses                                               | ** ** | **33,445**  |        | 31,659     |       | 31,439     |       |
| Communications and  supplies                                                    | ** ** | **16,034**  |        | 16,406     |       | 16,904     |       |
| Professional services                                                           | ** ** | **31,483**  |        | 21,914     |       | 25,302     |       |
| Advertising and promotional                                                     | ** ** | **11,663**  |        | 9,103      |       | 8,418      |       |
| Other expenses                                                                  | ** ** | **70,055**  |        | 66,746     |       | 53,291     |       |
| Total  noninterest expenses                                                     | ** ** | **457,389** |        | 420,821    |       | 391,958    |       |
| Income before  income taxes                                                     | ** ** | **453,132** |        | 437,849    |       | 360,531    |       |
| Provision for income  taxes                                                     | ** ** | **164,846** |        | 161,530    |       | 131,124    |       |
| **NET  INCOME**                                                                 | ** ** | **$**       | **288,286** |       | $          | 276,319    |       | $ | 229,407 |   |
| **NET INCOME PER SHARE OF COMMON  STOCK**                                       |       |        |        |       |       |       |       |
| Basic                                                                           | ** ** | **$**       | **2.32**    |       | $          | 2.28       |       | $ | 1.93 |   |
| Diluted                                                                         | ** ** | **$**       | **2.30**    |       | $          | 2.26       |       | $ | 1.92 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                                             | ** ** | **$**       | **1.10**    |       | $          | 0.99       |       | $ | 0.92 |   |

 

SeeNotes to Consolidated Financial Statements.

 

67

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Statements of Changes in Consolidated Shareholders’ Equity

**FOR YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**
| ** **                                                                                             | ** ** | ** ** | ** ** | **Common** | ** ** | **Capital** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|-------------|------------|--------------|------------|---------------------------------------|------------|
| **(Dollars in thousands, except per share data)**                        | ** ** | **Total**  | ** ** | **Stock**  | ** ** | **Surplus** | ** ** | **Earnings** | ** ** | **Income (Loss)**                | ** ** |
| BALANCE, DECEMBER 31,  2003                                                                            |       | $          | 1,841,441  |       | $          | 159,545     |       | $            | 548,664    |                                  | $          | 1,110,748 |   | $ | 22,484 |   |
| Net income                                                                                             |       | 229,407    |       |       |       |        |       | 229,407      |       |                                  |       |
| Unrealized losses on  securities available-for-sale, net of reclassification adjustment, net of  taxes |       | (25,209    | )          |       |       |        |       |         |       | (25,209                               | )          |
| Comprehensive income                                                                                   |       | 204,198    |       |       |       |        |       |         |       |                                  |       |
| Cash dividends paid:                                                                                   |       |       |       |       |       |        |       |         |       |                                  |       |
| Common stock  ($0.92 per share)                                                                        |       | (109,295   | )          |       |       |        |       | (109,295     | )          |                                  |       |
| Issuance of 117,126  shares for dividend reinvestment and stock purchase plan                          |       | 5,281      |       | 234        |       | 5,047       |       |         |       |                                  |       |
| Issuance of 24,583  shares for employee stock purchase dividend reinvestment plan                      |       | 1,130      |       | 50         |       | 1,080       |       |         |       |                                  |       |
| Stock options                                                                                          |       |       |       |       |       |        |       |         |       |                                  |       |
| Issuance of  350,110 shares                                                                            |       | 7,911      |       | 700        |       | 7,211       |       |         |       |                                  |       |
| Expense                                                                                                |       | 1,892      |       |       |       | 1,892       |       |         |       |                                  |       |
| Stock awards                                                                                           |       |       |       |       |       |        |       |         |       |                                  |       |
| Issuance of  35,982 shares                                                                             |       | 1,632      |       | 72         |       | 1,560       |       |         |       |                                  |       |
| Deferred  compensation                                                                                 |       | (1,632     | )          |       |       |        |       | (1,632       | )          |                                  |       |
| Expense                                                                                                |       | 2,042      |       |       |       |        |       | 2,042        |       |                                  |       |
| Directors’ deferred  compensation plan                                                            |       |       |       |       |       |        |       |         |       |                                  |       |
| Transfer opening  balance                                                                              |       | 6,406      |       |       |       | 6,406       |       |         |       |                                  |       |
| Contribution                                                                                           |       | 787        |       |       |       | 787         |       |         |       |                                  |       |
| Dividend                                                                                               |       | —     |       |       |       | 168         |       | (168         | )          |                                  |       |
| Purchase of 1,000,000  shares under stock repurchase plan                                              |       | (44,110    | )          | (2,000     | )          | (42,110     | )          | —       |       | —                                |       |
| BALANCE, DECEMBER 31,  2004                                                                            |       | 1,917,683  |       | 158,601    |       | 530,705     |       | 1,231,102    |       | (2,725                                | )          |
| Net income                                                                                             |       | 276,319    |       |       |       |        |       | 276,319      |       |                                  |       |
| Unrealized losses on  securities available-for-sale, net of reclassification adjustment, net of  taxes |       | (30,119    | )          |       |       |        |       |         |       | (30,119                               | )          |
| Comprehensive income                                                                                   |       | 246,200    |       |       |       |        |       |         |       |                                  |       |
| Cash dividends paid:                                                                                   |       |       |       |       |       |        |       |         |       |                                  |       |
| Common stock  ($0.99 per share)                                                                        |       | (120,167   | )          |       |       |        |       | (120,167     | )          |                                  |       |
| Issuance of 2,460,995  shares for acquisitions                                                         |       | 125,351    |       | 4,922      |       | 120,429     |       |         |       |                                  |       |
| Fair value of 138,764  converted options related to employee stock option plan of acquired bank        |       | 5,182      |       |       |       | 5,182       |       |         |       |                                  |       |
| Issuance of 108,693  shares for dividend reinvestment and stock purchase plan                          |       | 5,506      |       | 217        |       | 5,289       |       |         |       |                                  |       |
| Issuance of 22,803  shares for employee stock purchase dividend reinvestment plan                      |       | 1,195      |       | 46         |       | 1,149       |       |         |       |                                  |       |
| Stock options                                                                                          |       |       |       |       |       |        |       |         |       |                                  |       |
| Issuance of  203,695 shares                                                                            |       | 4,504      |       | 407        |       | 4,097       |       |         |       |                                  |       |
| Expense                                                                                                |       | 5,196      |       |       |       | 5,196       |       |         |       |                                  |       |
| Stock awards                                                                                           |       |       |       |       |       |        |       |         |       |                                  |       |
| Issuance of 57,728  shares                                                                             |       | 3,055      |       | 116        |       | 2,939       |       |         |       |                                  |       |
| Deferred  compensation                                                                                 |       | (3,222     | )          |       |       |        |       | (3,222       | )          |                                  |       |
| Expense                                                                                                |       | 2,637      |       |       |       |        |       | 2,637        |       |                                  |       |
| Directors’ deferred  compensation plan                                                            |       |       |       |       |       |        |       |         |       |                                  |       |
| Issuance of  10,994 shares                                                                             |       | 470        |       | 22         |       | 448         |       |         |       |                                  |       |
| Contribution                                                                                           |       | 1,132      |       |       |       | 1,132       |       |         |       |                                  |       |
| Dividend                                                                                               |       | —     |       | —     |       | 264         |       | (264         | )          | —                                |       |
| BALANCE, DECEMBER 31, 2005                                                                             |       | 2,194,722  |       | 164,331    |       | 676,830     |       | 1,386,405    |       | (32,844                               | )          |
|                                                                                                        |            |            |            |            |            |             |            |              |            |                                       |            |  |  |  |  |  |

 

*Continued on following page*

 

68

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**FOR YEARSENDED DECEMBER 31, 2006, 2005 and 2004**

 
| ** **                                                                                            | ** ** | ** ** | ** **    | ** ** | ** ** | ** **  | ** ** | ** **   | ** **  | **Accumulated  Other** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|---------------|------------|------------|-------------|------------|--------------|-------------|------------------------|------------|
| ** **                                                                                            | ** ** | ** ** | ** **    | **Common** | ** ** | **Capital** | ** ** | **Retained** | ** **  | **Comprehensive**      | ** ** |
| **(Dollars in thousands, except per share data)**                       | ** ** | **Total**  | ** **    | **Stock**  | ** ** | **Surplus** | ** ** | **Earnings** | ** **  | **Income (Loss)** | ** ** |
| Net income                                                                                            |       | 288,286    |          |       |       |        |       | 288,286      |        |                   |       |
| Unrealized gains  on securities available-for-sale, net of reclassification adjustment, net of  taxes |       | 8,457      |          |       |       |        |       |         |        | 8,457                  |       |
| Comprehensive  income                                                                                 |       | 296,743    |          |       |       |        |       |         |        |                   |       |
| Adjustment to  initially apply SFAS No. 158, net of taxes                                             |       | (23,144    | )             |       |       |        |       |         |        |                   |       |
| Cash dividends  paid:                                                                                 |       |       |          |       |       |        |       |         |        | (23,144                | )          |
| Common stock ($1.10 per share)                                                                        |       | (136,714   | )             |       |       |        |       | (136,714     | )           |                   |       |
| Issuance of  1,833,757 shares for bank acquisition                                                    |       | 63,140     |          | 3,668      |       | 59,472      |       |         |        |                   |       |
| Fair value of  138,066 converted options related to employee stock option plan of acquired  bank      |       | 1,605      |          |       |       | 1,605       |       |         |        |                   |       |
| Issuance of  134,274 shares for dividend reinvestment and stock purchase plan                         |       | 4,706      |          | 268        |       | 4,438       |       |         |        |                   |       |
| Issuance of  28,613 shares for employee stock purchase dividend reinvestment plan                     |       | 1,073      |          | 57         |       | 1,016       |       |         |        |                   |       |
| Stock options                                                                                         |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of 195,724 shares                                                                            |       | 4,178      |          | 392        |       | 3,786       |       |         |        |                   |       |
| Expense                                                                                               |       | 3,020      |          |       |       | 3,020       |       |         |        |                   |       |
| Stock awards and  units                                                                               |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of 177,480 shares                                                                            |       | 368        |          | 355        |       | 13          |       |         |        |                   |       |
| Repurchase of 44,409 shares for tax settlement                                                        |       | (1,755     | )             | (89        | )          | (1,666      | )          |         |        |                   |       |
| Expense                                                                                               |       | 8,133      |          |       |       | 8,133       |       |         |        |                   |       |
| Directors’  deferred compensation plan                                                           |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of 5,721 shares                                                                              |       | 192        |          | 11         |       | 181         |       |         |        |                   |       |
| Contribution                                                                                          |       | 981        |          |       |       | 981         |       |         |        |                   |       |
| Dividend                                                                                              |       |       |          |       |       | 347         |       | (347         | )           |                   |       |
| Adoption of SFAS  No. 123(R)                                                                          |       |       |          |       |       | (3,206      | )          | 3,206        |        |                   |       |
| Issuance of  41,084,826 shares for a 3-for-2 stock split                                              |       | (82        | )             | 82,170     |       | (82,252     | )          |         |        |                   |       |
| **BALANCE, DECEMBER 31, 2006**                                                                        | ** ** | **$**      | **2,417,166** | ** ** | **$**      | **251,163** | ** ** | **$**        | **672,698** | ** **             | **$**      | **1,540,836** | ** ** | **$** | **(47,531** | **)** |
|                                                                                                       |            |            |               |            |            |             |            |              |             |                        |            |  |  |  |  |  |

 

SeeNotes to Consolidated Financial Statements.

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Statementsof Consolidated Cash Flows

 
| **FOR YEARS ENDED DECEMBER 31,**                               | ** ** | ** **     | ** **  | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------|-------------|------------|------------|------------|------------|
| **(Dollars in thousands)**                                               | ** ** | **2006**       | ** **  | **2005**   | ** ** | **2004**   | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         | ** ** | ** **     |        |       |       |       |       |
| Net income                                                                         | ** ** | **$**          | **288,286** |       | $          | 276,319    |       | $ | 229,407 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: | ** ** | ** **     |        |       |       |       |       |
| Provision for  credit losses                                                       | ** ** | **—**     |        | 1,576      |       | 7,221      |       |
| Depreciation                                                                       | ** ** | **15,780**     |        | 15,558     |       | 15,645     |       |
| Amortization of  other intangible assets                                           | ** ** | **9,901**      |        | 8,773      |       | 8,142      |       |
| Provision for  deferred tax benefits                                               | ** ** | **(9,678**     | **)**       | (9,263     | )          | (23,749    | )          |
| Tax benefit from  the issuance of stock-based awards                               | ** ** | **168**        |        | —     |       | —     |       |
| Write-downs of  other real estate owned                                            | ** ** | **—**     |        | 1          |       | 14         |       |
| Gains on sales  of other real estate owned                                         | ** ** | **(7**         | **)**       | (198       | )          | (204       | )          |
| Gains on sales  of investments securities                                          | ** ** | **(212**       | **)**       | (405       | )          | (1,239     | )          |
| Gains on sales  of premises                                                        | ** ** | **(1,744**     | **)**       | (4,341     | )          | (1,664     | )          |
| Net (increase)  decrease in assets:                                                | ** ** | ** **     |        |       |       |       |       |
| Loans  held-for-sale                                                               | ** ** | **27,468**     |        | (14,974    | )          | 3,925      |       |
| Interest  receivable                                                               | ** ** | **(11,595**    | **)**       | (9,052     | )          | 2,486      |       |
| Nonmarketable  investments                                                         | ** ** | **(11,972**    | **)**       | 13,100     |       | (11,297    | )          |
| Trading account  assets, net                                                       | ** ** | **(3,605**     | **)**       | —     |       | —     |       |
| Other assets                                                                       | ** ** | **(15,024**    | **)**       | 7,360      |       | 14,349     |       |
| Net increase (decrease)  in liabilities:                                           | ** ** | ** **     |        |       |       |       |       |
| Interest payable                                                                   | ** ** | **19,286**     |        | 8,373      |       | (1,113     | )          |
| Other  liabilities                                                                 | ** ** | **7,329**      |        | (1,205     | )          | 7,307      |       |
| Net cash  provided by operating activities                                         | ** ** | **314,381**    |        | 291,622    |       | 249,230    |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         | ** ** | ** **     |        |       |       |       |       |
| Proceeds from  maturities of investment securities held-to-maturity                | ** ** | **3,560**      |        | 3,517      |       | 8,037      |       |
| Proceeds from  maturities of investment securities available-for-sale              | ** ** | **1,006,738**  |        | 898,334    |       | 917,216    |       |
| Proceeds from sales of  investment securities available-for-sale                   | ** ** | **108,184**    |        | 121,634    |       | 49,314     |       |
| Purchases of investment  securities available-for-sale                             | ** ** | **(1,005,380** | **)**       | (1,078,446 | )          | (871,948   | )          |
| Net increase in  customer loans                                                    | ** ** | **(777,196**   | **)**       | (713,794   | )          | (973,155   | )          |
| Proceeds from sales of  other real estate owned                                    | ** ** | **2,241**      |        | 485        |       | 533        |       |
| Capital expenditures                                                               | ** ** | **(23,831**    | **)**       | (10,214    | )          | (10,474    | )          |
| Proceeds from sales of  premises                                                   | ** ** | **2,969**      |        | 7,981      |       | 3,872      |       |
| Proceeds from sale of  interest in Ltd Partnership                                 | ** ** | **6,705**      |        | —     |       | —     |       |
| Business acquisitions  (net of cash received)                                      | ** ** | **(61,251**    | **)**       | (78,655    | )          | —     |       |
| Business acquisition  contingent consideration                                     | ** ** | **(8,806**     | **)**       | —     |       | —     |       |
| Purchase of  nonmarketable investments                                             | ** ** | **(14,619**    | **)**       | (58,581    | )          | (9,799     | )          |
| Net cash used in  investing activities                                             | ** ** | **(760,686**   | **)**       | (907,739   | )          | (886,404   | )          |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         | ** ** | ** **     |        |       |       |       |       |
| Net increase (decrease)  in noninterest-bearing deposits                           | ** ** | **(149,080**   | **)**       | 167,769    |       | 298,310    |       |
| Net increase in  interest-bearing deposits                                         | ** ** | **412,602**    |        | 485,400    |       | 238,338    |       |
| Net increase in  short-term borrowings                                             | ** ** | **360,323**    |        | 340,151    |       | 78,836     |       |
| Proceeds from issuance  of long-term debt                                          | ** ** | **—**     |        | —     |       | 51,250     |       |
| Repayment of long-term  debt                                                       | ** ** | **(95,837**    | **)**       | (118,535   | )          | (8,044     | )          |
| Tax benefit from the  issuance of stock-based awards                               | ** ** | **1,164**      |        | —     |       | —     |       |
| Excess tax benefit  related to stock-based awards                                  | ** ** | **860**        |        | —     |       | —     |       |
| Proceeds from issuance  of shares                                                  | ** ** | **9,957**      |        | 11,205     |       | 14,322     |       |
| Repurchase of common  shares                                                       | ** ** | **(1,755**     | **)**       | —     |       | (44,110    | )          |
| Dividends paid                                                                     | ** ** | **(136,714**   | **)**       | (120,167   | )          | (109,295   | )          |
| Net cash  provided by financing activities                                         | ** ** | **401,520**    |        | 765,823    |       | 519,607    |       |
| Net increase (decrease)  in cash and cash equivalents                              | ** ** | **(44,785**    | **)**       | 149,706    |       | (117,567   | )          |
| Cash and cash  equivalents at beginning of period                                  | ** ** | **394,840**    |        | 245,134    |       | 362,701    |       |
| Cash and cash equivalents  at end of period                                        | ** ** | **$**          | **350,055** |       | $          | 394,840    |       | $ | 245,134 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |           |        |       |       |       |       |
| Cash payments for  interest                                                        | ** ** | **$**          | **322,475** |       | $          | 189,186    |       | $ | 114,370 |   |
| Cash payments for income taxes                                                     | ** ** | **175,987**    |        | 173,306    |       | 138,832    |       |

 

See Notes to Consolidated Financial Statements.

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Notes to Consolidated Financial Statements

1.SIGNIFICANT ACCOUNTING POLICIES

A.Basis of PresentationMercantile BanksharesCorporation (“Bankshares”) is a regional multibank holding companyheadquartered in Baltimore, Maryland.  AtDecember 31, 2006, Bankshares had $17.7 billion in assets, $12.8 billion inloans and $12.8 billion in deposits.  Itis the largest bank holding company headquartered in the state ofMaryland.  The two principal lines ofbusiness are Banking Services and Investment & Wealth Management (“IWM”),delivered through the lead bank Mercantile-Safe Deposit and Trust Company (“MSD&T”)and 10 affiliated banks.  Theconsolidated financial statements, which include the accounts of MercantileBankshares Corporation (“Bankshares”) (Nasdaq:  MRBK) and all of itsaffiliates, are prepared in conformity with accounting principles generallyaccepted in the United States of America and follow general practice within thebanking industry.  All significant intercompanytransactions have been eliminated.  Forpurposes of comparability, certain prior period amounts have been reclassifiedto conform to current period presentation.

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and contingent assets and liabilities at the date of the financialstatements and the disclosure of revenues and expenses during the reportingperiod.  These estimates and assumptions,such as the accounting for loan losses and reserve for unfunded commitments,depreciation and pension obligations, are based on information available as ofthe date of the financial statements and could differ from actual results.

Assets(other than cash deposits) held for others under fiduciary and agencyrelationships are not included in the accompanying balance sheets since theyare not assets of Bankshares or its affiliates. Acquisitions accounted for as purchases are included in the financialstatements from the respective dates of affiliation.

OnJanuary 10, 2006, Bankshares announced a three-for-two stock split on itscommon stock.  Certain share, averageshare and per share amounts have been adjusted to give effect to the split.

B.Investment SecuritiesInvestments areclassified as either “held-to-maturity” or “available-for-sale” or “trading” atthe date of commitment of purchase.  Thefair value of securities is based on pricing services that rely on quotedmarket prices, or if quoted market prices are not available, then the fairvalue is estimated using quoted market prices for similar securities, pricingmodels or discounted cash flow analysis. Interest and dividends declared on securities are recognized in interestand dividend income on an accrual basis. Premiums and discounts on debt securities are amortized/accreted by thelevel yield methods adjusted for the effects of prepayments on the underlyinginvestments.  Realized gains and lossesare recognized on a specific identification trade date basis.  Amortized cost is used to compute gains orlosses on the sales of securities, which are reported in the Statement ofConsolidated Income.

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Investmentsecurities classified as “held-to-maturity” are acquired with the intent andability to hold until maturity and are carried at cost, adjusted foramortization of premiums and accretion of discounts.  Investment securities classified as “available-for-sale”are acquired to be held for indefinite periods of time and may be sold inresponse to changes in interest rates and/or prepayment risk or for liquiditymanagement purposes.  These securities arecarried at fair value, and any unrealized gain or loss in the market value ofavailable-for-sale securities is reported as accumulated other comprehensiveincome, a separate component of shareholders’ equity, net of applicabletaxes.  Trading securities are acquiredwith the intent to be held for a short period with a subsequent resale.  These securities are carried at fair valuewith realized and unrealized gains and losses recorded in trading accountprofit and losses in the results of operations.

Anassessment is made at the end of each quarter to determine whether there havebeen any events or economic circumstances to indicate that a security isimpaired on an other-than-temporary basis. An other-than-temporary impairment may develop if, based on allavailable evidence, the carrying amount of the investment is not recoverablewithin a reasonable period of time. Factors considered in making this assessment include, among others, theintent and ability to hold the investment for a period of time sufficient for arecovery in value; external credit ratings and recent downgrades; market pricefluctuations due to factors other than interest rates; and the probability ofcollection of contractual cash flows. Securities on which there is an unrealized loss that is deemed to beother-than-temporary are written down to fair value, and the adjustment isrecorded as a realized loss in securities gains (losses).

C.LoansInterestincome on loans is accrued at the contractual rate on the principal amountoutstanding.  Beginning in 2005, loanorigination and commitment fees, direct loan acquisition and origination costs,when significant, are deferred and accreted to interest income over the life ofthe loan or over the commitment period. Loans held-for-sale in conjunction with the mortgage banking businessare carried at the lower of aggregate cost or fair value.  Fees related to loans held-for-sale arerecognized as a component of mortgage banking income upon the sale of theloan.  Valuation allowances on these impairedloans reflect only losses incurred after the acquisition (meaning the presentvalue of all cash flows expected at acquisition that are ultimately notreceived) with the estimated cash flows reevaluated on a quarterly basis.  When scheduled principal or interest paymentsare past due 90 days or more at quarter-end on any loan, the accrual ofinterest income is discontinued. Subsequent receipts on these loans are recorded as a reduction ofprincipal, and interest income is recorded only once principal recovery isreasonably assured.  Previously accruedbut uncollected interest on these loans is charged against interestincome.  Generally, a loan may berestored to accruing status when all past due principal, interest and latecharges have been paid and Bankshares expects repayment of the remainingcontractual principal and interest.

In accordance with Statements of Financial AccountingStandards (“SFAS”) Nos. 114 and 118, “Accounting by Creditors for Impairment ofa Loan - an amendment of FASB Statements Nos. 5 and 15” a loan is consideredimpaired when, based on current information and events, if it is probable thatBankshares will not collect all principal and interest payments according tothe contractual terms of the loan agreement. The impairment of a loan is measured based on the present value ofexpected future cash flows discounted at the loan’s effective interest rate, orthe fair value of the collateral if the repayment is expected to be providedpredominantly by the underlying collateral. Impaired loans do not include largegroups of smaller balance homogeneous loans that are evaluated collectively forimpairment (e.g., residential mortgages and consumer installment loans).  The allowance for loan losses related tothese loans is included in the allowance for loan losses applicable to otherthan impaired loans. A majority of Bankshares’impaired loans are measured by reference to the fair value of the collateral.

D.Allowance for Loan Losses and Reserve for Unfunded CommitmentsThe allowance forloan losses and reserve for unfunded commitments are estimated at a levelconsidered by management to be adequate to absorb losses inherent in the loanportfolio.  Management’s assessmentincludes the systematic evaluation of several factors:  current economic conditions and their impacton specific borrowers and industry groups; the level of classified andnonperforming loans; the historical loss probability of default and loss givendefault by loan type; the results of regulatory examinations; and, in specificcases, the estimated value of underlying collateral.  The assessments of economic conditions,results of regulatory examinations and other risk elements are primarilydetermined by management at each affiliate and reviewed by Bankshares.  In developing this assessment, managementmust rely on estimates and exercise judgment in assigning credit risk.Depending on changing circumstances, future assessments of credit risk mayyield materially different results from the estimates, which may require anincrease or a decrease in the allowance for loan losses and reserve forunfunded commitments.

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Theallowance is increased or reduced by the loan loss provision charged orcredited to operating expenses and reduced by loan charge-offs, net ofrecoveries.  The provision for loanlosses is based on a continuing review of the loan portfolios, past lossexperience and current economic conditions that may affect borrowers’ abilityto pay.  A loan is charged-off when, inmanagement’s judgment, the collection of the remaining balance carried isremote.  Consumer loans that are 90 dayspast due at quarter end, unless well secured and in the process of collection,are charged off immediately.

Weemploy modeling and estimation tools in developing the appropriate allowanceand reserve for unfunded commitments. Bankshares’ allowance consists of formula-based components for businessand retail loans, an allowance for impaired loans and an unallocatedcomponent.  The following provides adescription of each of these components of the allowance, the techniques usedand the estimates and judgments inherent in each.  In the first quarter of 2006, managementrefined the methodologies for the formula-based components to align more appropriatelythe allowance methodology with our current framework for analyzing creditlosses.  Formula-based allowancecalculations for business and retail components permit us to addressspecifically the current trends and events affecting the credit risk in theloan portfolio.  The reserve for unfundedcommitments is estimated using the same methodology.

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

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

Forboth business and retail loans, the formula-based components include additionalqualitative amounts to establish reasonable ranges that consider observedhistorical variability in losses. Factors we may consider in setting these amounts include, but are notlimited to, industry-specific data, portfolio specific risks or concentrations,and macroeconomic conditions. Including these variability components in themodel enables us to capture probable incurred losses that are not yet evidentin current default grades, delinquencies and other credit-risk measurementtools.

Themodeling process used in for the determination of the reserve for unfundedlending commitments is consistent with the process for the formula-basedcomponent of the allowance for loan losses, also including as a key factor abenchmark average rate at which unfunded exposures have been funded at the timeof default.  The development of thismodeling in 2006 enabled Bankshares to evaluate specifically the risk inherentin unfunded commitments.  As no modeldata existed in previous years, prior period data has not been reclassified forcomparability.

E.Loans Held-for-SaleBankshares entersinto commitments to sell loans that it has originated.  Generally, these loans are held for a shortterm.  Mortgage loans held for sale arerecorded at the principal amount less deferred fee income, with fee incomesubsequently reflected in earnings when the loan is sold.   The carrying amounts of loans held-for-saleare reported at the lower of cost or fair market value, with the originalprincipal amount adjusted to reflect changes in the loans’ fair value asapplicable through fair value hedge accounting. Pursuant to SFAS No. 133, loans held-for-sale, commitments to sell theloans and any commitments to originate loans are recorded on the balance sheetat estimated fair market value.  Thedetermination of any write-down to market value on loans held-for -saleincludes consideration of all open positions and outstanding commitments frominvestors.  Declines in the market valueof loans held-for-sale are recorded as a charge in mortgage banking-relatedfees.  Subsequent declines or recoveriesof previous declines in the market value of loans held for sale are recorded inmortgage banking-related fees.  Sales ofloans are recorded when the proceeds are received, and any difference betweenthe proceeds and the carrying amount is recorded as a gain or loss in mortgagebanking-related fees.

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F.Bank Premises and EquipmentBank premises andequipment are stated at cost less accumulated depreciation andamortization.  Depreciation andamortization are computed using both the straight-line and accelerated methodsover the estimated useful lives of the properties.  Expenditures for repairs and maintenance arecharged to operating expenses as incurred. Expenditures for improvements that extend the life of an asset arecapitalized and depreciated over the asset’s remaining useful life.  Gains or losses realized on the dispositionof properties are reflected in consolidated income.

G.Other Real Estate OwnedOther real estateowned consists primarily of real estate obtained through foreclosure oracceptance of deeds in lieu of foreclosure. Other real estate owned is held forsale and is stated at the lower of cost or fair value.

H.Goodwill and Intangible AssetsGoodwill is theexcess of the cost of Bankshares’ investment over the equity in the net assetsof purchased businesses.  Goodwill andidentified intangible assets with indefinite useful lives are not subject toamortization.  Rather they are subject toimpairment testing on an annual basis, or more often if events or circumstancesindicate there may be impairment.

Separatelyidentified intangible assets that have a finite useful life are amortized overthat life in a manner that reflects the estimated decline in the economic valueof the identified intangible asset. Identified intangible assets that have a finite useful life areperiodically reviewed to determine whether there have been any events or circumstancesto indicate the recorded amount is not recoverable from projected undiscountednet operating cash flows.  If theprojected undiscounted net operating cash flows are less than the carryingamount, a loss is recognized to reduce the carrying amount to fair value, orwhen appropriate, the amortization period is reduced.

Bankshares’impairment evaluations for the year ended December 31, 2006, indicated thatnone of Bankshares’ goodwill or identified intangible assets was impaired withthe exception of one small customer relationship intangible.

Banksharesrecognizes as assets the right to service mortgage loans for others.  Market quotes are used to determine the fairvalue of the mortgage servicing rights at the date of the sale.  The capitalized mortgage servicing rights areamortized over the estimated period of net servicing income.  Bankshares analyzes the capitalized mortgageservicing rights for impairment using a discounted cash flow analysis.  A valuation allowance is established througha charge to earnings if the amount of unamortized mortgage servicing rightsexceeds fair value.

I.Stock-Based CompensationBankshares’stock-based compensation plans are accounted for in accordance with theprovisions of SFAS No. 123(R), “Share-Based Payment.”  Under this standard, awards granted toretirement-eligible employees are expensed immediately; compensation cost foroptions is determined based on the fair value of each option and the number ofoptions that are granted and expected to vest; and forfeitures are estimatedupon the grant of awards and the amount to be charged to expense is reduced bythe forfeiture amount.  Bankshares’ stockoptions have an exercise price equal to the fair value of the stock on the dateof grant, and vest based on continued service for a specified period, generallyover three to five years.  The fair valueof the option is measured on the date of grant using the Black-Scholesoption-pricing model with market assumptions. This amount is amortized on a straight-line basis over the vestingperiod.  Option pricing models requirethe use of highly subjective assumptions, including expected stock pricevolatility, which if changed can materially affect fair value estimates.Compensation expense for restricted stock awards and restricted stock units arebased on the closing market value of Bankshares’ stock on the date an award isgranted and is amortized as salaries expense in the results of operations inaccordance with the applicable vesting schedule, generally on a straight-lineover one to three years.

J.Pension and Postretirement Benefit ObligationsBankshares offersvarious pension plans and postretirement benefit plans to employees.  The calculation of the obligations andrelated expenses under these plans requires the use of actuarial valuationmethods and assumptions.  Actuarialvaluations and assumptions used in the determination of future values of planassets and liabilities are subject to management judgment and may differsignificantly if different assumptions are used.  At December 31, 2006, Bankshares implementedSFAS No.158, “Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans—an amendment of FASBStatements No. 87, 88, 106, and 132(R).”  Therefore, starting in 2006, Bankshares recognizes the fundedstatus of its benefits plans, measured as the difference between the fair valueof plan assets and the benefit

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obligationsin its consolidated statement of financial position.  Gains or losses and prior service costs orcredits that arise during the period but are recognized as components of netperiodic benefit costs of the period pursuant to SFAS No. 87 and 106 arerecognized as a component of other comprehensive income.  Previously, Bankshares recognizedcorresponding adjustments in other comprehensive income when gains or losses,prior service costs or credits, and transition assets or obligations remainingfrom the initial application of SFAS 87 and 106 are subsequently recognized ascomponents of net periodic benefits costs pursuant to the recognition andamortization provisions of SFAS No. 87, 88, and 106.  These adjustments are recorded on a taxeffected basis.

K.Income TaxesIncometaxes are recorded in accordance with SFAS No. 109, “Accountingfor Income Taxes.”  The asset and liability approach underlyingSFAS No. 109 requires the recognition of deferred tax liabilities and assetsfor the expected future tax consequences of temporary differences between thecarrying amounts and tax bases of Bankshares’ assets and liabilities.  Deferredtaxes are determined using enacted tax rates in effect for the year in whichthe temporary difference is expected to reverse.  To the extent tax rates or laws change,deferred tax assets and liabilities are adjusted in the period that the taxchange is enacted.  Income tax expenseincludes deferred tax expense, which represents the net change in the deferredtax asset or liability balance during the year plus any change in a valuationallowance; and current tax expense, which represents the aggregate amount oftax currently payable to or receivable from tax authorities.

L.Earnings Per ShareBasic and dilutedearnings per share (“EPS”) amounts are computed in accordance with theprovisions of SFAS No. 128, “Earnings Per Share.”  Basic EPS is computed by dividing incomeavailable to common shareholders by weighted average common shares outstandingduring the period.  Diluted EPS iscomputed using the same components as in basic EPS with the denominatoradjusted for the dilutive effect of stock options and restricted stock awards.

M.Cash FlowsFor purposes ofreporting cash flows, cash and cash equivalents include cash and due frombanks, interest-bearing deposits in other banks, federal funds sold andsecurities purchased under resale agreements. Generally, federal funds are purchased and sold for one-day periods;securities purchased/sold under resale agreements are purchased/sold forperiods of one to sixty days.

N.Derivatives and Hedging ActivitiesDerivatives areaccounted for in accordance with SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities” as subsequently amended by SFAS No. 137, SFAS No. 138and SFAS No. 149, which establishes accounting and reporting standards forderivatives and hedging activities. Under SFAS No. 133, Bankshares may designate a derivative as either ahedge of the fair value of a recognized fixed-rate asset or liability or anunrecognized firm commitment (“fair value” hedge), a hedge of a forecastedtransaction or of the variability of future cash flows of a floating-rate assetor liability (“cash flow” hedge), or a foreign currency fair value or cash flowhedge (“foreign currency” hedge).  Allderivatives are recorded as other assets or other liabilities on the balancesheet at their respective fair values with unrealized gains and losses recordedeither in other comprehensive income or in the results of operations, dependingon the purpose for which the derivative is held.  Derivatives that do not meet the criteria fordesignation as a hedge under SFAS No. 133 at inception, or fail to meet thecriteria thereafter, are included in trading account assets or liabilities.

Changesin the fair value of a derivative that is designated and qualifies as a fairvalue hedge, along with the gain or loss on the hedged asset or liability thatis attributable to the hedged risk are recorded as other noninterest income inthe results of operations.  To the extentof the effectiveness of a hedge, changes in the fair value of a derivative thatis designated and qualifies as a cash flow hedge are recorded in othercomprehensive income.  For all hedgerelationships, ineffectiveness resulting from differences between the changesin fair values or cash flows of the hedged item and changes in fair value ofthe derivative are recognized as other noninterest income in the results ofoperations.  The net interest settlementon derivatives designated as fair value or cash flow hedges is treated as anadjustment of the interest income or interest expense of the hedged assets orliabilities.

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Atinception of a hedge transaction, Bankshares formally documents the hedge, aswell as the risk management objective and strategy for undertaking the hedgetransactions.  This process includesidentification of the hedging instrument, hedged item, risk being hedged andthe methodology for measuring ineffectiveness. Both at inception and on an ongoing basis, an assessment is made as towhether the derivatives used in hedging transactions have been highly effectivein offsetting changes in the fair value of hedged items and whether thosederivatives may be expected to remain highly effective in future periods.

Banksharesdiscontinues hedge accounting prospectively when either it is determined thatthe derivative is no longer highly effective in offsetting changes in the fairvalue or cash flows of a hedged item; the derivative expires or is sold,terminated or exercised; the derivative is de-designated because it is unlikelythat a forecasted transaction will occur; or management determines thatdesignation of the derivative as a hedging instrument is no longer appropriate.

Whenhedge accounting is discontinued, the derivative is reclassified as a tradingaccount asset or liability.  When a fairvalue hedge is discontinued, the hedged asset or liability is no longeradjusted for changes in fair value, and the existing basis adjustment isamortized or accreted as an adjustment to yield over the remaining life of theasset or liability.  When a cash flowhedge is discontinued but the hedged cash flows or forecasted transaction arestill expected to occur, unrealized gains and losses that were accumulated inother comprehensive income are included in the results of operations in thesame period when the results of operations are also affected by the hedged cashflow.  They are recognized in the resultsof operations immediately if the cash flow hedge was discontinued because aforecasted transaction is not expected to occur.

UnderSFAS No. 133, as amended, commitments to purchase loans and certain commitmentsto sell loans are derivatives.  Thesecommitments can be designated as a hedge; otherwise, they are recorded as afreestanding derivative and classified as a trading account asset or liability.

Banksharesoccasionally may enter into a contract (“host contract”) that contains aderivative that is embedded in the financial instrument.  If applicable, an embedded derivative isseparated from the host contract and can be designated as a hedge; otherwise,the derivative is recorded as a freestanding derivative and classified as atrading account asset or liability.

O.Nonmarketable Investments Nonmarketableinvestments include private equity investments that are not publicly traded,securities acquired to meet various regulatory requirements (for example,Federal Reserve Bank Stock), bank-owned life insurance and hedge fundinvestments. Bankshares’ reviews typically include an analysis of the facts andcircumstances of each investment for fair value determination, the expectationsfor the investments’ cash flows and capital needs, the viability of itsbusiness model and our exit strategy. Since these private equity investments have no readily ascertainablefair value, they are reported at amounts that we have estimated to be fairvalue. In estimating the fair value of each investment, we must apply judgmentusing certain assumptions.  Banksharesbelieves that an investment’s cost is the best indication of its fair valueinitially, provided that there have been no significant positive or negativedevelopments subsequent to its acquisition that indicate the necessity of anadjustment to a fair value estimate. Private equity investments are reviewed at least quarterly for possibleother-than-temporary impairment. If, and when, such an event takes place,Bankshares adjusts the investment’s fair value by an amount that Banksharesbelieves reflects the nature of the event. Bankshares recognizes any adjustment to fair value as other noninterestincome.  Bank-owned life insurance iscarried at cash surrender value, which approximates fair value.  Investments in hedge funds are recorded atfair value.  Changes in fair values arereported as noninterest income.

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P. Recent AccountingPronouncements On February 16, 2006, the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 155, “Accounting for Certain Hybrid Instruments.”  This standard amends the guidance in SFASNo. 133, “Accounting for DerivativeInstruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities.”  SFAS No. 155 allows financial instrumentsthat have embedded derivatives to be accounted for as a whole (eliminating theneed to bifurcate the derivative from its host) if the holder elects to accountfor the instrument on a fair value basis. SFAS No. 155 is effective for all financial instruments acquired orissued after the beginning of an entity’s first fiscal year that begins afterSeptember 15, 2006.  Bankshares does notanticipate this statement will have a material effect on its results ofoperations or financial condition.

InMarch 2006, the FASB issued SFAS No. 156, “Accounting for Servicing ofFinancial Assets-An Amendment of FASB Statement No. 140.”  This standard amends the guidance in SFASNo.140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.”  Amongother requirements, SFAS No. 156 requires an entity to recognize a servicingasset or servicing liability each time it undertakes an obligation to service afinancial asset by entering into a servicing contract.  The standardrequires initial measurement of all newly purchased or issued separatelyrecognized servicing assets and servicing liabilities at fair value, ifpracticable.  Subsequent measurements maybe made using either the fair value or amortization method.  SFAS No. 156 is effective as of thebeginning of an entity’s first fiscal year that begins after September 15, 2006with early adoption permitted in the quarter-ended March 31, 2006.  Bankshares does not anticipate this statementwill have a material effect on its results of operations or financialcondition.

# On July 13, 2006, the FASBissued FASB Interpretation No. 48 (“FIN 48”).  FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, “Accounting for IncomeTaxes”.  FIN 48 prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  An enterprise shall disclose thecumulative effect of the change on retained earnings in the statement offinancial position as of the date of adoption and such disclosure is requiredonly in the year of adoption. Bankshares expects that the effect of adoptingFIN 48 will result in an immaterial adjustment to 2007 opening retainedearnings.

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

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

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

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2.BUSINESS COMBINATIONS

Thefollowing provides information concerning mergers, acquisitions andrestructurings completed during the two years ended December 31, 2006.  These acquisitions were accounted for aspurchases.  The numbers of shares issuedin the purchases have been adjusted for the three-for-two stock split.  The results of operations of theseacquisitions subsequent to the acquisition dates are included in Bankshares’Statements of Consolidated Income. Individually, the results of operations of these acquisitions prior tothe acquisition dates were not material to Bankshares’ results of operations.

OnJuly 17, 2006, Bankshares completed its acquisition of James Monroe Bancorp,Inc. (“James Monroe”), an Arlington, Virginia-based commercial bank.  James Monroe was merged into Mercantile-SafeDeposit & Trust Company (“MSD&T”). At the time of the acquisition, James Monroe operated six full-servicebranches and a loan production office located in Northern Virginia and suburbanWashington, D.C.  The total considerationpaid to James Monroe shareholders in connection with the acquisition was $71.4million in cash and 1.8 million shares of Bankshares’ common stock.  The results of James Monroe’s operations havebeen included in Bankshares’ financial results subsequent to July 17,2006.  The assets and liabilities ofJames Monroe were recorded on the consolidated balance sheet at theirrespective fair values.  The fair valueswere determined as of July 17, 2006.  Thetransaction resulted in total assets acquired of $552 million, including $414million in gross loans; and liabilities assumed of $507 million, including $434million in total deposits.  Additionally,Bankshares preliminarily recorded $95.4 million of goodwill and $7.8 million ofcore deposit intangible (“CDI”). Intangible assets subject to amortization are being amortized on anaccelerated basis.

Aspart of the acquisition, Bankshares considered SFAS No. 146 and, as such,Bankshares’ exit costs, referred to herein as “merger-related” costs, aredefined to include costs for branch closings and related severance, combiningoperations such as systems conversions, and printing/mailing costs incurred byBankshares prior to and after the merger date and are included in Bankshares’results of operations.  Banksharesexpensed merger-related costs totaling $1.0 million for 2006.  The costs associated with these activitiesare included in noninterest expense. Merger-related expenses incurred to date consisted largely of expensesfor systems conversion and branch closing costs**.**

OnMay 18, 2005, Bankshares completed its acquisition of CBNV, a bankheadquartered in Sterling, Virginia, which was merged into MSD&T.  CBNV operated 14 branch offices in theNorthern Virginia metropolitan market at the time of the acquisition.  The primary reason for the merger with CBNVwas to expand Bankshares’ distribution network in Northern Virginia, a highergrowth market.  The total considerationpaid to CBNV shareholders in connection with the acquisition was $82.9 millionin cash and 3.7 million shares of Bankshares’ common stock.  CBNV transactions have been included inBankshares’ financial results subsequent to May 18, 2005.  The assets and liabilities of CBNV wererecorded on the consolidated balance sheet at their respective fairvalues.  The transaction resulted intotal assets acquired as of May 18, 2005 of $888.2 million, including $671.0million of loans and leases; liabilities assumed were $842.3 million, including$626.9 million of deposits.  Additionally,Bankshares recorded $162.9 million of goodwill and $4.6 million of CDI.  CDI are subject to amortization and are beingamortized on an accelerated basis.

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Banksharesexpensed merger-related costs totaling $1.3 million for the year ended December31, 2005.  The costs associated withthese activities are included in noninterest expenses.  Merger-related expenses incurred consistedlargely of expenses for systems conversion costs, branch closings andintegrations of operations.  Prior to themerger, CBNV recorded exit costs of $9.7 million relating to severance, systemconversions, branch consolidations and costs associated with terminatingcontracts.

3.INVESTMENT SECURITIES

Theamortized cost and fair value of investment securities at December 31, 2006 and2005 were as follows:
| ** **                        | ** ** | **2006**            | ** **    | **2005**                     | ** ** |
|-----------------------------------|------------|---------------------|---------------|------------------------------|------------|
| **(Dollars in  thousands)**       | ** ** | **Amortized  Cost** | ** **    | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Securities  held-to-maturity      |       |                |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions | ** ** | **$**               | **13,099**    | ** **                   | **$**      | **372** | ** ** | **$** | **9** | ** ** | **$** | **13,462** |   | $ | 16,659 |   | $ | 541 |   | $ | 19 |   | $ | 17,181 |   |
| Securities  available-for-sale    | ** ** | ** **          | ** **    | ** **                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                     | ** ** | **$**               | **338,283**   | ** **                   | **$**      | **227** | ** ** | **$** | **1,993** | ** ** | **$** | **336,517** |   | $ | 434,893 |   | $ | 223 |   | $ | 3,080 |   | $ | 432,036 |   |
| U.S. Government agencies          | ** ** | **843,634**         | ** **    | **109**                      | ** ** | **6,006** | ** ** | **837,737** |   | 992,040 |   | 29 |   | 12,761 |   | 979,308 |   |
| Mortgage-backed securities (1)    | ** ** | **1,853,028**       | ** **    | **2,289**                    | ** ** | **33,587** | ** ** | **1,821,730** |   | 1,581,845 |   | 685 |   | 38,269 |   | 1,544,261 |   |
| States and political subdivisions | ** ** | **56,709**          | ** **    | **163**                      | ** ** | **173** | ** ** | **56,699** |   | 70,017 |   | 306 |   | 188 |   | 70,135 |   |
| Other bonds, notes and debentures | ** ** | **6,028**           | ** **    | **—**                   | ** ** | **92** | ** ** | **5,936** |   | 19,083 |   | — |   | 215 |   | 18,868 |   |
| Total bonds                       | ** ** | **3,097,682**       | ** **    | **2,788**                    | ** ** | **41,851** | ** ** | **3,058,619** |   | 3,097,878 |   | 1,243 |   | 54,513 |   | 3,044,608 |   |
| Other investments                 | ** ** | **51,271**          | ** **    | **1,099**                    | ** ** | **536** | ** ** | **51,834** |   | 43,980 |   | 1,236 |   | 196 |   | 45,020 |   |
| Total                             | ** ** | **$**               | **3,148,953** | ** **                   | **$**      | **3,887** | ** ** | **$** | **42,387** | ** ** | **$** | **3,110,453** |   | $ | 3,141,858 |   | $ | 2,479 |   | $ | 54,709 |   | $ | 3,089,628 |   |

 

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(1)  Maturities are reflected based on projectedmaturities at time of purchase. Actual maturities will vary as a result of thelevel of loan prepayments in the underlying mortgage pools.

Theamortized cost and fair value of the bond investment portfolio by contractualmaturity at December 31, 2006 and 2005 are shown below.
| ** **                           | ** ** | **2006**            | ** **    | **2005**        | ** ** |
|--------------------------------------|------------|---------------------|---------------|-----------------|------------|
| **(Dollars in thousands)** | ** ** | **Amortized  Cost** | ** **    | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities  held-to-maturity         | ** ** | ** **          |          |            |       |   |   |   |   |
| Within 1 year                        | ** ** | **$**               | **1,990**     | ** **      | **$**      | **1,989** |   | $ | 2,347 |   | $ | 2,349 |   |
| 1-5 years                            | ** ** | **5,574**           | ** **    | **5,664**       |       | 7,353 |   | 7,492 |   |
| 5-10 years                           | ** ** | **5,535**           | ** **    | **5,809**       |       | 6,959 |   | 7,340 |   |
| After 10 years                       | ** ** | **—**          | ** **    | **—**      |       | — |   | — |   |
| Total                                | ** ** | **$**               | **13,099**    | ** **      | **$**      | **13,462** |   | $ | 16,659 |   | $ | 17,181 |   |
| Securities  available-for-sale       | ** ** | ** **          |          |            |       |   |   |   |   |
| Within 1 year                        | ** ** | **$**               | **761,878**   | ** **      | **$**      | **757,365** |   | $ | 621,979 |   | $ | 617,587 |   |
| 1-5 years                            | ** ** | **2,196,139**       | ** **    | **2,162,643**   |       | 2,292,959 |   | 2,244,736 |   |
| 5-10 years                           | ** ** | **139,665**         | ** **    | **138,611**     |       | 182,940 |   | 182,285 |   |
| After 10 years                       | ** ** | **—**          | ** **    | **—**      |       | — |   | — |   |
| Total                                | ** ** | **$**               | **3,097,682** | ** **      | **$**      | **3,058,619** |   | $ | 3,097,878 |   | $ | 3,044,608 |   |

 

AtDecember 31, 2006 and 2005, no single issue of investment securities exceeded10.0% of shareholders’ equity. At December 31, 2006 and 2005, securities withan amortized cost of $1.6 billion and $1.3 billion, respectively, were pledgedas collateral for certain deposits as required.

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Thefollowing table shows the gross unrealized losses and fair value of Bankshares’investments with unrealized losses that are not deemed to beother-than-temporarily impaired (in thousands), aggregated by investmentcategory and length of time that individual securities have been in acontinuous unrealized loss position at December 31, 2006 and 2005.
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**      | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------|------------|
| ** **                              | ** ** | **Gross**                              | ** ** | ** **                           | ** ** | **Gross**      | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| **At December 31, 2006** | ** ** | **Unrealized**                         | ** ** | **Fair**                             | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)**    | ** ** | **Losses**                             | ** ** | **Value**                            | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |                                   |       |                                 |       |           |       |   |   |   |   |   |   |
| U.S. Treasury                           | ** ** | **$**                                  | **382**    | ** **                           | **$**      | **181,456**    | ** ** | **$** | **1,611** | ** ** | **$** | **155,061** | ** ** | **$** | **1,993** | ** ** | **$** | **336,517** | ** ** |
| U.S. Government  agencies               | ** ** | **328**                                | ** ** | **293,051**                          | ** ** | **5,678**      | ** ** | **544,686** | ** ** | **6,006** | ** ** | **837,737** | ** ** |
| Mortgage-backed  securities             | ** ** | **1,364**                              | ** ** | **713,866**                          | ** ** | **32,223**     | ** ** | **1,107,864** | ** ** | **33,587** | ** ** | **1,821,730** | ** ** |
| States and political  subdivisions      | ** ** | **14**                                 | ** ** | **38,913**                           | ** ** | **159**        | ** ** | **17,785** | ** ** | **173** | ** ** | **56,699** | ** ** |
| Other bonds, notes and  debentures      | ** ** | **—**                             | ** ** | **—**                           | ** ** | **92**         | ** ** | **5,936** | ** ** | **92** | ** ** | **5,936** | ** ** |
| Total bonds                             | ** ** | **2,088**                              | ** ** | **1,227,286**                        | ** ** | **39,763**     | ** ** | **1,831,333** | ** ** | **41,851** | ** ** | **3,058,619** | ** ** |
| Other investments                       | ** ** | **536**                                | ** ** | **51,834**                           | ** ** | **—**     | ** ** | **—** | ** ** | **536** | ** ** | **51,834** | ** ** |
| Total                                   | ** ** | **$**                                  | **2,624**  | ** **                           | **$**      | **1,279,120**  | ** ** | **$** | **39,763** | ** ** | **$** | **1,831,333** | ** ** | **$** | **42,387** | ** ** | **$** | **3,110,453** | ** ** |

 
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**      | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------|------------|
| ** **                              | ** ** | **Gross**                              | ** ** | ** **                           | ** ** | **Gross**      | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| **At December 31, 2005** | ** ** | **Unrealized**                         | ** ** | **Fair**                             | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)**    | ** ** | **Losses**                             | ** ** | **Value**                            | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |                                   |       |                                 |       |           |       |   |   |   |   |   |   |
| U.S. Treasury                           |       | $                                      | 1,301      |                                 | $          | 334,188        |       | $ | 1,779 |   | $ | 97,848 |   | $ | 3,080 |   | $ | 432,036 |   |
| U.S. Government  agencies               |       | 4,834                                  |       | 513,169                              |       | 7,927          |       | 466,139 |   | 12,761 |   | 979,308 |   |
| Mortgage-backed  securities             |       | 15,420                                 |       | 1,026,218                            |       | 22,848         |       | 518,043 |   | 38,269 |   | 1,544,261 |   |
| States and political  subdivisions      |       | 173                                    |       | 83,626                               |       | 34             |       | 3,690 |   | 207 |   | 87,316 |   |
| Other bonds, notes and  debentures      |       | 30                                     |       | 5,129                                |       | 186            |       | 13,739 |   | 215 |   | 18,868 |   |
| Total bonds                             |       | 21,758                                 |       | 1,962,330                            |       | 32,774         |       | 1,099,459 |   | 54,532 |   | 3,061,789 |   |
| Other investments                       |       | 196                                    |       | 45,020                               |       | —         |       | — |   | 196 |   | 45,020 |   |
| Total                                   |       | $                                      | 21,954     |                                 | $          | 2,007,350      |       | $ | 32,774 |   | $ | 1,099,459 |   | $ | 54,728 |   | $ | 3,106,809 |   |

 

Theunrealized losses on Bankshares’ investments in U. S. Treasury obligations anddirect obligations of U. S. Government agencies were caused by interest rateincreases.  The contractual terms ofthose investments do not permit the issuer to settle the securities at a price lessthan the amortized cost of the investment. Because Bankshares has the ability and intent to hold those investmentsuntil a recovery of fair value, which may be at maturity, Bankshares does notconsider those investments to be other-than-temporarily impaired at December31, 2006.

Theunrealized losses on Bankshares’ investment in federal agency mortgage-backedsecurities were caused by interest rate increases. Bankshares purchased thoseinvestments at a modest premium or discount to their face amount, and thecontractual cash flows of those investments are guaranteed by an agency of theU.S. Government.  Accordingly, it isexpected that the securities would not be settled at a price less than theamortized cost of Bankshares’ investment. Because the decline in market value is attributable to changes ininterest rates and not credit quality, and because Bankshares has the abilityand intent to hold those investments until a recovery of fair value, which maybe at maturity, Bankshares does not consider those investments to beother-than-temporarily impaired at December 31, 2006.

Theunrealized losses on Bankshares’ investments in state and political subdivisionobligations were caused by interest rate increases.  Credit quality within this portfolio remainedstrong with 78.8% of the portfolio rated AAA and 100.0% of the portfolio ratedinvestment grade.  The contractual termsof those investments do not permit the issuer to settle the security at a priceless than the amortized cost of the investment. Because Bankshares has the ability and intent to hold those investmentsuntil a recovery of fair value, which may be at maturity, it does not considerthose investments to be other-than-temporarily impaired at December 31, 2006.

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Theunrealized losses on Bankshares’ investments in other bonds, notes anddebentures were caused by interest rate increases.  The credit quality of these bonds hasremained strong throughout 2006 and it is expected that the securities wouldnot be settled at a price less than the amortized cost of Bankshares’investment.  Because Bankshares has theability and intent to hold those investments until a recovery of fair value,which may be at maturity, it does not consider those investments to beother-than-temporarily impaired at December 31, 2006.

Bankshares’investments in other investments consist of investments in common stock ofother banking companies and a mutual fund that invests in bonds that qualify asCommunity Reinvestment Act (“CRA”) investments. The unrealized loss of $536 thousand relates to the CRA mutual fund.  Based on the level of the impairment (approximately1% of the cost) and the duration of the impairment (less than 12 months) andBankshares’ ability and intent to hold this investment for a reasonable periodof time sufficient for a forecasted recovery of fair value, Bankshares does notconsider this investment to be other-than-temporarily impaired at December 31,2006.

Thefollowing table shows the gross realized gains and losses on the sale ofsecurities in the available-for-sale portfolio, including marketable equitysecurities.
| ** **                           | ** ** | **2006**     | ** ** | **2005**     | ** ** | **2004**     | ** ** |
|--------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|
| ** **                           | ** ** | **Gross**    | ** ** | **Gross**    | ** ** | **Gross**    | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Gross** | ** ** |
| ** **                           | ** ** | **Realized** | ** ** | **Realized** | ** ** | **Realized** | ** ** | **Realized** | ** ** | **Realized** | ** ** | **Realized** | ** ** |
| **(Dollars in thousands)** | ** ** | **Gains**    | ** ** | **Losses**   | ** ** | **Gains**    | ** ** | **Losses** | ** ** | **Gains** | ** ** | **Losses** | ** ** |
| Securities  available-for-sale       |       |         |       |         |       |         |       |   |   |   |   |   |   |
| Debt                                 | ** ** | **$**        | **35**     | ** **   | **$**      | **40**       |       | $ | 293 |   | $ | 56 |   | $ | — |   | $ | 202 |   |
| Other Investments                    | ** ** | **230**      | ** ** | **13**       |       | 279          |       | 111 |   | 1,441 |   | — |   |
| Total                                | ** ** | **$**        | **265**    | ** **   | **$**      | **53**       |       | $ | 572 |   | $ | 167 |   | $ | 1,441 |   | $ | 202 |   |

 

4.LOANS AND ALLOWANCE FOR LOAN LOSSES AND RESERVE FOR UNFUNDED COMMITMENTS

Loansat December 31, 2006 and 2005 were as follow.
| **(Dollars in thousands)** | ** ** | **2006**      | ** **     | **2005**  | ** ** |
|--------------------------------------|------------|---------------|----------------|-----------|------------|
| Commercial and  leasing              | ** ** | **$**         | **3,053,832**  |      | $          | 2,957,301 |   |
| Commercial real  estate              | ** ** | **4,240,303** |           | 3,703,297 |       |
| Construction                         | ** ** | **2,009,837** |           | 1,607,095 |       |
| Residential real  estate             | ** ** | **2,012,960** |           | 1,802,373 |       |
| Home equity  lines                   | ** ** | **455,655**   |           | 505,508   |       |
| Consumer                             | ** ** | **1,020,146** |           | 1,032,271 |       |
| Total                                | ** ** | **$**         | **12,792,733** |      | $          | 11,607,845 |   |

 

AtDecember 31, 2006 and 2005, $31.0 million and $22.6 million, respectively, wereplaced on nonaccrual loans (loans in which interest income is recognized onlyas collected).  Interest income onnonaccrual loans that would have been recorded if accruing was $2.7 million and$2.1 million in 2006 and 2005, respectively. Interest income on nonaccrual loans that was recorded totaled $0.7million and $0.5 million in 2006 and 2005, respectively.  See Note 1 - Significant Accounting Policiesfor an explanation of the nonaccrual loan policy.

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Infirst quarter of 2006, we reclassified $14.0 million of the allowance for loanlosses to a reserve for unfunded commitments, which is included in the otherliabilities section of the consolidated balance sheet.  The modeling process used in thedetermination of the reserve for unfunded lending commitments is consistentwith the process for the formula-based component of the allowance for loanlosses, also including as a key factor a benchmark average rate at whichunfunded exposures have been funded at the time of default.  The development of this modeling in 2006enabled Bankshares to evaluate specifically the risk inherent in unfundedcommitments and make the reclassification discussed above.  As no model data existed in previous years,prior period data has not been reclassified for comparability.  In the third quarter of 2006, Banksharesreclassified $1.8 million of the allowance for loan losses to the reserve forunfunded commitments.  This resulted froma refinement in the manner in which the required reserves for unfundedcommitments were calculated.

Thechanges in the allowance for loan losses follow.
| **(Dollars in thousands)**          | ** ** | **2006**    | ** **  | **2005**   | ** ** |
|-----------------------------------------------|------------|-------------|-------------|------------|------------|
| **Allowance  for Loan Losses**                | ** ** | ** **  | ** **  | ** ** | ** ** |
| Balance,  beginning of period                 | ** ** | **$**       | **156,673** |       | $          | 149,002 |   |
| Allowance of  acquired bank                   | ** ** | **3,985**   |        | 7,086      |       |
| Provision for  credit losses                  | ** ** | **(990**    | **)**       | 1,576      |       |
| Transfer to  reserve for unfunded commitments | ** ** | **(15,824** | **)**       | —     |       |
| Total                                         | ** ** | **143,844** |        | 157,664    |       |
| Charge-offs                                   | ** ** | **(6,287**  | **)**       | (7,602     | )          |
| Recoveries                                    | ** ** | **5,472**   |        | 6,611      |       |
| Net charge-offs                               | ** ** | **(815**    | **)**       | (991       | )          |
| Balance, end of  period                       | ** ** | **$**       | **143,029** |       | $          | 156,673 |   |
|                                          |       |        |        |       |       |
| **Reserve  for Unfunded Commitments**         | ** ** | ** **  | ** **  | ** ** | ** ** |
| Balance,  beginning of period                 | ** ** | **$**       | **—**  |       | $          | — |   |
| Provision for  credit losses                  | ** ** | **990**     |        | —     |       |
| Transfer from  allowance for loan losses      | ** ** | **15,824**  |        | —     |       |
| Balance, end of period                        | ** ** | **$**       | **16,814**  |       | $          | — |   |

 

Informationwith respect to impaired loans and the related valuation allowance (if themeasure of the impaired loan is less than the recorded investment) as ofDecember 31, 2006 and 2005 is shown below. Refer to Note No. 1 - Significant Accounting Policies for an expandeddiscussion on impaired loans.
| **(Dollars in thousands)**                                          | ** ** | **2006**    | ** **  | **2005** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------|-------------|----------|------------|
| Impaired loans  with a specific valuation allowance                           | ** ** | **$**       | **14,725**  |     | $          | 11,512 |   |
| All other  impaired loans                                                     | ** ** | **11,078**  |        | 9,086    |       |
| Total impaired loans                                                          | ** ** | **$**       | **25,803**  |     | $          | 20,598 |   |
|                                                                          |       |        |        |     |       |
| Specific  allowance for loan losses applicable to impaired loans              | ** ** | **$**       | **6,556**   |     | $          | 4,150 |   |
| General  allowance for loan losses applicable to other than impaired loans    | ** ** | **136,473** |        | 152,523  |       |
| Total allowance for loan losses                                               | ** ** | **$**       | **143,029** |     | $          | 156,673 |   |
|                                                                          |       |        |        |     |       |
| Year-to-date  interest income on impaired loans recorded on the cash basis    | ** ** | **$**       | **137**     |     | $          | 128 |   |
| Year-to-date average  recorded investment in impaired loans during the period | ** ** | **$**       | **24,656**  |     | $          | 26,703 |   |

 

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5.BANK PREMISES AND EQUIPMENT

Bankpremises and equipment at December 31, 2006 and 2005 consisted of thefollowing:
| **(Dollars in thousands)**       | ** ** | **2006**     | ** **  | **2005** | ** ** |
|--------------------------------------------|------------|--------------|-------------|----------|------------|
| Land                                       | ** ** | **$**        | **26,774**  |     | $          | 26,670 |   |
| Building and  leasehold improvements       | ** ** | **149,551**  |        | 144,200  |       |
| Equipment                                  | ** ** | **118,625**  |        | 113,134  |       |
| Total bank premises and equipment          | ** ** | **294,950**  |        | 284,004  |       |
| Accumulated  depreciation and amortization | ** ** | **(153,486** | **)**       | (146,585 | )          |
| Bank premises  and equipment, net          | ** ** | **$**        | **141,464** |     | $          | 137,419 |   |

 

Bankshares’bank affiliates conduct a part of their branch banking operations from leasedfacilities.  Generally, the initial termsof the leases range from a period of one to fifteen years.  Most of the leases contain options forrenewal at the fair rental value for periods of one to twenty years.  In addition to minimum rentals, certainleases have escalation clauses based on various price indices and includeprovisions for additional payments to cover taxes, insurance and maintenance.

Totalrental expense for 2006, 2005 and 2004 was:
| **(Dollars in thousands)**    | ** ** | **2006**  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Bank premises  (1)                      | ** ** | **$**     | **15,201** |     | $          | 11,185   |       | $ | 9,501 |   |
| Equipment / software  expense | ** ** | **6,556** |       | 6,053    |       | 5,670    |       |
| Total rental  expense                   | ** ** | **$**     | **21,757** |     | $          | 17,238   |       | $ | 15,171 |   |

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(1)Amounts do not reflect offset for rental income from outside tenants.

Themain offices of Bankshares and MSD&T are located in a 21-story building atTwo Hopkins Plaza in Baltimore, Maryland. Pursuant to the lease agreement,effective as of December 13, 2004, MSD&T agreed to lease up to approximately179,000 square feet of prime office space and approximately 27,000 square feetof back-office and storage space at Two Hopkins Plaza, for a term of tenyears.  At December 31, 2006, MSD&Tand Bankshares occupied approximately 206,000 square feet.  The lease agreement contains two five-yearrenewal options.  The lease agreement isaccounted for as a lease-financing obligation. See Note No. 9 - Long-term Debtfound elsewhere in this document.

AtDecember 31, 2006, the aggregate minimum rental commitments undernon-cancelable operating leases were as follows:

2007-$18.6 million, 2008 - $15.4 million, 2009 - $11.9 million, 2010 - $9.8 million,2011 - $7.3 million, thereafter - $46.8 million.

6.OTHER ASSETS & LIABILITIES

Thefollowing table provides selected information on Bankshares’ other assets atDecember 31, 2006 and 2005.
| **(Dollars in thousands)** | ** ** | **2006**    | ** **  | **2005** | ** ** |
|--------------------------------------|------------|-------------|-------------|----------|------------|
| Nonmarketable  investments           |       |        |        |     |       |
| Private equity and other investments | ** ** | **$**       | **80,161**  |     | $          | 69,445 |   |
| Hedge funds-of-funds                 | ** ** | **68,771**  |        | 62,778   |       |
| Bank-owned life insurance            | ** ** | **162,495** |        | 152,613  |       |
| Total nonmarketable investments      | ** ** | **311,427** |        | 284,836  |       |
| Interest  receivable                 | ** ** | **103,648** |        | 90,075   |       |
| Deferred taxes,  net                 | ** ** | **101,326** |        | 79,322   |       |
| Prepaid assets                       | ** ** | **61,751**  |        | 82,667   |       |
| All other assets                     | ** ** | **53,666**  |        | 51,500   |       |
| Total other  assets                  | ** ** | **$**       | **631,818** |     | $          | 588,400 |   |

 

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Netgains from sales or income from private equity and other nonmarketableinvestments were $10.4 million, $10.8 million and $2.6 million in 2006, 2005and 2004, respectively. Income from hedge funds was $6.2 million, $8.4 millionand $5.5 million in 2006, 2005 and 2004, respectively. In the third quarter of2005, Bankshares purchased additional bank-owned life insurance in the amountof $50.0 million and acquired $13.0 million through the CBNV acquisition. Incomefrom bank-owned life insurance was $6.9 million, $4.8 million and $3.3 millionin 2006, 2005 and 2004, respectively.

Thefollowing table provides selected information on Bankshares’ other liabilitiesat December 31, 2006 and 2005.
| **(Dollars in thousands)** | ** ** | **2006**   | ** **  | **2005** | ** ** |
|--------------------------------------|------------|------------|-------------|----------|------------|
| Accrued expenses                     | ** ** | **$**      | **95,801**  |     | $          | 81,906 |   |
| Interest payable                     | ** ** | **46,736** |        | 26,276   |       |
| All other liabilities                | ** ** | **71,215** |        | 61,598   |       |
| Total other liabilities              | ** ** | **$**      | **213,752** |     | $          | 169,780 |   |

 

7.DEPOSITS

Includedin time deposits are certificates of deposit issued in denominations of$100,000 and over, which totaled $2.3 billion and $1.7 billion at December31, 2006 and 2005, respectively. The amount outstanding and maturitydistribution of time deposits issued in amounts of $100,000 and over atDecember 31, 2006 are presented in the following table.
| ** **                           | ** ** | ** ** | ** ** | **Maturing**                  | ** ** |
|--------------------------------------|------------|------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**  | ** ** | **1 year  or less** | ** ** | **Over   1 through  2 years** | ** ** | **Over   2 through  3 years** | ** ** | **Over   3 through  4 years** | ** ** | **Over   4 through  5 years** | ** ** | **Over 5  5 years** | ** ** |
| Time deposits                        |       |       |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 and over                    |       | $          | 2,339,321  |                          | $          | 2,047,895 |   | $ | 141,835 |   | $ | 68,009 |   | $ | 56,488 |   | $ | 23,309 |   | $ | 1,785 |   |
|                                      |            |            |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Depositsat December 31, 2006 and 2005 consisted of the following.
| **(Dollars in thousands)** | ** ** | **2006**      | ** **     | **2005**   | ** ** |
|--------------------------------------|------------|---------------|----------------|------------|------------|
| Noninterest-bearing                  | ** ** | **$**         | **3,271,286**  | ** ** | $          | 3,324,650 |   |
| Savings                              | ** ** | **1,110,904** | ** **     | 1,339,215  |       |
| Checking plus interest               | ** ** | **1,295,472** | ** **     | 1,430,524  |       |
| Money market                         | ** ** | **2,299,054** | ** **     | 1,944,513  |       |
| Time - $100,000 and  over            | ** ** | **2,339,321** | ** **     | 1,743,885  |       |
| Other time                           | ** ** | **2,457,854** | ** **     | 2,294,563  |       |
| Total                                | ** ** | **$**         | **12,773,891** | ** ** | $          | 12,077,350 |   |

 

8.SHORT-TERM BORROWINGS

Thefollowing table provides selected information on Bankshares’ short-termborrowings and applicable weighted average interest rates at December 31, 2006and 2005.
| ** **                                                               | ** ** | **Year-end** | ** **    | **During Year** | ** ** |
|--------------------------------------------------------------------------|------------|--------------|---------------|----------------------|------------|
| **2006 (Dollars in thousands)**                           | ** ** | **Amount**   | ** **    | **Rate**             | ** ** | **Highest** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| Federal funds  purchased and securities sold under repurchase agreements | ** ** | **$**        | **1,529,752** | ** **           | **4.33**   | **%** | **$** | **1,529,752** | ** ** | **$** | **1,278,057** | ** ** | **3.99** | **%** |
| Commercial paper                                                         | ** ** | **122,444**  | ** **    | **3.04**             | ** ** | **204,619** | ** ** | **157,025** | ** ** | **2.61** | ** ** |
| Total                                                                    | ** ** | **$**        | **1,652,196** | ** **           | **4.24**   | **%** | ** ** | ** ** | **$** | **1,435,082** | ** ** | **3.84** | **%** |
|                                                                          |            |              |               |                      |            |  |  |  |  |  |  |  |  |  |

 

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| ** **                                                               | ** ** | **Year-end** | ** ** | **During Year** | ** ** |
|--------------------------------------------------------------------------|------------|--------------|------------|----------------------|------------|
| **2005 (Dollars in thousands)**                           | ** ** | **Amount**   | ** ** | **Rate**             | ** ** | **Highest** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| Federal funds  purchased and securities sold under repurchase agreements |       | $1,044,660   |       | 3.04                 | %          | $1,084,364 |   | $928,207 |   | 2.49 | % |
| Commercial paper                                                         |       | 193,054      |       | 2.37                 |       | 209,355 |   | 177,781 |   | 1.79 |   |
| Total                                                                    |       | $1,237,714   |       | 2.93                 | %          |   |   | $1,105,988 |   | 2.37 | % |

 

Othershort-term borrowings consist of borrowings from the Federal Home Loan Bank ofAtlanta. During 2006 and 2005, commercial paper borrowings were partiallysupported by back-up lines of credit of $40.0 million. Unused committed linesof credit at December 31, 2006 and 2005 were $40.0 million. These lines ofcredit are paid for quarterly, semiannually or annually on a fee basis of0.09%. In addition, Bankshares also has $3.2 billion in lines with the FederalHome Loan Banks of Atlanta and Pittsburgh (“FHLB”), although Bankshares’ $15.0million in senior notes contain debt covenant restrictions that limitadditional FHLB borrowings to 4.00% of average total assets unless Banksharesrenegotiates this restriction with existing investors.

9.LONG-TERM DEBT

Long-termdebt at December 31, 2006 and 2005 consisted of the following.
| **(Dollars in thousands)**                                                                    | ** ** | **2006**    | ** **  | **2005**   | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|
| Senior notes of  Bankshares, unsecured 6.80%, due 2009                                                  | ** ** | **$**       | **15,000**  |       | $          | 50,000 |   |
| Senior notes of  MSD&T, unsecured (1) 5.70%, due 2011 Book value                                    | ** ** | **199,775** |        | 199,739    |       |
| Fair value basis adjustment                                                                             | ** ** | **(2,571**  | **)**       | (866       | )          |
| Adjusted balance                                                                                        | ** ** | **197,204** |        | 198,873    |       |
| Subordinated  notes of MSD&T, unsecured (2) Floating rate of LIBOR plus 2.75%, due 2014-Book  value | ** ** | **9,819**   |        | 9,794      |       |
| Subordinated  notes of Bankshares, unsecured (3) 4.625%, due 2013-Book value                            | ** ** | **299,478** |        | 299,410    |       |
| Fair value basis adjustment                                                                             | ** ** | **(10,067** | **)**       | (9,486     | )          |
| Adjusted balance                                                                                        | ** ** | **289,411** |        | 289,924    |       |
| Lease finance  obligation, Hopkins building (4) 4.00%, due 2011                                         | ** ** | **47,183**  |        | 49,288     |       |
| Advances from  Federal Home Loan Bank (5) Ranging from 2.00% to 5.51% yield, due 2007 to  2018          | ** ** | **82,786**  |        | 144,284    |       |
| Trust Preferred  Securities (6)                                                                         | ** ** | **17,527**  |        | —     |       |
| Fair value basis adjustment                                                                             | ** ** | **90**      |        | —     |       |
| Adjusted balance                                                                                        | ** ** | **17,617**  | ** **  | **—** | ** ** |
| Total                                                                                                   | ** ** | **$**       | **659,020** |       | $          | 742,163 |   |

 

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Note: All debt is subjectto interest payments at various intervals. Several of the FHLB advances and thelease-financing obligation are subject to monthly principal payments.

(1) The debt has a facevalue of $200.0 million, with an unamortized discount of $225 thousand based onan effective rate of 6.26%. These fixed-rate notes were converted to floatingrates through an interest rate swap. This swap was designed as a hedge of thefair value of the debt; therefore, the debt has been adjusted to reflect thechange in the fair value of the swap.

(2) The debt has a facevalue of $10.0 million, with an unamortized discount of $181 thousand based onan effective rate of 8.12%.

(3) The debt has a facevalue of $300.0 million, with an unamortized discount of $522 thousand based onan effective rate of 5.36%. $150.0 million of these fixed-rate notes wereconverted to floating rates through interest rate swaps. These swaps weredesigned as a hedge of the fair value of the debt; therefore, the debt has beenadjusted to reflect the change in the fair value of the swap.

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(4) Represents theunamortized amount due on the lease of the Hopkins Plaza Building.

(5) Of the $82.8 millionthat the Federal Home Loan Bank of Atlanta (“FHLB”) advanced to Bankshares asof December 31, 2006, $38.4 million is convertible to three-month LIBOR at theoption of the FHLB. These advances are convertible on a quarterly basis uponwritten notice from the FHLB. With the exception of $14.9 million in advances,each of these convertible advances is within its conversion period and may beconverted on any quarterly payment date should the FHLB give notice. Of the$14.9 million in advances, $5.0 million is callable on September 20, 2007 and$9.9 million is callable on March 11, 2008.

(6) Of the $17.5 millionof James Monroe Trust Preferred securities, $5.2 million (Trust I) is floatingat 3 month LIBOR with a 3.60% spread, $4.1 million (Trust II) is floating at 3month LIBOR with a 3.10% spread and $8.2 million (Trust III) is fixed at 6.253%with a repricing date of September 15, 2010.

The annual maturities onall long-term debt are 2007 - $19.0 million, 2008 - $26.6 million, 2009 - $24.3million, 2010 - $3.4 million, 2011 - $234.2 million, thereafter - $351.5million.

10.COMMITMENTS AND CONTINGENCIES

Banksharesis a party to financial instruments that are not reflected in the balancesheet, which include commitments to extend credit and standby letters ofcredit. Various commitments to extend credit (lines of credit) are made in thenormal course of banking business. Letters of credit are issued for the benefitof customers by affiliated banks. These commitments are subject to loanunderwriting standards and geographic boundaries consistent with Bankshares’loans outstanding. Bankshares’ lending activities are concentrated in Maryland,Delaware and Virginia.

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. Total commitments to extend credit were $5.0 billionat December 31, 2006 and $4.8 billion at December 31, 2005.

Lettersof credit are commitments issued to guarantee the performance of a customer toa third party. Outstanding letters of credit were $596.9 million at December31, 2006 and $540.6 million at December 31, 2005. In accordance with FASBInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others,” the feesreceived for issuing letters of credit are deferred and amortized over the lifeof the commitment. The unamortized fees on letters of credit at December 31,2006 and December 31, 2005 had a carrying value of $2.6 million and $2.7million, respectively.

Bankshares’mortgage banking subsidiary is a Fannie Mae Delegated Underwriting andServicing lender and has a loss-sharing arrangement for loans originated onbehalf of and sold to Fannie Mae. The unamortized principal balance of theunderlying loans totaled $330.9 million at December 31, 2006 and $249.8 millionat December 31, 2005. The reserve for potential losses on loans originated andsold in the secondary market was $154 thousand and $61 thousand at December 31,2006 and December 31, 2005, respectively. The mortgage subsidiary also hasoriginated and sold loans with recourse in the event of foreclosure on theunderlying real estate.

Bankshareshas committed to invest funds in third-party private equity funds. At December31, 2006 and 2005, $30.6 million and $26.6 million, respectively, remainedunfunded.

Banksharesentered into a seven-year service contract with SunGard Wealth ManagementServices, which subsequently sold its business to Reliance Information Systems,LLC, to provide a new core wealth management accounting system and back-officeoperations beginning in January 2005. The annual purchase obligationcommitments on this contract are: 2007 - $5.0 million, 2008 - $5.0 million,2009 - $5.0 million, 2010 - $5.0 million, 2011 - $5.0 million.

Foradditional information on other commitments, see Notes No. 5, 9, and 18.

Inthe ordinary course of business, Bankshares and its subsidiaries are involvedin a number of pending and threatened legal actions and proceedings. In certainof these actions and proceedings, claims for substantial monetary damages areasserted against Bankshares and its subsidiaries. In view of the inherentdifficulty of predicting the outcome of such

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matters,Bankshares cannot state what the eventual outcome of pending matters will be. However,based on current knowledge, management does not believe that liabilities, ifany, arising from pending litigation matters, will have a material adverseeffect on the consolidated financial position, earnings or liquidity ofBankshares. If payment associated with a claim becomes probable and the costcan be reasonably estimated, a contingent liability would be established basedon information currently available, advice of counsel and available insurancecoverage.

Between2001 and 2003, on behalf of either individual plaintiffs or a putative class ofplaintiffs, eight separate actions were filed in state and federal courtagainst CBNV and other defendants challenging the validity of second mortgageloans the defendants made to the plaintiffs. All of the cases were either filedin or removed to the federal district court for the Western District ofPennsylvania. In June 2003, the parties to the various actions informed thecourt that they had reached an agreement in principle to settle the variousactions. On July 17, 2003, the court conditionally certified a class for settlementpurposes, preliminarily approved the class settlement and directed the issuanceof notice to the class.

Thereafter,certain plaintiffs who had initially opted out of the proposed settlement andother objectors challenged the validity of the settlement in the districtcourt. The district court denied their arguments and approved the settlement. These“opt out” plaintiffs and other objectors appealed the district court’s approvalof the settlement to the Third Circuit Court of Appeals. In August 2005, theThird Circuit reversed the district court’s approval of the settlement andremanded the case to the district court with instructions to consider andaddress certain specific issues when re-evaluating thesettlement.  In July 2006, the settling parties modified the originalsettlement agreement and submitted the modified settlement agreement to theDistrict Court.  Certain individuals who were excluded from the settlementclass have filed two actions on behalf of a putative class of plaintiffs allegingclaims similar to those raised in the initial filing.  Theseactions were later consolidated in the Western District ofPennsylvania.

11.SHAREHOLDERS’ EQUITY

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

TheBoard of Directors has the authority to classify and reclassify any unissuedshares of preferred stock by fixing the preferences, rights, voting powers(which may include separate class voting on certain matters), restrictions andqualifications, dividends, times and prices of redemption and conversion rights.

Bankshareshas a Dividend Reinvestment and Stock Purchase Plan. The Plan allowsshareholders to invest their cash dividends automatically in Bankshares stockat a price that is 5% less than the market price on the dividend payment date.Plan participants also may make additional cash payments to purchase stockthrough the Plan at the market price. The number of shares of common stock thatremain available for issuance under the Plan is 228,492 shares. Banksharesreserves the right to amend, modify, suspend or terminate the Plan at any timeat its discretion. Pursuant to the PNC merger agreement, Bankshares suspendedthe Plan until the effective time of the merger.

Bankshareshas an Employee Stock Purchase Plan. The Plan allows employees (other than executiveofficers of Bankshares) to purchase stock through payroll deduction anddividend reinvestment at the then current market price for employee purchasesand at 95% of market for dividend reinvestment. The number of shares of commonstock that remain available for issuance under the Plan is 1,046,902 shares.Bankshares reserves the right to amend, modify, suspend or terminate the Planat any time at its discretion. Pursuant to the PNC merger agreement, Banksharessuspended the Plan until the effective time of the merger.

TheBoard of Directors has authorized Bankshares to purchase shares of its commonstock. Purchases may be made from time to time, subject to regulatoryrequirements, in the open market or in privately negotiated transactions. Purchasedshares are retired. In 2006, Bankshares purchased 44,409 shares in netsettlement of the minimum tax liability for vested restricted stock. During2005 there were no shares repurchased under this plan. In June 2006, the Boardof Directors authorized the repurchase of an additional two million shares. Thenumber of shares remaining available for purchase under the plan was 2,670,081shares at December 31, 2006. Pursuant to the PNC merger agreement, Banksharessuspended the Plan until the effective time of the merger.

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Pursuantto a Shareholders Protection Rights Agreement adopted in June 1999, each shareof outstanding common stock carries a right, initially for the purchase of1/1,000 of a share of preferred stock at an exercise price of $100 (subject toadjustment). The rights, which do not carry voting or dividend rights, may beredeemed by Bankshares at $0.005 per right. The rights expire on September 29,2009 unless sooner exercised, exchanged or redeemed. The rights will not becomeexercisable and will not trade separately from the common stock until the tenthbusiness day (or such other date as the Board of Directors selects) aftercommencement of a tender or exchange offer for, or announcement of theacquisition by a person or group of 10.0% or more of the outstanding commonstock. Upon exercisability of the rights after acquisition by a person or group(acquiring person) of 10.0% or more of the outstanding common stock or upon certainbusiness combinations or other defined transactions involving Bankshares, eachright (except rights of the acquiring person, which become void) will entitleits holder to acquire common stock (or at Bankshares’ discretion, preferredstock) of Bankshares, or common stock of the acquiring entity in a businesscombination or other defined transaction, with a value of twice the thencurrent exercise price of the right. In certain such cases, Bankshares mayexchange one share of common stock (or at Bankshares’ discretion, 1/1,000 of ashare of preferred stock) for each right that has not become void. The Board ofDirectors has classified 1,600,000 shares of preferred stock as Class APreferred Stock for potential issuance on exercise of rights.

Cash dividends paid to Bankshares by its consolidatedsubsidiaries for the years ended 2006, 2005 and 2004 were $165.7 million,$173.0 million and $145.8 million, respectively. In aggregate, our affiliatebanks have $447.7 million of capital beyond the level necessary to maintain “wellcapitalized” status at December 31,2006. The amount of dividends that Bankshares’ bank and nonbank affiliates could have paid to the holding companywithout approval from bank regulators at December 31, 2006 was $361.5 million.

TheMercantile Bankshares Corporation Stock Retainer and Deferred Compensation Planfor Non-Employee Directors was approved at the 2005 Annual Shareholders’meeting. The Plan provides for an annual stock retainer of 750 shares ofBankshares’ common stock to each nonemployee director of Bankshares. The Planpermits nonemployee directors of Bankshares and its affiliates to elect todefer voluntarily their annual stock and cash retainers and some or all oftheir fees. The initial annual stock retainer under the plan was paid on June1, 2005 to nonemployee directors.

OnMarch 29, 2006, the Compensation Committee authorized the issuance of upto 317,802 performance-based restricted stock units (“Performance RSUs”)pursuant to the 2006 Performance Stock Program. The vesting of the PerformanceRSUs will be determined based upon the percentage improvement in Bankshares’pre-tax operating income (“PTOI”) over a three-year performance period (the “PerformancePeriod”) ending December 31, 2008 (with no adjustments for acquisitions orother extraordinary events). In addition to the performance period, the awardsearned are subject to an additional one-year service requirement. Depending onactual performance, the Performance RSUs will vest at levels from 0% to 100%. Banksharesrecognized compensation expense related to the vesting of 211,868 of thesePerformance RSUs during 2006. On the same date, the Committee also awarded104,630 RSUs to Bankshares’ chief executive officer. The award will vestratably over four years. The Performance RSUs and the RSUs granted toBankshares chief executive officer vest and convert into common stock inconnection with a change of control of Bankshares.

*EarningsPer Share*Basic earnings per share (“EPS”) is computed by dividingincome available to common shareholders by weighted average common sharesoutstanding, which were 124,080,613 for 2006, 121,348,742 for 2005 and118,830,128 for 2004. Diluted EPS is computed using the same components as inbasic EPS with the denominator adjusted for the dilutive effect of weightedaverage common shares from the various share-based compensation plans. Theadjusted weighted average shares were 125,321,143 for 2006, 122,390,007 for2005 and 119,781,506 for 2004. The following tables provide reconciliationsbetween the computation of basic EPS and diluted EPS for the years ended December31, 2006, 2005 and 2004.
| **2006 (In thousands, except per share data)** | ** ** | **Net  Income** | ** **  | **Weighted Average  Common Shares** | ** **  | **EPS**    | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|-------------|-----------------------------------------------|-------------|------------|------------|
| Basic EPS                                                                    | ** ** | **$**           | **288,286** | ** **                                    | **124,081** | ** ** | **$**      | **2.32** | ** ** |
| Dilutive effect  of :                                                        | ** ** | ** **      |        |                                          | ** **  | ** ** | ** ** |
| Stock options                                                                | ** ** | ** **      | ** **  | **826**                                       | ** **  | ** ** | ** ** |
| Restricted stock awards and units                                            | ** ** | ** **      | ** **  | **117**                                       | ** **  | ** ** | ** ** |
| Vested directors’ deferred compensation plan shares                     |       |            | ** **  | **297**                                       |        |       |       |
| Diluted EPS                                                                  | ** ** | **$**           | **288,286** | ** **                                    | **125,321** | ** ** | **$**      | **2.30** | ** ** |

 

88

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| **2005 (In thousands, except per share data)** | ** ** | **Net Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------------------------------|------------|---------|------------|
| Basic EPS                                                                    |       | $                   | 276,319    |                                          | 121,349    |    | $          | 2.28 |   |
| Dilutive effect of :                                                         |       |                |       |                                          |       |    |       |
| Stock options                                                                |       |                |       | 665                                           |       |    |       |
| Restricted stock awards                                                      |       |                |       | 115                                           |       |    |       |
| Vested directors’ deferred compensation plan shares                     |       |                |       | 261                                           |       |    |       |
| Diluted EPS                                                                  |       | $                   | 276,319    |                                          | 122,390    |    | $          | 2.26 |   |

 
| **2004 (In thousands, except per share data)** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|-----------------------------------------------|------------|---------|------------|
| Basic EPS                                                                    |       | $               | 229,407    |                                          | 118,830    |    | $          | 1.93 |   |
| Dilutive effect  of :                                                        |       |            |       |                                          |       |    |       |
| Stock options                                                                |       |            |       | 689                                           |       |    |       |
| Restricted stock awards                                                      |       |            |       | 89                                            |       |    |       |
| Vested directors’ deferred compensation plan shares                     |       |            |       | 174                                           |       |    |       |
| Diluted EPS                                                                  |       | $               | 229,407    |                                          | 119,782    |    | $          | 1.92 |   |

 

Antidilutiveweighted average common shares from the various share-based compensation plansexcluded from the computation of diluted EPS were 48,895 for 2006, none for2005 and 61,417 for 2004.

*ComprehensiveIncome*The two major components of comprehensive income are netincome and other comprehensive income. Other comprehensive income includes suchitems as net unrealized gains and losses on securities available-for-sale. Duringthe year ended December 31, 2006, Bankshares implemented SFAS 158. The initialapplication of SFAS 158 did not affect Bankshares’ results of operationshowever, shareholders’ equity through accumulated other comprehensive incomewas reduced by $23.1 million as of December 31, 2006. The following tablesummarizes the market value change and related tax effect of unrealized gains(losses) on securities available-for-sale for each of the three years in theperiod ended December 31, 2006. See the “Statements of Changes in ConsolidatedShareholders’ Equity.”
| **2006 (Dollars in thousands)**                | ** ** | **Pretax  Amount** | ** **  | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** **  |
|---------------------------------------------------------------|------------|--------------------|-------------|-----------------------------|------------|-----------------|-------------|
| Net Income                                                    |       |               | ** **  | ** **                  | ** ** | **$**           | **288,286** | ** ** |
| Other  comprehensive income                                   |       |               |        |                        |       |            |        |
| Unrealized holding gains arising during the period            | ** ** | **13,941**         | ** **  | **(5,356**                  | **)**      | **8,585**       | ** **  |
| Reclassification adjustment for gains included in  net income | ** ** | **(212**           | **)**       | **84**                      | ** ** | **(128**        | **)**       |
| Total other comprehensive income                              | ** ** | **13,729**         | ** **  | **(5,272**                  | **)**      | **8,457**       | ** **  |
| Total comprehensive income                                    |       |               | ** **  | ** **                  | ** ** | **$**           | **296,743** | ** ** |
| Adjustment to  initially apply SFAS No. 158, net of taxes     | ** ** | **$**              | **(38,287** | **)**                       | **15,143** | ** **      | **$**       | **(23,144** | **)** |
|                                                               |            |                    |             |                             |            |                 |             |  |  |

 
| **2005 (Dollars in thousands)**                | ** ** | **Pretax  Amount** | ** ** | **Tax  Benefit** | ** ** | **Net  Amount** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|------------|
| Net Income                                                    |       |               |       |             |       | $               | 276,319    |   |
| Other  comprehensive income                                   |       |               |       |             |       |            |       |
| Unrealized holding losses arising during the period           |       | (47,718            | )          | 17,844           |       | (29,874         | )          |
| Reclassification adjustment for gains included in  net income |       | (405               | )          | 160              |       | (245            | )          |
| Total other comprehensive losses                              |       | (48,123            | )          | 18,004           |       | (30,119         | )          |
| Total comprehensive  income                                   |       |               |       |             |       | $               | 246,200    |   |

 

89

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| **2004 (Dollars in thousands)**                | ** ** | **Pretax  Amount** | ** ** | **Tax  Benefit** | ** ** | **Net  Amount** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|------------|
| Net Income                                                    |       |               |       |             |       | $               | 229,407    |   |
| Other  comprehensive income                                   |       |               |       |             |       |            |       |
| Unrealized holding losses arising during the period           |       | (39,156            | )          | 14,696           |       | (24,460         | )          |
| Reclassification adjustment for gains included in  net income |       | (1,239             | )          | 490              |       | (749            | )          |
| Total other comprehensive losses                              |       | (40,395            | )          | 15,186           |       | (25,209         | )          |
| Total comprehensive  income                                   |       |               |       |             |       | $               | 204,198    |   |

 

*CapitalAdequacy*Bankshares and its bank affiliates are subject to variousregulatory capital requirements administered by the federal and state bankingagencies. Failure to meet minimum capital requirements can initiate certainmandatory - and possibly additional discretionary - actions by regulators that,if undertaken, could have a direct material effect on Bankshares’ financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, Bankshares and its bank affiliates must meet specificcapital guidelines that involve quantitative measures of Bankshares’ assets,liabilities and certain off-balance sheet items as calculated under regulatoryaccounting practices. Bankshares’ capital amounts and classification are alsosubject to qualitative judgments by the regulators about components, riskweightings and other factors.

Quantitativemeasures established by regulation to ensure capital adequacy requireBankshares and its bank affiliates to maintain at least the minimum amounts andratios of Tier I capital (as defined in the regulations) to risk-weightedassets (as defined). Management believes that, as of December 31, 2006,Bankshares and its bank affiliates exceeded all capital adequacy requirementsto which they are subject.

Asof December 31, 2006, the most recent notification from the primary regulatorsfor each of Bankshares’ affiliate banking institutions categorized them as wellcapitalized under the prompt corrective action regulations. To be categorizedas well capitalized, a bank must maintain certain capital ratios above minimumlevels. These capital ratios include Tier I capital and total risk-basedcapital as percents of net risk-weighted assets and Tier I capital as a percentof adjusted average total assets (leverage ratio). There are no conditions orevents since the last notifications that management believes have changed theaffiliate banks’ category.

Actualcapital amounts and ratios are presented in the following table for Banksharesand its affiliates. The minimum ratios for capital adequacy purposes are 4.00%,8.00% and 4.00% for the Tier I Capital, Total Capital and Leverage ratios,respectively. To be categorized as well capitalized, a bank must maintainminimum ratios of 6.00%, 10.00% and 5.00% for its Tier I Capital, Total Capitaland Leverage ratios, respectively. Bankshares, as a bank holding company, isnot subject to the well-capitalized requirement. No deduction from capital isrequired for interest rate risk or the pension adjustment resulting from theadoption of SFAS 158 “Employees’ Accounting for Defined Benefit Pension andOther Retirement Plans, an amendment of FASB Statements No. 87, 88,106 and132(R).” See Note No. 14 — Pensions and Other Postretirement Benefit Plans.

 
| **December 31, 2006  (Dollars in thousands)** | ** ** | **Tier I  Capital** | ** **    | **Total  Risk-Based  Capital** | ** ** | **Net  Risk-  Weighted  Assets** | ** ** | **Adjusted  Average  Total Assets** | ** **     | **Tier I  Capital  Ratio** | ** ** | **Total  Capital  Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------|---------------|--------------------------------|------------|----------------------------------|------------|------------------------------------------|----------------|---------------------------------|------------|---------------------------|------------|---------------------|------------|
| **Bankshares**                                                    | ** ** | **$**                    | **1,676,117** | ** **                     | **$**      | **2,135,443**                    | ** ** | **$**                                    | **13,948,141** | ** **                      | **$**      | **16,688,333**            | ** ** | **12.02**           | **%**      | **15.31** | **%** | **10.04** | **%** |
| Annapolis  Banking & Trust                                    |       | 44,583                   |          | 51,904                         |       | 345,371                          |       | 488,233                                  |           | 12.91                           |       | 15.03                     |       | 9.13                |       |
| Citizens  National Bank                                           |       | 110,493                  |          | 158,219                        |       | 1,236,047                        |       | 1,383,553                                |           | 8.94                            |       | 12.80                     |       | 7.99                |       |
| Farmers &  Mechanics Bank                                     |       | 169,807                  |          | 230,846                        |       | 1,381,235                        |       | 1,688,885                                |           | 12.29                           |       | 16.71                     |       | 10.05               |       |
| Marshall  National Bank & Trust                               |       | 14,374                   |          | 20,451                         |       | 146,254                          |       | 190,290                                  |           | 9.83                            |       | 13.98                     |       | 7.55                |       |
| Mercantile  County Bank                                           |       | 84,545                   |          | 121,171                        |       | 775,245                          |       | 984,542                                  |           | 10.91                           |       | 15.63                     |       | 8.59                |       |
| Mercantile  Eastern Shore Bank                                    |       | 56,124                   |          | 87,575                         |       | 483,544                          |       | 619,546                                  |           | 11.61                           |       | 18.11                     |       | 9.06                |       |
| Mercantile  Peninsula Bank                                        |       | 153,960                  |          | 225,423                        |       | 1,410,884                        |       | 1,764,680                                |           | 10.91                           |       | 15.98                     |       | 8.72                |       |
| Mercantile-Safe  Deposit & Trust Company                      |       | 617,610                  |          | 741,157                        |       | 6,492,655                        |       | 7,697,706                                |           | 9.51                            |       | 11.42                     |       | 8.02                |       |
| Mercantile  Southern Maryland Bank                                |       | 96,625                   |          | 133,537                        |       | 707,690                          |       | 1,016,547                                |           | 13.65                           |       | 18.87                     |       | 9.51                |       |
| National Bank of  Fredericksburg                                  |       | 40,168                   |          | 50,984                         |       | 405,635                          |       | 479,095                                  |           | 9.90                            |       | 12.57                     |       | 8.38                |       |
| Westminster Union Bank                                            |       | 72,444                   |          | 103,034                        |       | 526,022                          |       | 825,681                                  |           | 13.77                           |       | 19.59                     |       | 8.77                |       |
|                                                                   |            |                          |               |                                |            |                                  |            |                                          |                |                                 |            |                           |            |                     |            |  |  |  |  |

 

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

 

12.INCOME TAXES

Applicableincome taxes on net income for 2006, 2005 and 2004 consisted of the following:
| ** **                           | ** ** | **2006**    | ** **  | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|
| **(Dollars in thousands)** | ** ** | **Federal** | ** **  | **State**  | ** ** | **Total**  | ** ** | **Federal** | ** ** | **State** | ** ** | **Total** | ** ** | **Federal** | ** ** | **State** | ** ** | **Total** | ** ** |
| Current tax  expense                 | ** ** | **$**       | **155,999** | ** ** | **$**      | **18,525** | ** ** | **$** | **174,524** |   | $ | 151,657 |   | $ | 19,136 |   | $ | 170,793 |   | $ | 140,618 |   | $ | 14,255 |   | $ | 154,873 |   |
| Deferred tax  benefit                | ** ** | **(5,910**  | **)**       | **(3,768** | **)**      | **(9,678** | **)**      | (9,047 | ) | (216 | ) | (9,263 | ) | (21,937 | ) | (1,812 | ) | (23,749 | ) |
| Total                                | ** ** | **$**       | **150,089** | ** ** | **$**      | **14,757** | ** ** | **$** | **164,846** |   | $ | 142,610 |   | $ | 18,920 |   | $ | 161,530 |   | $ | 118,681 |   | $ | 12,443 |   | $ | 131,124 |   |

 

Significantcomponents of Bankshares’ deferred tax assets and liabilities as of December31, 2006 and 2005 were as follows:
| **(Dollars in thousands)**                    | ** ** | **2006**    | ** **  | **2005** | ** ** |
|---------------------------------------------------------|------------|-------------|-------------|----------|------------|
| Deferred tax  assets:                                   | ** ** | ** **  |        |     |       |
| Allowance for loan losses                               | ** ** | **$**       | **54,822**  |     | $          | 60,308 |   |
| Reserve for unfunded commitments                        | ** ** | **6,500**   |        |     |       |
| Write-down of other real estate owned                   | ** ** | **—**  |        | 51       |       |
| Deferred income                                         | ** ** | **26,024**  |        | 35,607   |       |
| Net unrealized losses on securities  available-for-sale | ** ** | **14,114**  |        | 19,388   |       |
| Other                                                   | ** ** | **11,164**  |        | 9,218    |       |
| Total deferred tax assets                               | ** ** | **112,624** |        | 124,572  |       |
| Deferred tax  liabilities:                              | ** ** | ** **  |        |     |       |
| Purchase accounting adjustments                         | ** ** | **10,121**  |        | 10,939   |       |
| Depreciation                                            | ** ** | **14,206**  |        | 30,205   |       |
| Accrued employee benefits                               | ** ** | **(13,042** | **)**       | 4,106    |       |
| Prepaid items                                           | ** ** | **—**  |        | —   |       |
| Total deferred tax liabilities                          | ** ** | **11,285**  |        | 45,250   |       |
| Net deferred tax  assets                                | ** ** | **$**       | **101,339** |     | $          | 79,322 |   |

 

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Areconciliation of actual tax expense and taxes computed at the statutoryfederal rate of 35% for each of the three years in the period ended December31, 2006 follows.
| ** **                                             | ** ** | **2006**   | ** **  | **2005**                      | ** ** | **2004**   | ** ** |
|--------------------------------------------------------|------------|------------|-------------|-------------------------------|------------|------------|------------|
| **(Dollars in thousand)**                    | ** ** | **Amount** | ** **  | **% of  Pretax  Income** | ** ** | **Amount** | ** ** | **% of  Pretax  Income** | ** ** | **Amount** | ** ** | **% of  Pretax  Income** | ** ** |
| Tax computed at  statutory rate                        | ** ** | **$**      | **158,596** | ** **                    | **35.0**   | **%**      | $          | 153,247 |   | 35.0 | % | $ | 126,186 |   | 35.0 | % |
| Increases  (decreases) in tax resulting from:          | ** ** | ** ** |        |                          |       |       |       |   |   |   |   |   |   |
| Tax-exempt interest income                             | ** ** | **(3,928** | **)**       | **(0.9**                      | **)**      | (3,658     | )          | (0.8 | ) | (3,567 | ) | (0.9 | ) |
| State income taxes, net of federal income tax  benefit | ** ** | **12,563** | ** **  | **2.8**                       |       | 12,298     |       | 2.8 |   | 8,088 |   | 2.2 |   |
| Nondeductible goodwill amortization                    | ** ** | **—** | ** **  | **—**                    |       | —     |       | — |   | — |   | — |   |
| Other, net                                             | ** ** | **(2,385** | **)**       | **(0.5**                      | **)**      | (357       | )          | (0.1 | ) | 417 |   | 0.1 |   |
| Actual tax  expense                                    | ** ** | **$**      | **164,846** | ** **                    | **36.4**   | **%**      | $          | 161,530 |   | 36.9 | % | $ | 131,124 |   | 36.4 | % |

 

13.RELATED PARTY TRANSACTIONS

Inthe normal course of business, loans are made to officers and directors ofBankshares and its affiliates, as well as to their related interests.  Inthe opinion of management, these loans are consistent with sound bankingpractices, are within regulatory lending limitations and do not involve morethan the normal risk of collectibility.  At December 31, 2006 and 2005,loans to executive officers and directors of Bankshares and its principal affiliates,including loans to their related interests, totaled $115.6 million and$119.1 million, respectively.  During 2006, loan additions and loanmaturities and payoffs were $108.4 million and $109.1 million, respectively.

BanksharesChairman and Chief Executive Officer is a director of an insurance company withwhich Bankshares had investments in bank owned life insurance of approximately$72 million and $69 million at December 31, 2006 and 2005, respectively. In addition, one of Bankshares’ directors serves as the Chairman of theExecutive Board and Chief Executive Officer of an insurance company with whichBankshares has an investment in bank owned life insurance of approximately $40million and $38 million at December 31, 2006 and 2005, respectively.

Bankshareshas two directors who are partners with law firms which Bankshares has engagedto provide legal services.  Bankshares incurred approximately $1.6 million,$2.6 million and $2.9 million in legal fees with these law firms forthe years ended December 31, 2006, 2005 and 2004, respectively.

14.PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS

Banksharesadopted SFAS No. 158, “Employees’ Accounting for Defined Benefit Pension andOther Retirement Plans, an amendment of FASB Statements No. 87, 88,106 and132(R),” as of December 31, 2006. This Statement requires an employer torecognize the overfunded or underfunded status of a defined benefitpostretirement plan as an asset or liability in its balance sheet and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income, net of tax. The initial application of SFAS No.158 did not affect Bankshares’ results of operations however, Shareholders’Equity through accumulated other comprehensive income was reduced by $23.1million as of December 31, 2006.

Banksharessponsors qualified and nonqualified pension plans and other postretirementbenefit plans for its employees. Under the prior provisions of SFAS No. 87, “Employers’Accounting for Pensions,” there was no additional minimum pension liabilityrequired to be recognized. Included in the other postretirement benefit plansare health care and life insurance. All Bankshares affiliates have adopted thesame health care and life insurance plans, except for one affiliate, which hasseparate benefit plans. Employees were eligible for a company-paid subsidytowards their health care insurance if their age plus length of service wasequal to at least 65 as of December 31, 1990. Employees may become eligible forcompany-paid life insurance benefits if they qualify for retirement whileworking for Bankshares. In addition

tothe plans disclosed in the following tables, Bankshares has periodicallyentered into separate supplemental retirement agreements with key executives. Theseare generally unfunded obligations, with an accrued liability of $19.1 millionand $18.7 million at December 31, 2006 and 2005, respectively.

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Thefollowing table provides the incremental effect of applying SFAS No. 158 onindividual line items in the consolidated balance sheet at December 31, 2006.
| ** **                              | ** ** | **Before**              | ** ** | ** **      | ** ** | **After**               | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| ** **                              | ** ** | **application of** | ** ** | ** **      | ** ** | **application of** | ** ** |
| **(Dollars in thousands)**    | ** ** | **SFAS No.158**    | ** ** | **Adjustments** | ** ** | **SFAS No.158**    | ** ** |
| Other assets                            |       | $                       | 644,175    |            | $          | (12,357                 | )          | $ | 631,818 |   |
| Total assets                            |       | 17,728,382              |       | (12,357         | )          | 17,716,025              |       |
| Accrued expenses and  other liabilities |       | 202,965                 |       | 10,787          |       | 213,752                 |       |
| Total liabilities                       |       | 15,288,072              |       | 10,787          |       | 15,298,859              |       |
| Accumulated other  comprehensive income |       | (24,387                 | )          | (23,144         | )          | (47,531                 | )          |
| Total shareholders’ equity         |       | $                       | 2,440,310  |            | $          | (23,144                 | )          | $ | 2,417,166 |   |

 

Thefollowing table provides a reconciliation of the changes in the plans’ benefitobligation, fair value of assets and funded status for each of the two years inthe period ended December 31, 2006.
| ** **                                      | ** ** | **Pension Benefits** | ** **  | ** **    | ** ** | ** **              | ** ** |
|-------------------------------------------------|------------|---------------------------|-------------|---------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                  | ** **  | **2005**      | ** ** | **Other Benefits** | ** ** |
| ** **                                      | ** ** | ** **                | ** **  | **Non-**      | ** ** | ** **              | ** ** | ** ** | ** ** | **Non-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**            | ** ** | **Qualified**             | ** **  | **qualified** | ** ** | **Total**               | ** ** | **Qualified** | ** ** | **qualified** | ** ** | **Total** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Change in Benefit Obligation**                | ** ** | ** **                | ** **  | ** **    | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Benefit obligation at  beginning of year        | ** ** | **$**                     | **209,941** | ** **    | **$**      | **4,512**               | ** ** | **$** | **214,453** |   | $ | 198,422 |   | $ | 2,910 |   | $ | 201,332 | ** ** | **$** | **15,401** |   | $ | 16,910 |   |
| Service cost                                    | ** ** | **7,645**                 | ** **  | **856**       | ** ** | **8,501**               |       | 7,320 |   | 607 |   | 7,927 | ** ** | **444** |   | 390 |   |
| Interest cost                                   | ** ** | **11,954**                | ** **  | **430**       | ** ** | **12,384**              |       | 11,276 |   | 161 |   | 11,437 | ** ** | **885** |   | 904 |   |
| Actuarial (gain) loss                           | ** ** | **(4,701**                | **)**       | **2,457**     | ** ** | **(2,244**              | **)**      | 2,160 |   | 955 |   | 3,115 | ** ** | **(789** | **)** | (1,705 | ) |
| Acquisition                                     | ** ** | —                    | ** **  | —        | ** ** | —                  |       | — |   | — |   | — | ** ** | — |   | — |   |
| Benefits paid                                   | ** ** | **(10,082**               | **)**       | **(596**      | **)**      | **(10,678**             | **)**      | (9,237 | ) | (121 | ) | (9,358 | ) | **(995** | **)** | (1,098 | ) |
| Benefit obligation at  end of year              | ** ** | **214,757**               | ** **  | **7,659**     | ** ** | **222,416**             |       | 209,941 |   | 4,512 |   | 214,453 | ** ** | **14,946** |   | 15,401 |   |
|                                            |       |                      |        |          |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| **Change in Plan Assets**                       | ** ** | ** **                | ** **  | ** **    | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fair value of plan  assets at beginning of year | ** ** | **211,511**               | ** **  | —        | ** ** | **211,511**             |       | 211,638 |   | — |   | 211,638 | ** ** | — |   | — |   |
| Actual return on plan  assets                   | ** ** | **28,556**                | ** **  | —        | ** ** | **28,556**              |       | 9,110 |   | — |   | 9,110 | ** ** | — |   | — |   |
| Employer contribution                           | ** ** | **15,000**                | ** **  | **596**       | ** ** | **15,596**              |       | — |   | 121 |   | 121 | ** ** | **995** |   | 1,098 |   |
| Plan participants’  contributions          | ** ** | —                    | ** **  | —        | ** ** | —                  |       | — |   | — |   | — | ** ** | **2,008** |   | 1,947 |   |
| Benefits paid                                   | ** ** | **(10,082**               | **)**       | **(596**      | **)**      | **(10,678**             | **)**      | (9,237 | ) | (121 | ) | (9,358 | ) | **(3,003** | **)** | (3,045 | ) |
| Fair value of plan  assets at end of year       | ** ** | **244,985**               | ** **  | **—**    | ** ** | **244,985**             |       | 211,511 |   | — |   | 211,511 | ** ** | **—** |   | — |   |
| Funded status at end of year                    | ** ** | **$**                     | **30,228**  | ** **    | **$**      | **(7,659**              | **)**      | **$** | **22,569** |   | $ | 1,570 |   | $ | (4,512 | ) | $ | (2,942 | ) | **$** | **(14,946** | **)** | $ | (15,401 | ) |

 

Amountsrecognized in the consolidated balance sheet consist of:
| ** **                           | ** ** | **Pension Benefits** | ** ** | **Other**     | ** ** |
|--------------------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                           | ** ** | **2006**                  | ** ** | **Benefits**  | ** ** |
| ** **                           | ** ** | ** **                | ** ** | **Non-**      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Qualified**             | ** ** | **qualified** | ** ** | **Total** | ** ** | **2006** | ** ** |
| Noncurrent  assets                   | ** ** | **$**                     | **30,228** | ** **    | **$**      | **—** | ** ** | **$** | **30,228** | ** ** | **$** | **—** | ** ** |
| Current  liabilities                 | ** ** | **—**                | ** ** | **(1,225**    | **)**      | **(1,225** | **)** | **(1,621** | **)** |
| Noncurrent  liabilities              | ** ** | **—**                | ** ** | **(6,434**    | **)**      | **(6,434** | **)** | **(13,325** | **)** |
|                                 | ** ** | **$**                     | **30,228** | ** **    | **$**      | **(7,659** | **)** | **$** | **22,569** | ** ** | **$** | **(14,946** | **)** |

 

93

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Pretaxamounts recognized in accumulated other comprehensive income consist of:
| ** **                           | ** ** | **Pension Benefits** | ** ** | **Other**     | ** ** |
|--------------------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                           | ** ** | **2006**                  | ** ** | **Benefits**  | ** ** |
| ** **                           | ** ** | ** **                | ** ** | **Non-**      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Qualified**             | ** ** | **qualified** | ** ** | **Total** | ** ** | **2006** | ** ** |
| Net loss                             | ** ** | **$**                     | **26,676** | ** **    | **$**      | **924** | ** ** | **$** | **27,600** | ** ** | **$** | **3,210** | ** ** |
| Prior service  cost                  | ** ** | **7,384**                 | ** ** | **196**       | ** ** | **7,580** | ** ** | **—** | ** ** |
|                                 | ** ** | **$**                     | **34,060** | ** **    | **$**      | **1,120** | ** ** | **$** | **35,180** | ** ** | **$** | **3,210** | ** ** |

 

Therewere no amounts recognized in accumulated other comprehensive income for 2005and 2004.

Theaccumulated benefit obligation for the pension plans was $211.5 million and$207.0 million at December 31, 2006 and 2005, respectively.

Thefollowing is information on the accumulated benefit obligation in excess of thefair value of assets for the nonqualified pension plan and other postretirementbenefit plans.
| ** **                           | ** ** | **Pension Benefits** | ** ** | ** **    | ** ** | ** **              | ** ** |
|--------------------------------------|------------|---------------------------|------------|---------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2006**                  | ** ** | **2005**      | ** ** | **Other Benefits** | ** ** |
| ** **                           | ** ** | ** **                | ** ** | **Non-**      | ** ** | ** **              | ** ** | **Non-** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Qualified**             | ** ** | **qualified** | ** ** | **Qualified**           | ** ** | **qualified** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Projected  benefit obligation        | ** ** | **N/A**                   | ** ** | **$**         | **7,659**  |                    | N/A        |   | $ | 4,512 | ** ** | **N/A** |   | N/A |   |
| Accumulated  benefit obligation      | ** ** | **N/A**                   | ** ** | **5,012**     |       | N/A                     |       | 4,512 | ** ** | **$** | **14,946** |   | $ | 15,401 |   |
| Fair value of assets                 | ** ** | **N/A**                   | ** ** | **—**    |       | N/A                     |       | — | ** ** | **—** |   | — |   |
|                                      |            |                           |            |               |            |                         |            |  |  |  |  |  |  |  |  |  |  |

 

Thecomponents of net periodic benefit cost and other pretax amounts recognized inother comprehensive income for the pension plans for 2006, 2005 and 2004follow.
| ** **                                                                                          | ** ** | **Pension Benefits** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                          | ** ** | ** **                | ** ** | **Non-** | ** ** | ** ** | ** ** | ** ** | ** ** | **Non-** | ** ** | ** ** | ** ** | ** ** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**                                                                | ** ** | **Qualified**             | ** ** | **qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **qualified** | ** ** | **Total** | ** ** | **Qualified** | ** ** | **qualified** | ** ** | **Total** | ** ** |
| **Net  periodic benefit cost**                                                                      | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                                                                        | ** ** | **$**                     | **7,645**  | ** ** | **$** | **856** | ** ** | **$** | **8,501** |   | $ | 7,320 |   | $ | 607 |   | $ | 7,927 |   | $ | 5,603 |   | $ | 618 |   | $ | 6,221 |   |
| Interest cost                                                                                       | ** ** | **11,954**                | ** ** | **430** | ** ** | **12,384** |   | 11,276 |   | 161 |   | 11,437 |   | 10,528 |   | 386 |   | 10,914 |   |
| Expected return  on plan assets                                                                     | ** ** | **(17,559**               | **)**      | — | ** ** | **(17,559** | **)** | (16,573 | ) | — |   | (16,573 | ) | (15,387 | ) | — |   | (15,387 | ) |
| Amortization of  prior service cost                                                                 | ** ** | **1,184**                 | ** ** | **30** | ** ** | **1,214** |   | 1,170 |   | 23 |   | 1,193 |   | 782 |   | 23 |   | 805 |   |
| Recognized net  actuarial (gain) loss                                                               | ** ** | **2,150**                 | ** ** | **80** | ** ** | **2,230** |   | 1,461 |   | (185 | ) | 1,276 |   | 1,052 |   | 92 |   | 1,144 |   |
| Amortization of  transition asset                                                                   | ** ** | **—**                | ** ** | **—** | ** ** | **—** |   | — |   | — |   | — |   | — |   | 94 |   | 94 |   |
| Net periodic  benefit cost                                                                          | ** ** | **5,374**                 | ** ** | **1,396** | ** ** | **6,770** |   | 4,654 |   | 606 |   | 5,260 |   | 2,578 |   | 1,213 |   | 3,791 |   |
|                                                                                                |       |                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Other  changes in plan assets and benefit obligations recognized in other  comprehensive income** | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                                            | ** ** | **26,676**                | ** ** | **924** | ** ** | **27,600** |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Prior service  cost                                                                                 | ** ** | **7,384**                 | ** ** | **196** | ** ** | **7,580** |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Total recognized  in other comprehensive income                                                     | ** ** | **34,060**                | ** ** | **1,120** | ** ** | **35,180** |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Total recognized in net  periodic benefit cost and other comprehensive income                       | ** ** | **$**                     | **39,434** | ** ** | **$** | **2,516** | ** ** | **$** | **41,950** |   | $ | 4,654 |   | $ | 606 |   | $ | 5,260 |   | $ | 2,578 |   | $ | 1,213 |   | $ | 3,791 |   |

 

The estimated net loss and prior service costfor the pension plans that will be amortized from accumulated othercomprehensive income into net periodic benefit cost over the next fiscal yearare $0.2 million  and $1.2 million,respectively.  The estimated net loss andprior service credit for the other defined benefit postretirement plans thatwill be amortized from accumulated other comprehensive income into net periodicbenefit cost over the next fiscal year are $13 thousand and $30 thousand,respectively.

94

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Thecomponents of net periodic benefit cost and other pretax amounts recognized inother comprehensive income for other post-retirement benefit plans for 2006,2005 and 2004 follow.
| ** **                                                                                          | ** ** | **Other Benefits** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| **(Dollars in thousands)**                                                                | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net  periodic benefit cost**                                                                      | ** ** | ** **              |       |   |   |   |   |
| Service cost                                                                                        | ** ** | **$**                   | **444**    |   | $ | 390 |   | $ | 352 |   |
| Interest cost                                                                                       | ** ** | **885**                 |       | 904 |   | 1,028 |   |
| Expected return  on plan assets                                                                     | ** ** | **—**              |       | — |   | — |   |
| Amortization of  prior service cost                                                                 | ** ** | **—**              |       | — |   | — |   |
| Recognized net  actuarial loss                                                                      | ** ** | **213**                 |       | 275 |   | 362 |   |
| Amortization of  transition asset                                                                   |       | —                  |       | — |   | — |   |
| Net periodic  benefit cost                                                                          | ** ** | **1,542**               |       | 1,569 |   | 1,742 |   |
| **Other  changes in plan assets and benefit obligations recognized in other  comprehensive income** |       |                    |       |   |   |   |   |
| Net loss                                                                                            | ** ** | **3,210**               |       | — |   | — |   |
| Prior service  cost                                                                                 | ** ** | **—**              |       | — |   | — |   |
| Total recognized  in other comprehensive income                                                     | ** ** | **3,210**               |       | — |   | — |   |
| Total recognized in net  periodic benefit cost and other comprehensive income                       | ** ** | **$**                   | **4,752**  |   | $ | 1,569 |   | $ | 1,742 |   |

 

Theestimated net loss and prior service cost for the other postretirement benefitplans that will be amortized from accumulated other comprehensive income intonet periodic benefit cost over the next fiscal year are $300 thousand and $0,respectively.

InMay 2004, the FASB issued FSP FAS 106-2, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003,” which provides guidance on accounting for theimpact of the Medicare Prescription Drug, Improvement and Modernization Act of2003.  Bankshares determined that certain benefits covered by itspostretirement plans are actuarially equivalent to Medicare Part Dbenefits.  The effects of the subsidy reduced the accumulatedpostretirement benefit obligation by $1.2 million and net periodic benefit costby $0.1 million.  Thereduction in the projected net periodic benefit cost was recognized inBankshares’ Statements of Consolidated Income in 2005.

Theweighted average assumptions used to determine the benefit obligation are shownin the following table.
| ** **                            | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|---------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| **As of December 31,** | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Discount rate                         | ** ** | **6.00**                  | **%**      | 5.75                    | %          | **6.00** | **%** | 5.75 | % |
| Rate of compensation  increase        | ** ** | **4.00**                  | **%**      | 4.00                    | %          | **4.00** | **%** | 4.00 | % |

 

Theweighted average assumptions used to determine the net periodic benefit costare shown in the following table.
| ** **                                | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| **As of December 31,**     | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Discount rate                             | ** ** | **5.75**                  | **%**      | 5.75                    | %          | **5.75** | **%** | 5.75 | % |
| Expected  long-term return on plan assets | ** ** | **8.00**                  | **%**      | 8.00                    | %          | **N/A** |   | N/A |   |
| Rate of compensation  increase            | ** ** | **4.00**                  | **%**      | 4.00                    | %          | **4.00** | **%** | 4.00 | % |

 

Indetermining pension expense for the qualified pension plan, a long-term returnon assets of 8% was assumed.  This returnconsists of an average return of 10% on equity securities and 5% on debtsecurities.

95

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Assumedhealth care cost trend rates are shown in the following table.
| **As of December 31,**                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Health care cost  trend rate assumed for next year                                 | ** ** | **10**   | **%**      | 10       | %          |
| Rate to which  the cost trend rate is assumed to decline (the ultimate trend rate) | ** ** | **5**    | **%**      | 5        | %          |
| Year that the rate  reaches the ultimate trend rate                                | ** ** | **2012** |       | 2011     |       |

 

Formeasurement purposes, a 10% annual rate of increase in the per capita cost ofcovered health care benefits was assumed for 2007 and assumed to decrease by 1%per annum until the annual rate reaches 5% and to remain level thereafter. Thisrate represents Bankshares’ portion of the annual rate of increase. Assumedhealth care cost trend rates have a significant effect on the amounts reportedfor the health care plans. A 1% change in assumed health care cost trend rateswould have the following effects.
| **(Dollars in thousands)**                     | ** ** | **1% Increase** | ** ** | **1% Decrease** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| Effect on total  of service and interest cost components |       | $                    | 108        |                 | $          | (94 | ) |
| Effect on  postretirement benefit obligation             |       | 1,081                |       | (960                 | )          |
|                                                          |            |                      |            |                      |            |  |  |

 

*PensionPlan Assets*

Bankshares’qualified pension plan weighted average asset allocations by category are asfollows.
|                         | ** ** | **Plan Assets**          | ** ** |
|-------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **at December 31,** | ** ** |
| **Asset category** | ** ** | **2006**                      | ** ** | **2005** | ** ** |
| Equity  securities      | ** ** | **68**                        | **%**      | 67 | % |
| Debt securities         | ** ** | **30**                        |       | 31 |   |
| Cash                    | ** ** | **2**                         |       | 2 |   |
| Total                   | ** ** | **100**                       | **%**      | 100 | % |

 

Thereturn objectives for the qualified pension plan are to (1) provide a growingand predictable income stream from year to year; (2) achieve an annual returnat least equal to the 8% actuarial assumption rate; (3) preserve the capitalvalue of the pension plan; and (4) achieve growth of capital with comparablepension funds.

Assetallocation targets are between 30% to 50% in debt securities and 50% to 70% inequity securities.  At December 31, 2006,assets of the qualified pension plan consisted of 68% equity securities, 30%debt securities, and 2% cash.

Onefinal objective of the qualified pension plan is to maintain the fair value ofplan assets greater than the plan benefit obligations.  At December 31, 2006, the fair value ofqualified plan assets was 114% of benefit obligations.  The qualified pension plan had no investmentsin Bankshares’ common stock as of December 31, 2006 and 2005.

*CashFlows*

Generally,Bankshares makes contributions to the pension plan in amounts permitted underemployee benefit and tax laws.  Cashcontributions are made after valuations have been finalized for the plan yearand prior to the tax return filing date. Bankshares made a contribution of $15.0 million in 2006 and does notanticipate making a contribution in 2007.

Thefollowing benefit payments, which reflect expected future service, asappropriate, are to be paid.
| ** **      | ** ** | **Pension Benefits** | ** ** | ** **    | ** ** |
|-----------------|------------|---------------------------|------------|---------------|------------|
| ** **      | ** ** | ** **                | ** ** | **Non-**      | ** ** | ** ** | ** ** | **Other** | ** ** |
| ** **      | ** ** | **Qualified**             | ** ** | **qualified** | ** ** | **Total** | ** ** | **Benefits** | ** ** |
| 2007            |       | $                         | 10,278     |          | $          | 1,225 |   | $ | 11,503 |   | $ | 1,621 |   |
| 2008            |       | 10,892                    |       | 367           |       | 11,259 |   | 1,567 |   |
| 2009            |       | 11,500                    |       | 543           |       | 12,043 |   | 1,536 |   |
| 2010            |       | 12,160                    |       | 495           |       | 12,655 |   | 1,527 |   |
| 2011            |       | 12,799                    |       | 897           |       | 13,696 |   | 1,525 |   |
| Years 2012-2016 |       | 75,054                    |       | 6,206         |       | 81,260 |   | 6,596 |   |
|                 |            |                           |            |               |            |  |  |  |  |  |  |  |  |

 

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15.  STOCK-BASED COMPENSATION EXPENSE

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

UnderSFAS No. 123(R), awards granted to retirement eligible employees are expensedimmediately.  Under Bankshares’ OmnibusStock Plan, retirement eligible is defined as employees reaching normalretirement at age 65.  As a practice,Bankshares has not granted awards to retirement eligible employees.  As of December 31, 2006, there were noretirement eligible employees with outstanding awards that had not been fullyexpensed.  Prior to implementing SFAS No.123(R), Bankshares accrued compensation cost for share-based compensation basedon total awards granted, pursuant to SFAS 123. Any subsequent forfeitures were reversed from compensation expense whenthe performance or service requirement was not achieved.  Upon implementation of SFAS 123(R), Banksharesis estimating forfeitures upon the grant of awards and reducing the amount tobe charged to expense by this estimate.

Banksharessponsors several share-based plans, which are described below.  The compensation cost expensed for thoseplans was $12.5 million, $6.1 million and $5.9 million for 2006, 2005 and 2004,respectively.  The total income taxbenefit recognized in the income statement for share-based compensationarrangements was $4.9 million, $2.7 million and $3.8 million for2006, 2005 and 2004, respectively.  AtDecember 31, 2006, unrecognized compensation cost related to nonvested stockoptions, restricted stock awards and restricted stock units (“RSUs”) totaled$19.0 million.  The cost of thesenonvested awards is expected to be recognized over a weighted average period of2.0 years.

The1999 Omnibus Stock Plan permitted the grant of stock options and other stockincentives, including restricted stock awards and restricted stock units, tokey employees of Bankshares and its affiliates. The 1999 Plan provided for the issuance of up to 4,500,000 shares ofBankshares authorized but unissued common stock.  The number of shares of common stock thatremained available for future grants under the Plan at December 31, 2006 was843,664 shares.  Options issued as aresult of mergers or acquisitions are not considered to be part of the 1999Omnibus Stock Plan.  Options outstandingwere granted at market value and included both performance-based andnonperformance-based options.  Optionsbecome exercisable ratably over three or four years.  All options terminate 10 years from date ofgrant if not exercised.  The estimatedforfeiture rate used to calculate compensation cost for 2006 was 2.0%.  Because of historically low forfeiture rates,the impact to compensation expense was immaterial for 2006, 2005 and 2004.  Pursuant to the PNC merger agreement, alloptions, restricted stock awards and restricted stock units vest as of theeffective date of the merger.

InMarch 2006, the Compensation Committee authorized the issuance of up to 317,802performance-based restricted stock units (“Performance RSUs”) pursuant to the2006 Performance Stock Program.  Thevesting of the Performance RSUs will be determined based upon the percentageimprovement in Bankshares’ pretax operating income (“PTOI”) over a three-yearperformance period (the “Performance Period”) ending December 31, 2008 (with noadjustments for acquisitions or other extraordinary events).  In addition to the performance period, theawards earned are subject to an additional one-year service requirement.  Depending on actual performance, thePerformance RSUs will vest at levels from 0% to 100%.  The Compensation Committee also awarded104,630 RSUs to Bankshares’ chief executive officer.  The award will vest ratably over fouryears.  The Performance RSUs and the RSUsgranted to Bankshares’ chief executive officer vest and convert into commonstock in connection with a change of control of Bankshares.

97

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Thetable below summarizes activity related to stock options during the three yearsended December 31, 2006.

 
| ** **                                 | ** ** | **Options issued  and outstanding** | ** ** | **Weighted average  exercise price** | ** ** | **Options  exercisable** | ** **    | **Weighted average  exercise price** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------|------------|--------------------------|---------------|------------------------------------------------|------------|
| Balance, December 31,  2003                |       | 2,267,146                                     |       | $                                              | 18.54      |                     |          |                                           |       |   |
| Granted                                    |       | 690,858                                       |       | 30.41                                          |       |                     |          |                                           |       |
| Expired/forfeited                          |       | (69,233                                       | )          | 24.88                                          |       |                     |          |                                           |       |
| Exercised                                  |       | (538,256                                      | )          | 12.72                                          |       |                     |          |                                           |       |
| Balance, December 31,  2004                |       | 2,350,515                                     |       | 23.18                                          |       | 1,153,838                |          | $                                              | 18.11      |   |
| Granted                                    |       | 436,538                                       |       | 34.15                                          |       |                     |          |                                           |       |
| Options (at fair value)  related to option |       |                                          |       |                                           |       |                     |          |                                           |       |
| plan of acquired  bank                     |       | 208,146                                       |       | 8.93                                           |       |                     |          |                                           |       |
| Expired/forfeited                          |       | (5,177                                        | )          | 10.08                                          |       |                     |          |                                           |       |
| Exercised                                  |       | (330,782                                      | )          | 14.03                                          |       |                     |          |                                           |       |
| Balance, December 31,  2005                |       | 2,659,240                                     |       | 25.01                                          |       | 1,489,397                |          | 20.80                                          |       |
| Granted                                    |       | 587,500                                       |       | 37.73                                          |       |                     |          |                                           |       |
| Options (at fair value)  related to option |       |                                          |       |                                           |       |                     |          |                                           |       |
| plan of acquired  bank                     |       | 138,066                                       |       | 22.81                                          |       |                     |          |                                           |       |
| Expired/forfeited                          |       | (33,062                                       | )          | 31.70                                          |       |                     |          |                                           |       |
| Exercised                                  |       | (205,963                                      | )          | 19.52                                          |       |                     |          |                                           |       |
| **Balance, December 31, 2006**             | ** ** | **3,145,781**                                 | ** ** | **$**                                          | **27.57**  | ** **               | **2,058,368** | ** **                                     | **$**      | **23.49** | ** ** |

 

Thetotal intrinsic value of stock options exercised during 2006, 2005 and 2004 was$4.3 million, $6.9 million and $9.7 million, respectively.  Cash received from options exercised underall share-based payment arrangements for 2006, 2005 and 2004 was $3.7 million,$3.8 million and $6.4 million, respectively. The actual tax return benefit associated with the tax deductionsrecognized in the income statement from the option exercise of the share-basedpayment arrangements totaled $1.2 million per year for 2006, 2005 and 2004.

Thefollowing table provides selected information on nonvested stock options forthe three years ended December 31, 2006.

 
| ** **                     | ** ** | **Nonvested  stock options** | ** ** | **Weighted average  grant-date  fair value** | ** ** |
|--------------------------------|------------|------------------------------|------------|----------------------------------------------|------------|
| Balance, December 31, 2003     |       | 918,587                      |       | $24.18                                       |       |
| Granted                        |       | 690,858                      |       | 30.41                                        |       |
| Vested                         |       | (353,369                     | )          | 23.18                                        |       |
| Forfeited                      |       | (59,399                      | )          | 24.26                                        |       |
| Balance, December 31, 2004     |       | 1,196,677                    |       | 28.06                                        |       |
| Granted                        |       | 436,538                      |       | 34.15                                        |       |
| Vested                         |       | (463,390                     | )          | 27.86                                        |       |
| Forfeited                      |       | (5,000                       | )          | 30.17                                        |       |
| Balance, December 31, 2005     |       | 1,164,825                    |       | 30.36                                        |       |
| Granted                        |       | 587,500                      |       | 37.73                                        |       |
| Vested                         |       | (639,788                     | )          | 28.61                                        |       |
| Forfeited                      |       | (25,124                      | )          | 33.79                                        |       |
| **Balance, December 31, 2006** | ** ** | **1,087,413**                | ** ** | **$35.29**                                   | ** ** |

 

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Thefollowing table provides selected information on stock options outstanding andexercisable at December 31, 2006.

 
| ** **                                            | ** ** | **December 31, 2006** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands, except per share  data)**    | ** ** | **Outstanding**       | ** ** | **Exercisable** | ** ** |
| Number of options                                     | ** ** | **3,145,781**         | ** ** | **2,058,368** | ** ** |
| Weighted-average exercise price                       | ** ** | **$27.57**            | ** ** | **$23.49** | ** ** |
| Aggregate intrinsic value                             | ** ** | **$60,454**           | ** ** | **$47,951** | ** ** |
| Weighted-average remaining contractual term, in years | ** ** | **6.87**              | ** ** | **5.99** | ** ** |

 

Theweighted average grant-date fair value of options granted during 2006, 2005 and2004 was $7.06, $6.36 and $4.14, respectively. The total fair value of sharesvested during 2006, 2005 and 2004 was $24.3 million, $16.3 million and $10.7million, respectively.

Theweighted average fair value of options granted is estimated as of the grantdate using the Black-Scholes option-pricing model.  The following weighted average assumptionswere used as inputs to the Black-Scholes model for grants in 2006, 2005 and2004, respectively:

·                  Dividendyields of 2.80%, 2.69% and 2.92%

·                  Volatilitiesof 20.56%, 21.85% and 22.32%

·                  Risk-freeinterest rates of 4.71%, 4.12% and 2.66%

·                  Expectedterms of 4.7, 4.6 and 3.0 years

Theexpected volatility assumptions were derived by analyzing the historical pricevolatility of Bankshares stock over the past five years.

Restrictedstock awards outstanding were granted at market value and generally vestratably over three years or in total at the end of a specified three-yearperiod.  Compensation expense isrecognized on a straight-line basis over the vesting period.  Relative to awards granted in 2006, 85,409shares are subject to a one-year vesting and 63,220 vest over three years.  Additionally, 19,899 shares representingdividend equivalent shares related to previous awards that vested during 2006were awarded and vested immediately.

Thefollowing table summarizes activity related to restricted stock awards andrestricted stock units during the three years ended December 31, 2006.

 
| ** **                     | ** ** | **Restricted  stock awards** | ** ** | **Restricted  stock units** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Balance, December 31, 2003     |       | 182,054                      |       | —                      |       |
| Granted                        |       | 61,958                       |       | —                      |       |
| Vested                         |       | (20,735                      | )          | —                      |       |
| Forfeited                      |       | (7,985                       | )          | —                      |       |
| Balance, December 31, 2004     |       | 215,292                      |       | —                      |       |
| Granted                        |       | 86,780                       |       | —                      |       |
| Vested                         |       | (52,794                      | )          | —                      |       |
| Forfeited                      |       | (188                         | )          | —                      |       |
| Balance, December 31, 2005     |       | 249,090                      |       | —                      |       |
| Granted                        |       | 178,643                      |       | 422,432                     |       |
| Vested                         |       | (188,561                     | )          | —                      |       |
| Forfeited                      |       | (1,163                       | )          | —                      |       |
| **Balance, December 31, 2006** | ** ** | **238,009**                  | ** ** | **422,432**                 | ** ** |

 

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

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16.SEGMENT REPORTING

Operatingsegments as defined by SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” are components of an enterprise withseparate financial information.  Thecomponent engages in business activities from which it derives revenues andincurs expenses and the operating results of which management relies on fordecision-making and performance assessment. Bankshares has two reportablesegments — Banking Services and Investment and Wealth Management (“IWM”).  The Banking Services segment is comprised of11 affiliate banks.  During 2005, thePrivate Banking Group of MSD&T was consolidated into the Private BankingGroup of IWM which is reflected in the segment results below.   Since loans and deposits are included in theIWM segment, a funds transfer-pricing model was utilized to match the durationof the funding and investment of the IWM segment assets and liabilities.  The accounting policies of the segments arethe same as those described in Note No. 1 - Significant Accounting Policies inNotes to Consolidated Financial Statements. However, the segment data reflectintersegment transactions and balances.

Thefollowing tables present selected segment information for the years endedDecember 31, 2006, 2005 and 2004. The components in the “Other” column consistof amounts for the nonbank affiliates, unallocated corporate expenses andintercompany eliminations. Certain expense amounts such as operations overheadhave been reclassified from internal financial reporting in order to providefor full cost absorption. These reclassifications are shown in the “Adjustments”line. The acquisitions of James Monroe and CBNV are included in the “Banking”column as of their respective acquisition dates.

 
| **2006 (Dollars in thousands)** | ** ** | **Banking**    | ** **     | **IWM**     | ** ** | **Other**    | ** ** | **Total**      | ** **  |
|------------------------------------------------|------------|----------------|----------------|-------------|------------|--------------|------------|----------------|-------------|
| Net interest  income                           | ** ** | **$**          | **642,835**    | ** **  | **$**      | **13,394**   | ** ** | **$**          | **(442**    | **)** | **$** | **655,787** | ** ** |
| Provision for  credit losses                   | ** ** | **—**     | ** **     | **—**  | ** ** | **—**   | ** ** | **—**     | ** **  |
| Noninterest  income                            | ** ** | **120,017**    | ** **     | **111,412** | ** ** | **23,305**   | ** ** | **254,734**    | ** **  |
| Noninterest  expenses                          | ** ** | **(352,092**   | **)**          | **(88,567** | **)**      | **(16,730**  | **)**      | **(457,389**   | **)**       |
| Adjustments                                    | ** ** | **25,683**     | ** **     | **(3,616**  | **)**      | **(22,067**  | **)**      | **—**     | ** **  |
| Income (loss)  before income taxes             | ** ** | **436,443**    | ** **     | **32,623**  | ** ** | **(15,934**  | **)**      | **453,132**    | ** **  |
| Income tax  (expense) benefit                  | ** ** | **(152,899**   | **)**          | **(13,049** | **)**      | **1,102**    | ** ** | **(164,846**   | **)**       |
| Net income  (loss)                             | ** ** | **$**          | **283,544**    | ** **  | **$**      | **19,574**   | ** ** | **$**          | **(14,832** | **)** | **$** | **288,286** | ** ** |
| Average loans                                  | ** ** | **$**          | **11,975,089** | ** **  | **$**      | **185,642**  | ** ** | **$**          | **281**     | ** ** | **$** | **12,161,012** | ** ** |
| Average earning  assets                        | ** ** | **15,309,149** | ** **     | **185,642** | ** ** | **(96,270**  | **)**      | **15,398,521** | ** **  |
| Average assets                                 | ** ** | **16,785,770** | ** **     | **186,226** | ** ** | **60,267**   | ** ** | **17,032,263** | ** **  |
| Average deposits                               | ** ** | **12,391,585** | ** **     | **316,367** | ** ** | **(334,481** | **)**      | **12,373,471** | ** **  |
| Average equity                                 | ** ** | **2,072,102**  | ** **     | **38,997**  | ** ** | **230,998**  | ** ** | **2,342,097**  | ** **  |

 
| **2005 (Dollars in thousands)** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|------------------------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest  income                           |       | $           | 609,758    |    | $          | 7,819     |       | $          | (451       | ) | $ | 617,126 |   |
| Provision for  credit losses                   |       | (1,576      | )          | —  |       | —    |       | (1,576     | )          |
| Noninterest  income                            |       | 132,154     |       | 95,958  |       | 15,008    |       | 243,120    |       |
| Noninterest  expenses                          |       | (341,543    | )          | (72,929 | )          | (6,349    | )          | (420,821   | )          |
| Adjustments                                    |       | 17,610      |       | (3,885  | )          | (13,725   | )          | —     |       |
| Income (loss)  before income taxes             |       | 416,403     |       | 26,963  |       | (5,517    | )          | 437,849    |       |
| Income tax  (expense) benefit                  |       | (145,044    | )          | (10,785 | )          | (5,701    | )          | (161,530   | )          |
| Net income  (loss)                             |       | $           | 271,359    |    | $          | 16,178    |       | $          | (11,218    | ) | $ | 276,319 |   |
| Average loans                                  |       | $           | 10,876,592 |    | $          | 152,572   |       | $          | 387        |   | $ | 11,029,551 |   |
| Average earning  assets                        |       | 13,917,161  |       | 152,572 |       | (1,596    | )          | 14,068,137 |       |
| Average assets                                 |       | 15,235,634  |       | 152,941 |       | 132,444   |       | 15,521,019 |       |
| Average deposits                               |       | 11,444,361  |       | 199,159 |       | (229,765  | )          | 11,413,755 |       |
| Average equity                                 |       | 1,891,834   |       | 34,354  |       | 170,229   |       | 2,096,417  |       |

 

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| **2004 (Dollars in thousands)** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|------------------------------------------------|------------|-------------|------------|---------|------------|-----------|------------|------------|------------|
| Net interest  income                           |       | $           | 534,468    |    | $          | 10,172    |       | $          | 1,141      |   | $ | 545,781 |   |
| Provision for  credit losses                   |       | (7,221      | )          | —  |       | —    |       | (7,221     | )          |
| Noninterest  income                            |       | 114,477     |       | 90,516  |       | 8,936     |       | 213,929    |       |
| Noninterest  expenses                          |       | (318,706    | )          | (69,575 | )          | (3,677    | )          | (391,958   | )          |
| Adjustments                                    |       | 18,098      |       | (3,603  | )          | (14,495   | )          | —     |       |
| Income (loss)  before income taxes             |       | 341,116     |       | 27,510  |       | (8,095    | )          | 360,531    |       |
| Income tax  (expense) benefit                  |       | (120,253    | )          | (11,004 | )          | 133       |       | (131,124   | )          |
| Net income  (loss)                             |       | $           | 220,863    |    | $          | 16,506    |       | $          | (7,962     | ) | $ | 229,407 |   |
| Average loans                                  |       | $           | 9,591,510  |    | $          | 127,739   |       | $          | 160        |   | $ | 9,719,409 |   |
| Average earning  assets                        |       | 12,576,465  |       | 127,739 |       | 28,800    |       | 12,733,004 |       |
| Average assets                                 |       | 13,413,992  |       | 127,949 |       | 451,030   |       | 13,992,971 |       |
| Average deposits                               |       | 10,323,349  |       | 175,096 |       | (84,753   | )          | 10,413,692 |       |
| Average equity                                 |       | 1,449,355   |       | 31,219  |       | 391,096   |       | 1,871,670  |       |

 

17.FAIR VALUE OF FINANCIAL INSTRUMENTS

SFASNo. 107, “Disclosures about the Fair Value of Financial Instruments,” requiresthat we disclose estimated fair values for our financial instruments.  This disclosure should be read in conjunctionwith the financial statements and Notes to Financial Statements in this AnnualReport.

Webase fair values on estimates or calculations using present value techniqueswhen quoted market prices are not available. Because broadly traded markets do not exist for many of our financialinstruments, we try to incorporate the current market conditions in the fairvalue calculation.  These valuations areour estimates and are often based on current pricing policy, thecharacteristics of the financial instrument and other such factors.  These calculations are subjective, involveuncertainties and rely on management judgment. There may be inherent weaknesses in any calculation technique andchanges in underlying assumptions used, including discount rates and estimatesof future cash flow, which could significantly affect the results.

Wehave not included certain material items in our disclosure, such as the valueof the long-term relationships with our deposit and wealth managementcustomers, since these intangibles are not financial instruments.  For all of these reasons, the total of thefair value calculations do not represent the underlying value of Bankshares.

Theestimated fair values of Bankshares’ financial instruments at December 31, 2006and 2005 were as follows:

 
| ** **                           | ** ** | **2006**       | ** **     | **2005**       | ** ** |
|--------------------------------------|------------|----------------|----------------|----------------|------------|
| ** **                           | ** ** | **Book**       | ** **     | **Fair**       | ** ** | **Book** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)** | ** ** | **Value**      | ** **     | **Value**      | ** ** | **Value** | ** ** | **Value** | ** ** |
| **Financial Assets**            | ** ** | ** **     | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans  held-for-sale                 | ** ** | **$**          | **—**     | ** **     | **$**      | **—** |   | $ | 26,263 |   | $ | 26,263 |   |
| Loans                                | ** ** | **12,792,733** | ** **     | **12,657,882** |       | 11,607,845 |   | 11,941,754 |   |
| Nonmarketable  investments           | ** ** | **311,427**    | ** **     | **311,427**    |       | 284,836 |   | 284,836 |   |
|                                 |       |           |           |           |       |   |   |   |   |
| **Financial  Liabilities**           | ** ** | ** **     | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                             | ** ** | **$**          | **12,773,891** | ** **     | **$**      | **11,936,456** |   | $ | 12,077,350 |   | $ | 11,169,923 |   |
| Short-term  borrowings               | ** ** | **1,652,196**  | ** **     | **1,634,879**  |       | 1,237,714 |   | 1,237,714 |   |
| Long-term debt                       | ** ** | **659,020**    | ** **     | **643,423**    |       | 742,163 |   | 736,858 |   |

 

Thefollowing methods and assumptions were used to estimate the fair valuedisclosures for financial instruments as of December 31, 2006 and 2005:

 

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*Cashand Short-Term Investments*The amounts reported in the balance sheet approximate thefair values of these assets. Short-term investments include interest-bearingdeposits in other banks and federal funds sold.

*InvestmentSecuritie*Fair values of investment securities are based on quotedmarket prices and are reported in Note No. 3 - Investment Securities.

*LoansHeld-for-Sale*Loans held-for-sale are based on what secondary markets arecurrently offering for portfolios with similar characteristics.

*Loans*The fair value calculation of loans differentiates loansbased on their financial characteristics, such as product classification, loancategory, pricing features and remaining maturity. Prepayment estimates areevaluated by product and loan rate.

Thefair value of commercial loans, commercial real estate loans and real estateconstruction loans is calculated by discounting contractual cash flows usingdiscount rates that are believed to reflect current credit quality and otherrelated factors.

Forreal estate 1-4 family first and junior lien mortgages, fair value iscalculated by discounting contractual cash flows, adjusted for prepaymentestimates, using discount rates based on current industry pricing for loans ofsimilar size, type, remaining maturity and re-pricing characteristics.

Forconsumer loans, the fair value is calculated by discounting the contractualcash flows, adjusted for prepayments, based on the current rates we offer forloans with similar characteristics.

Loancommitments and letters of credit not included in the preceding table hadcontractual values of $5.0 billion and $596.9 million, respectively, atDecember 31, 2006, and $4.8 billion and $540.6 million, respectively, atDecember 31, 2005.  These instrumentsgenerate ongoing fees at our current pricing levels.  Since many of the commitments are expected toexpire without being drawn upon, the total commitments do not necessarilyrepresent future cash requirements. Unamortized fees on letters of credit totaled $2.6 million and $1.9 millionat December 31, 2006 and 2005, respectively. Carrying cost estimates the fair value for these fees.

*NonmarketableInvestments*There are generallyrestrictions on the sale and/or liquidation of nonmarketable securities.  The carrying value of Federal Reserve Bankstock and Federal Home Loan Bank stock are carried at par, which approximatesfair value.  Private equity investments,hedge funds and the cash surrender value of BOLI are carried at fair valuebased on current market valuations.

*Deposits*The fair value of demand deposits, savings accounts and moneymarket deposits is the amount payable on demand at the reporting date.  The fair value of fixed-maturity certificatesof deposit is estimated using a discounted cash flow calculation that applies interestrates and remaining maturities for currently offered certificates of deposit.

*Short-TermBorrowings*The amounts reported in the balance sheet approximate thefair values because of the short duration of those instruments.

*Long-TermDebt*The fair value of long-term debt associated with interestrate swaps is based on quoted market prices. For all other long-term debt, fair value is estimated by discounting thefuture cash flows using estimates of rates currently available to Banksharesand its affiliates for debt with similar terms and remaining maturities.

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*Derivatives*Fair value forderivatives is determined based on the following:

·                  Position valuation - estimated by usingpricing models that incorporate quoted market prices for swap rates and futurescontracts, as well as market volatility, and assumes all counterparties havethe same credit rating;

·                  Optionvaluation - estimated by using standard market models (such as modifiedBlack-Scholes model on interest rate options), incorporating quoted marketprices and volatilities.

Thefair value of derivatives at December 31, 2006 and 2005 are reported in NoteNo. 18 - Derivative Instruments and Hedging Activities.

*Limitations*The valuation techniques employed above involve uncertaintiesand are affected by assumptions used and by judgments regarding prepayments,credit risk, future loss experience, discount rates, cash flows and otherfactors.  Therefore, derived fair valuescannot be substantiated by comparison with independent markets or with other financialinstitutions.  The reported fair valuesdo not necessarily represent what Bankshares would realize in immediate salesor other dispositions.  Changes inassumptions could significantly affect the reported fair values.  The information presented is based on fairvalue calculations and market quotes as of December 31, 2006 and 2005.  These amounts have not been updated sinceyear-end; therefore, the valuation may have changed significantly since thattime.

Asdiscussed above, some of our asset and liability financial instruments areshort-term, and therefore, the carrying amounts on the consolidated balance sheetapproximate fair value.  Othersignificant assets and liabilities, which are not considered financial assetsor liabilities and for which fair values have not been determined, includepremises and equipment, goodwill and other intangibles, deferred and otherliabilities.

18.DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

Banksharesmaintains an overall interest rate risk management strategy that incorporatesthe use of derivative instruments to minimize significant unplannedfluctuations in earnings that are caused by interest rate volatility.  Currently, derivative instruments that areused as part of the interest rate risk management strategy have been restrictedto interest rate swaps.  Interest rateswaps generally involve the exchange of fixed-rate and variable-rate interestpayments between two parties, based on a common notional principal amount andmaturity date.  At December 31, 2006, Bankshareshad interest rate swaps to convert a portion of its nonprepayable fixed-ratedebt to floating-rate debt.

Banksharesalso arranges interest rate swaps, caps and swaptions for commercial loancustomers through its Capital Markets Group. Derivative transactions executed with loan customers are hedged by meansof an offsetting derivative trade with a third party.  In this way, Bankshares manages the marketrisk arising from capital markets-related derivative activity.

Thefair value of derivative instruments is based on position and optionvaluations.  The swap value is estimatedby using pricing models that incorporate quoted market prices for swap ratesand futures contracts and assumes all counterparties have the same creditrating.  The option valuation isestimated by using standard market models (such as the modified Black-Sholesmodel on interest rate options), incorporating quoted market prices andvolatilities.  The fair value ofderivative instruments related to customer accommodations recorded in otherassets was $9.3 million (notional $596.1 million) and $5.3 million (notional$345.5 million) at December 31, 2006 and 2005, respectively. The fair value ofderivative instruments related to hedges and customer accommodations recordedin other liabilities was $16.2 million (notional $643.9 million) and $12.3million (notional $609.1 million) at December 31, 2006 and 2005, respectively.

Changesin the fair value of a derivative that is designated and qualifies as a fairvalue hedge, along with the gain or loss on the hedged asset or liability thatis attributable to the hedged risk are recorded as other noninterest income inthe results of operations.  For all hedgerelationships, ineffectiveness resulting from differences between the changesin fair values or cash flows of the hedged item and changes in fair value ofthe derivative are recognized as other noninterest income in the

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resultsof operations.  The net interestsettlement on derivatives designated as fair value or cash flow hedges is treatedas an adjustment of the interest income or interest expense of the hedgedassets or liabilities.  The fair-valuehedges of nonprepayable fixed-rate debt were effective for the reported periodsand qualified for short-cut hedge accounting treatment.  The impact of the hedges increased interestexpense $2.6 million in 2006 and decreased interest expense $3.7 million in2005.

Thefollowing table summarizes the gross position of derivatives relating tohedging activities at December 31, 2006 and 2005.

 
| ** **                           | ** ** | **December 31, 2006**           | ** **  | **December 31, 2005**   | ** ** |
|--------------------------------------|------------|-------------------------------------------|-------------|-----------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Notional or  Contractual  Amount** | ** **  | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** | **Notional or  Contractual  Amount** | ** ** | **Credit  Risk  Amount (1)** | ** ** | **Estimated  Net  Fair Value** | ** ** |
| *Asset/Liability  Management Hedges* |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Interest Rate  Contracts:            |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                     | **350,000** | ** **                        | **$**      | **—** | ** ** | **$** | **(12,638** | **)** | $ | 350,000 |   | $ | — |   | $ | (10,349 | ) |
|                                 |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| *Customer  Accommodations*           | * *   | * *                                  | * *    | * *                          | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Interest Rate  Contracts:            |       |                                      |        |                              |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                                     | **878,596** | ** **                        | **$**      | **9,342** | ** ** | **$** | **5,707** |   | $ | 592,934 |   | $ | 5,327 |   | $ | 3,462 |   |
| Swaptions/Caps Purchased             | ** ** | **5,723**                                 | ** **  | **30**                            | ** ** | **30** |   | 5,850 |   | 57 |   | 57 |   |
| Swaptions/Caps  Sold                 | ** ** | **5,723**                                 | ** **  | **—**                        | ** ** | **(30** | **)** | 5,850 |   | — |   | (57 | ) |

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

Mortgageloans held-for-sale have inherent forward contract (agreements to sell orpurchase loans at a specific rate or yield) characteristics. Risk may arisefrom the corresponding parties’ inability to meet the terms of their contractsand from movement in interest rates. Bankshares has forward commitments to sellindividual fixed-rate and variable-rate mortgage loans that are on its balancesheet at fair value or are approved, but not yet funded. There were no forwardcommitments at December 31, 2006.  Thefair value of the forward contracts was $0.2 million at December 31, 2005.

19.GOODWILL AND INTANGIBLE ASSETS

Goodwilltotaled $768.7 million at December 31, 2006 and $670.0 million at December 31,2005.  Bankshares recorded goodwilltotaling $95.4 million in connection with the James Monroe acquisitionincreasing the Banking segment’s goodwill to $720.1 million.  See Note No. 2 - Business Combinations.  The IWM segment goodwill was $48.6 million,an increase of $8.8 million over 2005. This increase was related to acontingent payment made, in the first quarter of 2006, to Boyd Watterson AssetManagement for meeting the performance conditions outlined in their mergeragreement.

Thefollowing table discloses the gross carrying amount and accumulatedamortization of intangible assets subject to amortization at December 31, 2006and December 31, 2005.

 
| ** **                           | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Gross carrying**         | ** ** | **Accumulated**                 | ** ** | **Net** | ** ** | **Gross carrying** | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)** | ** ** | **amount**                      | ** ** | **amortization**                | ** ** | **amount** | ** ** | **amount** | ** ** | **amortization** | ** ** | **amount** | ** ** |
| Core deposits                        | ** ** | **$**                           | **62,336** | ** **                      | **$**      | **(27,638** | **)** | **$** | **34,698** |   | $ | 54,509 |   | $ | (20,790 | ) | $ | 33,719 |   |
| Mortgage  servicing                  | ** ** | **3,823**                       | ** ** | **(1,242**                      | **)**      | **2,581** |   | 2,902 |   | (1,145 | ) | 1,757 |   |
| Customer lists  and other            | ** ** | **17,795**                      | ** ** | **(9,338**                      | **)**      | **8,457** |   | 17,845 |   | (6,668 | ) | 11,177 |   |
| Total                                | ** ** | **$**                           | **83,954** | ** **                      | **$**      | **(38,218** | **)** | **$** | **45,736** |   | $ | 75,256 |   | $ | (28,603 | ) | $ | 46,653 |   |

 

Accumulatedamortization for total intangible assets was $38.2 million and $28.6 million atyear-end 2006 and 2005, respectively. The projections of amortization expense shown for mortgage servicingrights are based on asset balances and the interest rate environment as ofDecember 31, 2006.  Future amortizationexpense may be significantly different depending on changes in themortgage-servicing portfolio, mortgage interest rates and market conditions.

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Inconnection with the James Monroe acquisition, Bankshares recorded core depositintangibles of $7.8 million.  Coredeposit intangibles capitalized prior to 2006 are amortized based on estimatedlives of nine years and those capitalized in 2006 are amortized on anaccelerated basis; mortgage-servicing intangibles are amortized based onestimated lives ranging from three to ten years; and customer lists and otherintangibles are amortized based on estimated lives ranging from four to fifteenyears.

Thefollowing table shows the current period and estimated future amortizationexpense for amortized intangible assets.

 
| ** **                             | ** ** | **Core**     | ** ** | **Mortgage**  | ** ** | **Customer Lists** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|--------------|------------|---------------|------------|-------------------------|------------|------------|------------|
| **(Dollars in thousands)**   | ** ** | **Deposits** | ** ** | **Servicing** | ** ** | **and Other**      | ** ** | **Total**  | ** ** |
| Year ended  December 31, 2006          | ** ** | **$**        | **6,849**  | ** **    | **$**      | **313**                 | ** ** | **$**      | **2,739**  | ** ** | **$** | **9,901** | ** ** |
|                                   |       |         |       |          |       |                    |       |       |       |
| Estimate for  years ended December 31, |       |         |       |          |       |                    |       |       |       |
| 2007                                   |       | 7,709        |       | 386           |       | 2,527                   |       | 10,621     |       |
| 2008                                   |       | 6,615        |       | 369           |       | 1,531                   |       | 8,514      |       |
| 2009                                   |       | 6,464        |       | 369           |       | 641                     |       | 7,474      |       |
| 2010                                   |       | 5,545        |       | 369           |       | 505                     |       | 6,419      |       |
| 2011                                   |       | 4,502        |       | 343           |       | 387                     |       | 5,231      |       |
|                                        |            |              |            |               |            |                         |            |            |            |  |  |  |  |

 

20.  MERCANTILE BANKSHARES CORPORATION (PARENTCORPORATION ONLY) FINANCIAL INFORMATION

**BALANCESHEET**

 
| **DECEMBER 31,**                                                                      | ** ** | ** **    | ** **    | ** ** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------|---------------|------------|------------|
| **(Dollars in thousands, except per share data)**            | ** ** | **2006**      | ** **    | **2005**   | ** ** |
| **ASSETS**                                                                                 | ** ** | ** **    | ** **    | ** ** | ** ** |
| Cash                                                                                       | ** ** | **$**         | **2,692**     |       | $          | 4,618 |   |
| Interest-bearing  deposits with bank affiliates                                            | ** ** | **195,500**   |          | 237,000    |       |
| Securities  purchased under resale agreements with bank affiliates                         | ** ** | **37,444**    |          | 93,054     |       |
| Cash and cash equivalents                                                                  | ** ** | **235,636**   |          | 334,672    |       |
| Investment in  bank affiliates                                                             | ** ** | **2,143,603** |          | 1,975,302  |       |
| Investment in  bank-related affiliates                                                     | ** ** | **16,065**    |          | 11,052     |       |
| Loans and  advances to affiliates                                                          | ** ** | **313,432**   |          | 328,074    |       |
| Investment  securities available-for-sale                                                  | ** ** | **14,283**    |          | 18,874     |       |
| Building  premises and equipment, net                                                      | ** ** | **11,805**    |          | 12,717     |       |
| Goodwill, net                                                                              | ** ** | **93,368**    |          | —     |       |
| Other assets                                                                               | ** ** | **121,789**   |          | 121,709    |       |
| Total                                                                                      | ** ** | **$**         | **2,949,981** |       | $          | 2,802,400 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                             | ** ** | ** **    | ** **    | ** ** | ** ** |
| Liabilities:                                                                               |       |          |          |       |       |
| Commercial paper                                                                           | ** ** | **$**         | **122,444**   |       | $          | 193,054 |   |
| Accounts payable and other liabilities                                                     | ** ** | **41,161**    |          | 25,412     |       |
| Long-term debt                                                                             | ** ** | **369,210**   |          | 389,212    |       |
| Total Liabilities                                                                          | ** ** | **532,815**   |          | 607,678    |       |
| Shareholders’  Equity:                                                                |       |          |          |       |       |
| Preferred stock, no par value; authorized 2,000,000  shares; issued and outstanding - None |       |          |          |       |       |
| Common stock, $2 par value; authorized 200,000,000  shares;                                |       |          |          |       |       |
| issued 125,581,400 shares in 2006 and 82,165,414  shares in 2005                           | ** ** | **251,163**   |          | 164,331    |       |
| Capital surplus                                                                            | ** ** | **672,698**   |          | 676,830    |       |
| Retained earnings                                                                          | ** ** | **1,540,836** |          | 1,386,405  |       |
| Accumulated other comprehensive loss                                                       | ** ** | **(47,531**   | **)**         | (32,844    | )          |
| Total shareholders’ equity                                                            | ** ** | **2,417,166** |          | 2,194,722  |       |
| Total                                                                                      | ** ** | **$**         | **2,949,981** |       | $          | 2,802,400 |   |

 

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**STATEMENTOF INCOME**

 
| ** **                                                                     | ** ** | **(Dollars in thousands)** | ** **  |
|--------------------------------------------------------------------------------|------------|--------------------------------------|-------------|
| **For the Years Ended December 31,**                  | ** ** | **2006**                             | ** **  | **2005** | ** ** | **2004** | ** ** |
| **INCOME**                                                                     | ** ** | ** **                           | ** **  | ** ** | ** ** | ** ** | ** ** |
| Dividends from  bank affiliates                                                | ** ** | **$**                                | **165,735** |   | $ | 172,885 |   | $ | 145,841 |   |
| Dividends from  bank-related affiliates                                        | ** ** | **—**                           |        | 150 |   | 767 |   |
| Interest on  interest-bearing deposits with bank affiliates                    | ** ** | **4,062**                            |        | 3,681 |   | 710 |   |
| Interest on  securities purchased under resale agreements with bank affiliates | ** ** | **2,018**                            |        | 1,393 |   | 362 |   |
| Interest on  loans to affiliates                                               | ** ** | **17,065**                           |        | 15,660 |   | 13,685 |   |
| Other income                                                                   | ** ** | **15,141**                           |        | 13,951 |   | 9,467 |   |
| Total income                                                                   | ** ** | **204,021**                          |        | 207,720 |   | 170,832 |   |
| **EXPENSES**                                                                   | ** ** | ** **                           | ** **  | ** ** | ** ** | ** ** | ** ** |
| Interest on  short-term borrowings                                             | ** ** | **4,099**                            |        | 3,181 |   | 893 |   |
| Interest on  long-term debt                                                    | ** ** | **20,132**                           |        | 18,563 |   | 13,846 |   |
| Other expenses                                                                 | ** ** | **7,854**                            |        | 4,028 |   | 4,984 |   |
| Total expenses                                                                 | ** ** | **32,085**                           |        | 25,772 |   | 19,723 |   |
| Income before  income tax expense and equity in                                |       |                                 |        |   |   |   |   |
| undistributed net income of affiliates                                         | ** ** | **171,936**                          |        | 181,948 |   | 151,109 |   |
| Income tax  expense                                                            | ** ** | **2,621**                            |        | 2,427 |   | 1,807 |   |
|                                                                           | ** ** | **169,315**                          |        | 179,521 |   | 149,302 |   |
| Equity in  undistributed net income of:                                        |       |                                 |        |   |   |   |   |
| Bank affiliates                                                                | ** ** | **114,959**                          |        | 95,779 |   | 79,637 |   |
| Bank-related affiliates                                                        | ** ** | **4,012**                            |        | 1,019 |   | 468 |   |
| **NET  INCOME**                                                                | ** ** | **$**                                | **288,286** |   | $ | 276,319 |   | $ | 229,407 |   |

 

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**STATEMENTOF CASH FLOWS**

 
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** **  |
|-----------------------------------------------------------------------|------------|--------------------------------------|-------------|
| **For the Years Ended December 31,**         | ** ** | **2006**                             | ** **  | **2005** | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                            | ** ** | ** **                           | ** **  | ** ** | ** ** | ** ** | ** ** |
| Net Income                                                            | ** ** | **$**                                | **288,286** |   | $ | 276,319 |   | $ | 229,407 |   |
| Adjustments to  reconcile net income to net cash provided             |       |                                 |        |   |   |   |   |
| by operating activities:                                              |       |                                 |        |   |   |   |   |
| Equity in undistributed net income of affiliates                      | ** ** | **(118,971**                         | **)**       | (96,798 | ) | (80,105 | ) |
| Depreciation and amortization                                         | ** ** | **3,018**                            |        | 2,810 |   | 102 |   |
| Investment securities gains                                           | ** ** | **(217**                             | **)**       | — |   | (1,295 | ) |
| Net (increase) decrease in other assets                               | ** ** | **(4,072**                           | **)**       | 834 |   | (8,574 | ) |
| Net increase (decrease) in liabilities:                               |       |                                 |        |   |   |   |   |
| Interest payable                                                      | ** ** | **51**                               |        | 618 |   | 478 |   |
| Other liabilities                                                     | ** ** | **1,292**                            |        | (10,899 | ) | 4,545 |   |
| Net cash provided by operating activities                             | ** ** | **169,387**                          |        | 172,884 |   | 144,558 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                            | ** ** | ** **                           | ** **  | ** ** | ** ** | ** ** | ** ** |
| Net decrease in  loans to affiliates                                  | ** ** | **14,642**                           |        | 30,002 |   | 1,444 |   |
| Proceeds from  maturities of investment securities available-for-sale | ** ** | **10,000**                           |        | — |   | — |   |
| Proceeds from  sales of investment securities available-for-sale      | ** ** | **8,362**                            |        | — |   | 27,224 |   |
| Purchases of  investment securities available-for-sale                | ** ** | **(13,447**                          | **)**       | (247 | ) | (25,933 | ) |
| Capital  expenditures                                                 | ** ** | **—**                           |        | — |   | (13,629 | ) |
| Investment in  affiliates                                             | ** ** | **(53,858**                          | **)**       | (561 | ) | 63,074 |   |
| Net cash provided by (used in) investing activities                   | ** ** | **(34,301**                          | **)**       | 29,194 |   | 52,180 |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                            | ** ** | ** **                           | ** **  | ** ** | ** ** | ** ** | ** ** |
| Net increase  (decrease) in commercial paper                          | ** ** | **(70,610**                          | **)**       | (23,576 | ) | 25,750 |   |
| Proceeds from  issuance of long-term debt                             | ** ** | **—**                           |        | — |   | 51,250 |   |
| Repayment of  long-term debt                                          | ** ** | **(35,000**                          | **)**       | — |   | — |   |
| Proceeds from  issuance of shares                                     | ** ** | **9,957**                            |        | 11,205 |   | 14,322 |   |
| Repurchase of  common shares                                          | ** ** | **(1,755**                           | **)**       | — |   | (44,110 | ) |
| Dividends paid                                                        | ** ** | **(136,714**                         | **)**       | (120,167 | ) | (109,295 | ) |
| Net cash used in financing activities                                 | ** ** | **(234,122**                         | **)**       | (132,538 | ) | (62,083 | ) |
| Net increase  (decrease) in cash and cash equivalents                 | ** ** | **(99,036**                          | **)**       | 69,540 |   | 134,655 |   |
| Cash and cash  equivalents at beginning of year                       | ** ** | **334,672**                          |        | 265,132 |   | 130,477 |   |
| Cash and cash  equivalents at end of year                             | ** ** | **$**                                | **235,636** |   | $ | 334,672 |   | $ | 265,132 |   |

 

21.   SUBSEQUENT EVENT

OnOctober 8, 2006, Bankshares entered into an Agreement and Plan of Merger withThe PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshareswill merge with and into PNC, with PNC as the surviving corporation in themerger.  When the merger is completed,Bankshares’ stockholders will receive a combination of PNC common stock andcash in exchange for their Bankshares common stock.  Each share of Bankshares common stock will beconverted into the right to receive 0.4184 of a share of PNC common stock(including the related preferred stock purchase rights under PNC’s May 2000Rights Agreement) and $16.45 in cash, without interest.  Under the formula set forth in the mergeragreement, an aggregate of up to approximately 54.2 million shares of PNCcommon stock (and an equal number of related rights) may be issued and $2.13billion paid in the merger.  This mergerwas approved by Bankshares’ stockholders on February 27, 2007 and received substantiallyall of the required regulatory approvals. The merger is currently expected to close in March of 2007.  Pending the merger, Bankshares must complywith the covenants contained in the merger agreement, but is generally continuingto operate in the ordinary course of business.

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**ITEM 9. CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

There was no matter which is required to be disclosed in this Item 9pursuant to the instructions contained in the form for this Report.

 

**ITEM 9A. CONTROLS AND PROCEDURES.**

Wehave carried out an evaluation, under the supervision and with theparticipation of our management including our principal executive officer andprincipal financial officer, of the effectiveness of the design and operationof our disclosure controls and procedures, as that term is defined in Rule13a-15(e) under the Securities and Exchange Act of 1934, as amended.  Based on that evaluation, our principalexecutive officer and principal financial officer concluded that as of December31, 2006, which is the end of the period covered by this Annual Report on Form10-K, our disclosure controls and procedures were effective.

Therehave been no changes in our internal controls over financial reporting in thefiscal quarter ended December 31, 2006 that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.  Management has issued its report on internal control over financialreporting as of December 31, 2006, which appears in Item 8 of this Report.  The report of the Independent RegisteredPublic Accounting firm on Management’s Report on Internal Control overFinancial Reporting also appears in Item 8.

**ITEM 9B. OTHER INFORMATION.**

Therewas no information required to be disclosed in a report on Form 8-K during thefourth quarter of 2006, but not reported.

#### **PARTIII**

**ITEM 10. DIRECTORS, EXECUTIVEOFFICERS AND CORPORATE GOVERNANCE.**

***Directors Serving until the 2007Annual Meeting of Stockholders***

**CYNTHIA A. ARCHER**(age 53) is Vice President of Marketing and Development of Sunoco,Inc., a major oil refiner. Ms. Archer has occupied this position since January2001.  Ms. Archer is a director of SunocoLogistics Partners, LP.  She was electeda director of Bankshares in 1997.  Shealso serves as Chair of the Board’s Audit Committee and as a member of theBoard’s Nominating and Corporate Governance Committee.

**RICHARD O. BERNDT**(age 64) is the Managing Partner of Gallagher Evelius & Jones LLP,a law firm engaged in the general practice of law.  Mr. Berndt has been a partner in that firmsince 1972.  He is a director ofMunicipal Mortgage and Equity, LLC.  Mr.Berndt was elected a director of MSD&T in 1976 and elected a director ofBankshares in 1978.  He is Chair of theBoard’s Employee Benefit Committee and is a member of the Board’s ExecutiveCommittee.

**HOWARD B. BOWEN**(age 56) is the President and Chief Executive Officer of Ewing OilCompany, Inc., a gasoline distributor. He has held this position since 1988. Mr. Bowen was elected a directorof Bankshares in 2003.

**WILLIAM R. BRODY, M.D.** (age 63) is the President of Johns HopkinsUniversity.  Dr. Brody has occupied thatposition since 1996. Dr. Brody is a director of Medtronic, Inc.  He was elected a director of Bankshares in1996.  He is a member of the Board’sNominating and Corporate Governance Committee.

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**EDWARD J. KELLY, III**(age 53) has been the Chairman of the Boardof Directors of Bankshares since March 2003, and President and Chief ExecutiveOfficer of Bankshares, and Chairman of the Board and Chief Executive Officer ofMSD&T, since March 2001.  Mr. Kellyis a director of CSX Corporation and Hartford Financial Services Group.  He was elected a director of MSD&T in 2001and elected a director of Bankshares in 2001. Mr. Kelly is the Chair of the Board’s Executive Committee.

***Directors Serving until the 2008Annual Meeting of Stockholders***

**EDDIE C. BROWN**(age 66) has been the President of Brown Capital Management, aninvestment management firm, since 1983. He is a director of Municipal Mortgage and Equity, LLC and of thefollowing Brown Capital Management Mutual Funds: Equity, Balanced, Mid-Cap,Small Company and International.  Mr.Brown was elected a director of Bankshares in 2003.  He is a member of the Board’s ExecutiveCommittee and Nominating and Corporate Governance Committee.

**ANTHONY W. DEERING**(age 62) is Chairman of the Board of Exeter Capital, a private equityfirm, Chairman of the Board of The Charlesmead Foundation, and served as theChairman and Chief Executive Officer of The Rouse Company, a corporationfocusing on regional shopping centers and community development, from 1997until 2004.  He is also the lead directorof the T. Rowe Price Mutual Funds and a director of Vornado Realty Trust.  Mr. Deering was elected a director ofBankshares in 2003.  He is a member ofthe Board’s Executive Committee, and is Chair of its Compensation Committee.

**FREEMAN A. HRABOWSKI, III**(age 56) is the President of the Universityof Maryland, Baltimore County.  Dr.Hrabowski has served in this capacity since 1993.  He is a director of Constellation EnergyGroup, Inc. and McCormick & Company, Inc. Dr. Hrabowski was elected a director of MSD&T in 1996 and a directorof Bankshares in 1996.  He is Chair ofthe Board’s Nominating and Corporate Governance Committee and a member of theEmployee Benefit Committee.

**JENNY G. MORGAN**(age 47) has been a Principal with Sterling Partners since September2006.  In addition, she has served as anExecutive Vice President of Emdeon Corporation (successor to WebMD Corporation)since August 2004.  From 1997 until 2004,she was President and Chief Executive Officer of ViPS, Inc., a healthcareinformation solutions company which became a part of the WebMD Corporation.  She was elected a director of Bankshares inMarch 2004.  She is a member of the Board’sAudit Committee.

**CLAYTON S. ROSE**(age 48) has been an adjunct professor at Columbia University’sGraduate School of Business since 2002. He has also taught at New York University’s Stern School ofBusiness.  From 1981 through 2000, Mr.Rose worked at J.P. Morgan & Co., Inc. He held a series of senior management positions at J.P. Morgan &Co., Inc., including heading each of the firm’s Global Investment Banking andGlobal Equities divisions and serving as a member of the firm’s executivecommittee.  He also served as ViceChairman and Chief Operating Officer of the investment bank of JPMorgan Chase& Co. following the merger of the two firms in 2001.  Mr. Rose serves as a director of LexiconGenetics, Public/Private Ventures and The Reinvestment Fund.  He was elected a director of Bankshares in2001.  He is a member of the Board’sAudit Committee and Compensation Committee.

**DONALD J. SHEPARD**(age 61) has been Chairman of the Executive Board and Chief ExecutiveOfficer of AEGON N.V., a holding company of insurance and insurance-relatedcompanies since April 2002.  Mr. Shepardhas been a member of the Executive Board of AEGON N.V. since 1992.  He also serves as a director, and since June2005, Chairman of the Board, of AEGON U.S. Corporation, a holding company ofAEGON’s U.S. operations.  From 1989 untilApril 2002, Mr. Shepard served as President and Chief Executive Officer ofAEGON USA, Inc., a subsidiary of AEGON N.V. In addition, Mr. Shepard served onthe Board of Directors of AEGON USA, Inc. from February 1989 through April2002, and as Chairman of that Board from May 1992 to July 1999 and from May2000 to April 2002.  He is a director ofCSX Corporation.  Mr. Shepard was electeda director of MSD&T in 1992 and a director of Bankshares in 1992.  He is a member of the Board’s CompensationCommittee.

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**JAY M. WILSON**(age 59) has been a Vice Chairman of Bankshares and Chief ExecutiveOfficer of the Investment and Wealth Management Division of MSD&T sinceJanuary 2005.  From September 1998 untilDecember 2004, he was General Partner of Spring Capital Partners, L.P., aprivate equity fund providing expansion and acquisition capital to emerginggrowth companies.  He was elected adirector of MSD&T in 2005 and a director of Bankshares in 2005.

***Directors Serving until the 2009Annual Meeting of Stockholders***

**R. CARL BENNA** (age 59) has been the President of North American Housing Corp., amanufacturer of modular structures sold to builders for resale, since1978.  He was elected a director ofBankshares in 2003.

**GEORGE L. BUNTING, JR.** (age 66) is the President and ChiefExecutive Officer of Bunting Management Group, a private financial managementcompany.  Mr. Bunting has occupied thisposition since 1991.  Mr. Bunting waselected a director of MSD&T in 1992 and a director of Bankshares in1992.  He is a member of the Board’sAudit Committee, Compensation Committee, and Executive Committee.

**DARRELL D. FRIEDMAN**(age 64) has been a consultant to the American Jewish JointDistribution Committee since fall 2003. From 1986 until fall 2003, he was the President and Chief ExecutiveOfficer of THE ASSOCIATED: Jewish Community Federation of Baltimore.  Mr. Friedman was elected a director ofBankshares in 1999.

**ROBERT A. KINSLEY**(age 66) is the Chairman and Chief Executive Officer of KinsleyConstruction, Inc., a general and heavy construction firm.  Mr. Kinsley has served in this capacity since1996.  Mr. Kinsley was elected a directorof Bankshares in 1996.

**ALEXANDER T. MASON**(age 56) has served as Vice Chairman of Bankshares since joiningBankshares in November 2003.  In January2005, he was named Chief Operating Officer of Bankshares.  He held the following positions at DeutscheBank: Vice Chairman, Deutsche Bank Americas, from 2002 to 2003; Chief OperatingOfficer, Global Corporate Finance, from 2001 to 2002; Co-Head, Global IndustryGroup, from 1999 to 2001; and Managing Director, Deutsche Bank Securities, from1999 to 2003.  He was elected a director ofMSD&T in 2005 and a director of Bankshares in 2005.

**CHRISTIAN H. POINDEXTER**(age 68) was Chairman of the ExecutiveCommittee of the Board of Directors of Constellation Energy Group, Inc., apublic utility holding company, from July 2002 until he retired in March2003.  From November 2001 until July2002, he was Chairman of the Board of Constellation, and, from April 1999 untilNovember 2001, he was also Constellation’s Chief Executive Officer.  Mr. Poindexter was Chairman of the Board ofBaltimore Gas and Electric Company from 1993 until July 2002.  From 1993 until July 2000, he was also itsChief Executive Officer.  He is adirector of DNP Select Income Fund.  Mr.Poindexter was elected a director of MSD&T in 1987 and a director ofBankshares in 1987.  He is a member ofthe Board’s Audit Committee, Compensation Committee and Executive Committee.

**JAMES L. SHEA**(age 54) is the Chairman of Venable LLP, a law firm engaged in thegeneral practice of law.  Mr. Shea wasManaging Partner of that firm from 1995 to 2006 and has been Chairman sinceJune 2006.  Mr. Shea was elected adirector of MSD&T in 2001 and a director of Bankshares in 2001.  He is a member of the Board’s ExecutiveCommittee.

***Audit Committee***

Bankshareshas a standing Audit Committee established in accordance with the Exchange Act,which consists of the following five members: Cynthia A. Archer, George L. Bunting, Jr., Jenny G. Morgan, Christian H.Poindexter, and Clayton S. Rose.  TheBoard of Directors has determined that Messrs. Rose and Poindexter are auditcommittee financial experts as defined in the regulations of the Securities andExchange Commission and that each of them is an independent director, asindependence for audit committee members is defined in the listing standards ofthe Nasdaq Global Select Market.

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***Executive Officers***

TheBankshares officers who file reports under Section 16 of the SecuritiesExchange Act of 1934, as amended, are:
| ** **                    | **Name** | ** **                                                                                             | ** ** | ** ** | **Position** | ** ** |
|-------------------------------|----------|--------------------------------------------------------------------------------------------------------|------------|------------|--------------|------------|
| Edward J. Kelly, III          |     | Chairman of the Board,  President and Chief Executive Officer                                          |
| Alexander T. Mason            |     | Vice Chairman and Chief  Operating Officer                                                             |
| Jay M. Wilson                 |     | Vice Chairman and  Chairman and Chief Executive Officer, Investment & Wealth Management            |
| J. Marshall Reid              |     | Executive Vice  President, Banking                                                                     |
| Peter W.  Floeckher, Jr. |     | Executive Vice  President, Affiliate Management                                                        |
| Terry L. Troupe               |     | Executive Vice  President and Chief Financial Officer                                                  |
| John L. Unger                 |     | Executive Vice  President, General Counsel and Secretary                                               |
| Michael M. Paese              |     | Executive Vice President,  Chief Administrative Officer, Chief Risk Officer and Deputy General Counsel |
| Deborah A. Kakaris            |     | Executive Vice  President, Operations and Technology Services                                          |
| Kaye A. Simmons               |     | Senior Vice President  and Treasurer                                                                   |
| William T. Skinner, Jr.  |     | Senior Vice President and Controller                                                                   |

 

Messrs. Kelly’s, Mason’s and Wilson’s business experience is set forthabove.

**J. Marshall Reid**(age 61) was elected President and ChiefOperating Officer of MSD&T in September 1997.  He joined MSD&T as a Senior VicePresident in 1993 and served as an Executive Vice President from 1994 untilSeptember 1997.

**Peter W. Floeckher, Jr.** (age 57) was appointed Executive VicePresident and Head of the Affiliates for Bankshares in November 2003.  He served as President and Chief ExecutiveOfficer of Citizens National Bank from 1995 until November 2003.  Mr. Floeckher is responsible for oversight ofthe Banks, which includes risk management, compliance and enhanced performancethrough coordinated sharing of best practices.

**Terry L. Troupe** (age 59) has been Chief Financial Officer ofBankshares and MSD&T since he joined Bankshares in September 1996.

**John L. Unger** (age 53 ) became General Counsel on March 23, 2002 and was electedSecretary of Bankshares and MSD&T on July 1, 2002.  Prior to joining Bankshares, Mr. Unger wasGeneral Counsel to IMI Resort Holdings, Inc., a privately held real estatecompany in Greenville, South Carolina.

**Michael M. Paese** (age 39) was named Chief AdministrativeOfficer of Bankshares in November 2004 and became Chief Risk Officer on January2, 2005.  He joined MSD&T as a SeniorVice President and Deputy General Counsel in January 2003.  Before joining Bankshares, Mr. Paese wasSenior Counsel to the Financial Services Committee of the U.S. House ofRepresentatives (minority).  Mr. Paeseadvised the Committee on legal and policy issues relating to U.S. capitalmarkets and corporate governance.  Priorthereto, Mr. Paese was a Vice President in equity capital markets, at J .P.Morgan & Co. Incorporated.  Priorthereto, Mr. Paese was an associate at Davis Polk & Wardwell.

**Deborah A. Kakaris** (age 43) has been an Executive VicePresident of Bankshares and MSD&T since 2002.  She is responsible for Operations andTechnology Services.  Mrs. Kakaris joinedthe bank in 1988 and served as a Senior Vice President from 1997 until March2002.

**Kaye A. Simmons** (age 51) joined Bankshares as Senior VicePresident and Treasurer in 2003, after the merger with F&M Bancorp.  She had been Treasurer of F&M Bancorpsince 2000 and Executive Vice President and Chief Financial Officer of Farmers& Mechanics Bank since 2000.  Priorto that time, Ms. Simmons served as Senior Vice President of Finance andTreasurer of Citizens Bancorp from 1989 to 1997.

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**William T. Skinner, Jr.**(age 59)****hasbeen Senior Vice President and Controller of Bankshares since 1998.  He has served as Controller of MSD&Tsince 1996.  Mr. Skinner joined MSD&Tin 1979.

No family relationships, as defined by the rules and regulations of theSecurities and Exchange Commission, exist among any of the ExecutiveOfficers.  All officers are electedannually by the Board of Directors and hold office at the pleasure of theBoard.

***Section 16(a) Beneficial OwnershipReporting Compliance***

Section 16(a) of the Securities Exchange Actof 1934, as amended, requires the directors and officers covered by thatsection to file reports with the Securities and Exchange Commission and Nasdaqrelating to their common stock ownership and any changes in that ownership. Wehave reviewed the copies of the reports that have been filed, and writtenrepresentations from the individuals required to file the reports. Based onthis review, we believe that during 2006 each of our directors and executiveofficers has complied with applicable reporting requirements for transactionsin our equity securities.

***Code of Ethics***

Bankshares has adopted a code of ethics thatapplies to its chief executive officer, chief financial officer and controller.The code of ethics is an exhibit to this Annual Report on Form 10-K.  The text of the code is posted on Bankshares’website at www.mercantile.com.  Bankshares will provide to any person, withoutcharge, upon request a copy of the code of ethics.  Requests for a copy of the code of ethics canbe made in writing to: Mercantile Bankshares Corporation, P.O. Box 1477,Baltimore, MD 21203, Attn: Investor Relations. Any future amendments to, or waivers from, the provisions of the code ofethics that require disclosure under applicable rules of the Securities andExchange Commission will be disclosed in a current report on Form 8-K.

***Stockholder recommended nominees fordirector***

The Board of Directors has a policy thatstockholders may propose nominees for consideration by the Nominating andCorporate Governance Committee for election at an annual meeting ofstockholders by submitting the names and qualifications of such persons to theNominating and Corporate Governance Committee in accordance with the timeframesrequired in our Bylaws.  Submissions mustbe made to the Nominating and Corporate Governance Committee, c/o MercantileBankshares Corporation, Secretary, Two Hopkins Plaza, Baltimore, Maryland21201.  The Nominating and CorporateGovernance Committee considers the qualifications for directors set forth inthe Corporate Governance Guidelines and does not impose additionalqualifications on stockholder-recommended potential nominees.

**ITEM 11. EXECUTIVE COMPENSATION**

***Compensation Discussion and Analysis***

**Introduction and Overview**

Banksharesbelieves that the quality of its senior management team is a critical factor indetermining its ability to achieve its short-term and long-term goals withrespect to profitability, growth and shareholder return.  We also believe that the most importantfactor in ensuring that we meet or exceed the highest standards in corporatebehavior (including ethics, compliance and governance) is the “tone at the top”provided by our senior executives. For these reasons, as well as the difficultyand expense of attracting, and the disruption that often results from thedeparture of, senior executives, we believe that it is critical to be able toattract, develop and retain talented, experienced and highly-motivatedexecutives who exhibit exceptional leadership abilities and possess the highestethical standards. The primary objective of our executive compensation programis to enable us to meet that challenge in a highly competitive market.

Webelieve that in order to achieve our objective, our executive compensationprogram must be competitive, reward good results and provide incentives forfuture performance that sustains and enhances long-term stockholder value.

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Executivecompensation is a complex subject that is affected by a variety ofever-changing factors. These factors include developments that are often beyondour control, such as changes in tax and pension laws, changing accountingstandards and policies, national and international market developments andtrends within a particular market sector. In addition, since the competitionfor the best management talent is intense, the actions of other companies canhave an impact on executive compensation policies and decisions. Moreover,Bankshares must take into account factors specific to itself, such as morale,team chemistry, changing strategic imperatives and the tension betweenpotentially competing short-term and long-term objectives. The overall designof our executive compensation program and the elements constituting thatprogram, therefore, must evolve over time as the marketplace and the needs ofBankshares continue to change. The result is that the program at any one timerepresents a combination of old and new elements, practices and polices.

Basedon the foregoing, we believe that executive compensation is not a “one-size-fits-all”exercise, and that our interests are best served when those making thedecisions have the flexibility to make those decisions based on the specificcircumstances before them, subject to the standard of conduct required of alldirectors under Maryland law — that they act in good faith, in a manner reasonablybelieved to be in the best interests of Bankshares, and with the care that anordinarily prudent person in a like position would use under similarcircumstances.

OnOctober 8, 2006, Bankshares entered into an Agreement and Plan of Merger withThe PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshareswill merge with and into PNC, with PNC as the surviving corporation in themerger.  When the merger is completed,Bankshares’ stockholders will receive a combination of PNC common stock andcash in exchange for their Bankshares common stock.  Each share of Bankshares common stock will beconverted into the right to receive 0.4184 of a share of PNC common stock(including the related preferred stock purchase rights under PNC’s May 2000Rights Agreement) and $16.45 in cash, without interest.  Under the formula set forth in the mergeragreement, an aggregate of up to approximately 54.2 million shares of PNCcommon stock (and an equal number of related rights) may be issued and $2.13billion paid in the merger.  This mergerwas approved by Bankshares’ stockholders on February 27, 2007, after receivingmost of the required regulatory approvals (such as approval by the Board ofGovernors of the Federal Reserve System and financial regulators in Marylandand Virginia).  The merger is currentlyexpected to close in March of 2007. Pending the merger, Bankshares must comply with the covenants containedin the merger agreement, but is generally continuing to operate in the ordinarycourse of business.

*Corporate Governance*Bankshares’ Board hasdelegated most decision-making authority on compensation matters to theCompensation Committee of the Board, which is referred to herein as theCommittee. The Committee’s primary function is to approve the compensation ofour most senior executive officers, and in 2006, the Committee determined thecompensation for the 14 members of Bankshares’ senior management team, whichincluded Mr. Kelly and the four other senior executives named in the SummaryCompensation Table below (the “Named Executives”).  These 14 individuals serve on Bankshares’Management Committee and have the most direct impact on our overallperformance. With respect to CEO compensation, the Committee makesrecommendations to the Board, and CEO compensation is approved by theindependent directors of the Board. The Committee also reviews and approvesother employment related matters, including all employment agreements providingfor annual salaries in excess of $200,000, all severance agreements withmembers of senior management, and all change in control agreements. TheCommittee also approves all equity-based awards, including awards granted underour stockholder-approved 1999 Omnibus Stock Plan, and reviews and approves theaggregate of all bonuses paid by Bankshares and its affiliates.

Historically,with the exception of new hires, it has been the practice of the Committee toaward or set the primary elements of executive compensation (salary and cashand equity incentives) in the first calendar quarter of each year. Typically,the Committee meets in January or February to review the process for makingcompensation decisions, including determining the information and advice itwill use in making such decisions. The Committee then meets one or more times generallyin March (typically on or around the time of the regularly scheduled quarterlyBoard meeting; to (i) certify the deductibility of cash incentives; (ii)confirm that specified performance goals have been met with respect to thepayment of cash bonuses or granting of equity awards relating to the past yearor any other prior period; (iii) authorize and approve the payment or issuanceof such prior year bonuses or awards; and (iv) set executive compensation forthe current year, including salary, cash bonus opportunity and the grant of anyequity-based compensation. This timing was selected because it enables theCommittee to consider prior-year performance by Bankshares and the potentialrecipients and our expectations for the current year. The CompensationCommittee’s schedule is determined in advance, and the proximity of any awardsto earnings announcements or other market events is coincidental. For the 2006fiscal year, these grants were made on March 29, 2006. In light of the scheduledclosing of the PNC Merger, it is not anticipated that any grants will be madein 2007 by Bankshares. Pursuant to the PNC Merger Agreement, however, if anysuch grants are made, they will be terminated without consideration at theEffective Time.  Except as noted in thefollowing paragraph, equity awards, including options, are always dated thedate of the Committee meeting at which such awards are approved and theexercise price of such options is determined by the closing price of Bankshares’stock on that date.

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Secondaryelements of executive compensation, such as employment agreements, severancearrangements (including change-in-control agreements), retirement arrangements,other employee benefits and perquisites are typically set at the time of an executive’sinitial employment and are reviewed periodically from time to time as the needarises. On occasion, new hires are awarded options or other equity-based awardsas an inducement to joining the company. If these awards are approved prior to the commencement of employment,the exercise price is set as the closing price of Bankshares’ stock on theexecutive’s first date of employment. If the awards are approved after thecommencement of employment, the exercise price of such options is determined bythe closing price of Bankshares’ stock on the date the Committee approves theaward.

Periodicallyover the past several years, as more fully described below, the Committee hasreviewed Bankshares’ executive compensation philosophy, plans, policies andpractices. This process was formalized under the amended charter of theCommittee adopted in March 2006, and such reviews now take place on an annualbasis in accordance with a fixed annual agenda.

*Compensation Consultants*In 2003, 2005 and2006, the Committee retained independent compensation consultants to advise iton executive compensation matters. Such consultants were retained by, andreported to, the Committee, which has the sole power to hire and fire suchconsultants. All work was commissioned by the Committee, although theconsultants interacted with management to obtain necessary factual informationregarding Bankshares’ performance and historical practices. The resultingreports were provided to both the Committee and management, and bills werepresented directly to, and authorized for payment by, the Committee’s Chairman.

In2003, the Committee retained Mellon Human Resources & Investor Solutions (“Mellon”)to provide an independent audit of Bankshares’ executive compensation program,which included an evaluation of the competitiveness of such program as comparedto a peer group of 14 comparable companies in the commercial banking industrywith assets, revenues and market capitalization similar to those of Bankshares.Mellon’s report, delivered to the Committee in December 2003 (the “MellonReport”), also recommended priorities for governing and refining the executivecompensation program in the future. In 2005, the Committee retained Frederic W.Cook & Co., Inc. (“Cook”) to assess the competitiveness of Bankshares’executive compensation program and, if appropriate, to make recommendations forpossible changes. Cook was selected by the Committee to replace Mellon as aresult of the acquisition of Mellon by a third party and upon therecommendations of Committee members who had worked with Cook previously.  Cook’s report, delivered in March 2005,compared Bankshares’ executive compensation program to those of 14 comparablecompanies in the commercial banking industry with assets, revenues and marketcapitalization similar to those of Bankshares. In 2006, the Committee asked Cook to prepare a competitive assessment ofMr. Kelly’s total compensation and equity holdings, and to prepare totalcompensation “tally sheets” for the nine most highly compensated members ofsenior management (including Mr. Kelly). These “tally sheets” showed for eachindividual (i) the value of total compensation for the previous year, (ii) thevalue of all stock-denominated compensation currently held, (iii) the projectedvalue of all stock-denominated compensation held (based on various projectedstock prices) and (iv) a summary of estimated benefits payable upon varioustermination of employment scenarios (including a change-in-control).

Fora discussion of the impact of these reports on Bankshares’ executivecompensation philosophy, policies and practices, see “Compensation ProgramsDesign and Key Policies”, and “2006 Compensation”, below.

Inaddition, since 2005 Bankshares has retained Mark Bieler as a consultant toadvise management on possible revisions of the executive compensation programsand on executive compensation matters generally. Mr. Bieler is President ofMark Bieler Associates, Inc., a consulting firm advising management of publicand private sector organizations on strategic human resource and organizationaldevelopment issues.  Prior to foundingthe firm, Mr. Bieler was Director of Human Resources for Bankers Trust Companyand Executive Vice President of its parent, Bankers Trust Corporation.Management determines the nature and scope of his assignments, which to datehave included advice on the redesign of Bankshares’ annual cash incentive andlong-term equity incentive programs.

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*Role of Management*Our CEO, Mr. Kelly,provides input to the Committee with respect to the objectives, design andimplementation of executive compensation policies, programs and practicesgenerally. This includes the general design of programs in which Mr. Kellyparticipates along with others as a member of senior management, but does notinclude the amount of specific awards for Mr. Kelly, whether or not under suchprograms. Mr. Mason, Vice Chairman of Bankshares, also works with Mr. Kelly andmanagement’s compensation consultant, Mr. Bieler, in providing such input tothe Committee.  In addition, Mr. Kellyprovides recommendations to the Committee with respect to the compensation ofhis direct reports and other members of senior management. Mr. Unger,Bankshares’ General Counsel, works closely with the Committee in anadministrative capacity, assisting in the preparation of agendas, the deliveryof materials in advance of meetings, and the documentation of Committeeactions. Generally, Messrs. Kelly, Mason and Unger attend all Committeemeetings. The Committee will ask some or all management members to excusethemselves from meetings as appropriate, and most meetings (including allmeetings at which CEO compensation is determined) end with the Committeemeeting in executive session with no members of management present.

**Compensation Program Objectives**

InMarch 2006, the Committee formalized its compensation philosophy by adoptingthe following, which was subsequently approved by Bankshares’ Board:

“The goal of our compensation program forsenior executive officers is to enable us to attract and retain highlymotivated executive personnel of outstanding ability and initiative, and toalign closely the interests of those executives throughout their careers withthose of our stockholders. In order to achieve our goal, we must reward goodresults and incent future performance which sustains and enhances long-termstockholder value. Compensation decisions are made within the context of threeguiding principles: (i) total compensation for executives should be competitivewith comparable companies, (ii) a substantial portion of the total compensationshould be at risk and consist of performance-based cash and equity incentivesthat are linked to Company financial and non-financial results and, (iii) asignificant portion of the total compensation opportunity should beequity-based, long-term incentives that are linked directly to achievingresults that create stockholder value.”

InMarch 2006, the Committee also adopted, and the Board later approved, thefollowing guidelines for assessing the CEOs performance for future compensationdecisions:

Significantaccomplishments

·                  Overall performance and leadership

o                 In context of any specific challenges

·                  Design and execution of strategic initiatives

·                  Acquisition execution/integration

·                  Building management team

·                  Leadership in creating a culture of ethics,compliance and diversity

·                  Leadership in transparency and corporategovernance

 

Operatingperformance (on an absolute and relative basis)

·                  increases in net income

·                  increases in earnings per share (basic)

·                  increases in loans, deposits and noninterestincome

·                  credit quality metrics

·                  returns on assets and equity

·                  maintenance of strong capital levels

 

Stockprice performance

·                  Stockholder return

·                  P/E ratio

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**Compensation Program Design and Key Policies**

Historically,the objectives of Bankshares’ executive compensation program have been toenable Bankshares to attract and retain highly-motivated executive personnel ofoutstanding ability and initiative in a competitive market, and to further theoverall goals and objectives of Bankshares (which include short-term andlong-term profitability, stability, growth and shareholder return) by includingincentive components that link compensation to appropriate measures ofindividual and corporate performance. Shortly after his arrival as CEO in 2001,however, Mr. Kelly advised the Committee that he believed that changing marketdynamics (particularly a sustained period of declining interest rates unprecedentedin recent history and a decrease in opportunities to grow through acquisition)had rendered the design of the executive compensation program then in placeinefficient, as it was no longer as effective as it could be in furtheringBankshares’ objectives. While the primary elements of the program at that timeconsisted of salary, annual cash incentives and long-term equity-basedincentives in the form of stock options granted once each four years, theprogram relied more on fixed compensation (salary) and benefits (includingperquisites), and less on incentives. As a result, executive salaries tended toexceed the median as compared to a peer group, and annual short-term cash andlong-term equity-based incentive compensation lagged the median. Bankshares’annual cash bonuses, expressed as a percentage of salary, were typically in thebottom quartile of peer results, and long-term equity-based incentivecompensation significantly lagged peers. While most peers awarded long-termequity-based incentive compensation annually, Bankshares made such awards to executive management in only two of theeight years prior to Mr. Kelly’s arrival (both times in the form ofperformance-based options). Furthermore, two performance metrics were used insuch performance-based option grants, as well as in the annual cash bonus plan,with the result that incentives often were not realized despite strongperformance by Bankshares across a host of other measures. This made theseincentives less effective in achieving the objectives for which they weredesigned.  Finally, the design ofBankshares’ shareholder-approved annual cash bonus plan did not properly alignmanagement and shareholder interests, as it provided a disincentive formanagement to take actions that would favor long-term prospects over short-termresults.

Theseconclusions were confirmed by the Mellon Report issued in December 2003, whichrecommended that incentive opportunities be enhanced and, in particular, thatBankshares develop a more competitive approach to long-term incentives.

Overthe past several years, the Committee has attempted to address these issues byredesigning various elements of Bankshares’ executive compensation program. In2002, it recommended that the cash bonus plan be amended to (i) increase themaximum percentage award from 65% (for class I participants), 50% (for class IIparticipants) and 33% (for class III participants) of base salary to 100%, 60%and 40%, respectively, to put more cash compensation at risk and create a moreappropriate allocation between salary and bonuses, and (ii) eliminate thecompounded and annual growth rate earnings-per-share performance test in stockoptions going forward. In 2006, the Committee recommended that an entirely newannual cash bonus plan be adopted to replace the prior plan, with the primarydifference being that under the new plan the Committee would have a muchbroader range of options for setting financial performance criteria, would havethe added ability to establish non-financial qualitative performance or othergoals for executives whose compensation was not subject to Section 162(m) ofthe Internal Revenue Code (“Non-162(m) Participants”), and would create thepossibility that class I and class II participants could earn annual bonuses ofup to 150% and 100%, respectively, for exceeding targeted performance goals “ina truly outstanding manner” (as opposed to the prior plan, which provided noincentive for exceeding targeted performance goals). In addition, in 2004 theCommittee recommended that the 1999 Omnibus Stock Plan be amended to add twoadditional performance criteria (total stockholder return and share price) onwhich the grant, vesting or exercisability of an equity-based award under suchplan could be made, and approved Bankshares’ first long-term incentive planthat provided for restricted stock awards to senior management based on meetingtargeted objectives with respect to total stockholder return as measured over atwo-year period. All of the foregoing recommendations were approved by theBoard and implemented upon approval by the stockholders of Bankshares.

Asa result of these changes, the current design of the executive compensationprograms now more accurately reflects the three guiding principles underlyingour compensation philosophy.

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**Elements of Compensation**

Theprimary elements of the executive compensation program are base salary, theopportunity for annual incentive cash (bonus) compensation and longer-termequity-based incentive compensation.

*BaseSalary*

Basesalary is designed to provide competitive levels of compensation to executivesbased upon their experience, duties, scope of responsibility and proficiencies.We want to provide our senior management with a level of assured cashcompensation in the form of base salary that reflects their professional statusand accomplishments. In setting executive salaries, the Committee reviewscompetitive information provided by its consultants. However, salary amountsare not objectively determined, but instead reflect levels that the Committeeconcludes are appropriate based upon its general experience. As noted above, inrecent years the Committee made a decision to put more cash compensation atrisk and create a more appropriate allocation between salary and bonuses. As aresult, in 2005 and 2006, annual salary increases among senior managementgenerally have become less important.

*Bonus*

Annualincentive cash compensation for senior executives is currently determined underthe Annual Cash Incentive Plan (“ACIP”), approved by our stockholders in 2006.Such compensation is based on meeting specified annual corporate (and, incertain cases, individual) performance goals related to specified performancecriteria. Under the ACIP, the maximum potential annual cash incentivecompensation award for those executives designated as Class I participants inany year is limited to a percentage (not to exceed 100% for meeting targetedperformance goals; not to exceed 150% in the event performance goals areexceeded in a truly outstanding and unusual manner) of the individual’sapplicable base salary. For all other participants (Class II participants) suchlimits are 60% and 90%, respectively, of the individual’s applicable basesalary. The maximum award payable to a Section 162(m) participant is $5million, and in the event of a change of control of Bankshares, the performancegoals for the year in which such change of control occurs shall be deemed tohave been met at 100% level of base salary for Class I participants and 60%level of base salary for Class II participants. Other than our CFO, Mr. Troupe(who is a Class II participant), all of the Named Executives are Class Iparticipants in the ACIP. Awards earned under the ACIP (and its predecessorplan) with respect to any plan year are paid in February or March of thefollowing year.

Underthe ACIP, the Committee has the authority to determine participants from amongkey employees of Bankshares and its affiliates, and to establish, at itsdiscretion, the basis and terms of participation for Non-Section 162(m)Participants. For those participants a portion of whose compensation is subjectto Section 162(m) (“Section 162(m) Participants”), the Committee is authorizedto designate the financial criteria that will apply to awards to suchindividuals, the performance goals that Bankshares must meet with respect tothe financial criteria designated and a payout matrix or formula fordetermining bonuses earned based on the level of performance achieved. Thefinancial criteria for use in determining awards for Section 162(m)Participants must consist of one or more of the following financial measures:operating income, growth in operating income or net income, earnings per share,growth in earnings per share, cash flow measures, credit quality measures,efficiency measures, net interest margin measures, expenses, return on equity,return on assets, stockholder returns, stock price and achievement of balancesheet or income statement objectives. Such financial criteria may becompany-wide or on a departmental, divisional or regional basis and may bemeasured in absolute terms, by reference to internal performance targets, or ascompared to another company or companies, and may be measured by the change inthat performance target compared to a previous period.

In2006, the Committee designated 13 participants in the ACIP, including all ofthe Named Executives. All Named Executives (other than Mr. Troupe) weredesignated as Section 162(m) participants. As both Mr. Kelly and Mr. Mason heldresponsibilities across the entire corporation, it was determined that themetrics for each should be based on overall corporate performance.  TheCommittee concluded that 50% of their target cash bonus award should remaintied to the traditional measure of earnings per share (“EPS”) growth.  Inaddition, it elected to use Return on Average Assets (“ROAA”) as a reflectionof the relative quality of earnings of Bankshares and the ratio ofNon-Performing Assets to Total Loans & Other Real Estate Owned as a measureof credit quality.  Both the Return on Average Assets and credit qualitymeasures were given equal 25% weightings in the target bonus computation forMr. Kelly and Mr. Mason.  The goals and payouts with respect to thesemeasures were set in the context of both Bankshares’ historical performance andits standing in relation to its peer group. The Committee also felt Mr. Wilsonshould have a 50% weighting on the corporate EPS growth measure.  Theremainder of his target cash bonus award was tied to metrics of performance forthe business unit for which 

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hehad direct responsibility.  The Committee selected measures of Investment& Wealth Management Division Pre-Tax Income Growth and Revenue Growth withequal 25% weightings, (but set a hurdle rate for Pre-Tax Income Growth beforethe Revenue Growth metric would apply).  Goals and payouts for the IWM-relatedmetrics were set in the context of historical and budgeted 2006 performance forthe division.  For all other members of the management team, the Committeechose to weight the corporate EPS metric at 40% of the target bonus award. Individual business unit performance metrics for Mr. Reid were setagainst Net Profit Contribution (pre-tax income before management fee) forMSD&T and separately for its MB&T division, each weighted at 20% oftarget cash bonus.  Goals and payouts against these business unit metricswere set against historical and budgeted 2006 performance for those businessunits. The remaining 20% of Mr. Reid’s bonus was to be awarded based on a qualitativeevaluation focused on management and leadership of his business unit as well ason the maintenance of credit quality standards, regulatory and audit complianceresults, and assignments and contributions resulting in unusual benefit to Bankshares. In addition to awarding 40% of his target cash bonus against the corporate EPSmetric, the committee felt Mr. Troupe should be measured against the samecorporate ROAA measurement of earnings quality applied to Messrs. Kelly andMason.  It weighted 20% of his target award against this metric and theremaining 40% on a qualitative evaluation of his business unit management andleadership, overall expense control, regulatory and audit compliance, projectmanagement, and assignments and contributions resulting in unusual benefit toBankshares.

Theremaining eight members of senior management who participated in the ACIP for2006 have more diverse performance goals and include a subjective, qualitativecomponent that accounts for between 20% and 50% of the executive’s total bonusopportunity. Where an employee has responsibility for a particular businessunit or division, the performance goals include goals based on the operationalperformance of those units. Where an employee has broader corporate responsibility,such as our general counsel, the goals are tailored to his or her particularobjectives for the year. However, Bankshares’ EPS growth is at least a 40%factor in all performance goals.

EPSgrowth performance goals for all ACIP participants start at 3% (whichcorresponds to a 10% payout of the applicable percentage of the total bonusopportunity based on the criterion), and each additional 1% of EPS growthcorresponds to an additional 10% payout, with a 100% payout being earned whenEPS growth equals 12% and the maximum payout of 150% being earned when EPSgrowth equals or exceeds 17%.

ROAAperformance goals for Mr. Kelly and Mr. Mason start at greater than 1.50% butless than 1.60% (which corresponds to a 25% payout of the applicable percentageof the total bonus opportunity based on that criterion), with a 100% payoutbeing earned when ROAA is greater than 1.75% but less than 1.80% and themaximum 150% payout when ROAA is greater than 1.85%.  Credit quality performance goals for Mr.Kelly and Mr. Mason start with a ratio of Non-Performing Assets to Total Loansand Other Real Estate Owned of less than or equal to 60 basis points (“bps”)but greater than 55bps (which corresponds to a 25% payout of the applicablepercentage of the total bonus opportunity based on that criterion), with a 100%payout thus being earned when that ratio is less than or equal to 45bps butgreater than 30bps and the maximum 150% payout when that ratio is less than orequal to 25bps.

Mr.Wilson’s IWM pre-tax income (“PTI”) goals and payout calculation methodologymirror those for the EPS goals described above, with a slight adjustment in thevarious thresholds. Thus, payout for IWM PTI growth performance starts at 6%(which corresponds to a 10% payout of the applicable percentage of the totalbonus opportunity based on that criterion), with each additional 1% of IWM PTIgrowth corresponding to an additional 10% payout, with a 100% payout beingearned when IWM PTI growth equals 15% and the maximum payout of 150% beingearned when IWM PTI growth equals or exceeds 20%. Mr. Wilson’s IWM revenuegrowth goals and payout matrix are identical to those relating to PTI growth.

Mr.Reid’s MSD&T and MB&T PTI goals and payout calculation methodology arethe same as Mr. Wilson’s noted above, but again with slight adjustments to thevarious thresholds. Thus, payout for MSD&T PTI growth performance starts at11% (which corresponds to a 10% payout of the applicable percentage of thetotal bonus opportunity based on that criterion), with each additional 1% ofMSD&T PTI growth corresponding to an additional 10% payout, with a 100%payout being earned when MSD&T PTI growth equals 20% and the maximum payoutof 150% being earned when PTI

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growthequals or exceeds 25%. Mr. Reid’s payout for MB&T PTI growth performancestarts at 1% (which corresponds to a 10% payout of the applicable percentage ofthe total bonus opportunity based on that criterion), with each additional 1%of MB&T PTI growth corresponding to an additional 10% payout, with a 100% payoutbeing earned when MB&T PTI growth equals 10% and the maximum payout of 150%being earned when PTI growth equals or exceeds 15%.

Mr.Troupe’s ROAA performance goals and payout calculation methodology are the sameas those for Mr. Kelly and Mr. Mason with respect to ROAA described above.

Insetting performance goals and payout methodology for 2006 awards under the ACIPwith respect to EPS and other corporate-wide financial performance metrics, theCommittee reviewed Bankshares’ historical performance with respect to theapplicable criteria, as well as Bankshares’ performance in these areas relativeto its peers. The Committee’s objective in setting these goals was to set goalsthat reflected superior performance but that were not unachievable and thus wouldeliminate the incentive factor.

Priorto 2006, bonuses for senior executives were determined under the AnnualIncentive Compensation Plan (“Old Bonus Plan”) approved by stockholders. Underthis plan, the CEO, COO and the heads of selected key operating subsidiaries orunits had the opportunity to earn cash bonuses equal to 100% of base salary,while the maximum bonus opportunity for other plan participants was limited toeither 60% or 40% of base salary.  Forthe years 2002 to 2005, bonuses were based solely on annual growth in EPS ofBankshares, with no bonuses earned if EPS growth was less than 3%, maximumbonuses earned if EPS growth equaled or exceeded 12% and bonuses pro-ratedbased on growth between 3% and 12%.

*Equity-BasedIncentives*

Longer-termequity-based incentive compensation is awarded pursuant to the 1999 OmnibusStock Plan (the “1999 Plan”), initially approved by our stockholders in 1999and amended and re-approved in 2004. The 1999 Plan is designed to align theinterests of key employees and stockholders, encouraging participants tomaintain and increase their ownership of our common stock with the opportunityto benefit along with our stockholders in both market-based andperformance-based share appreciation. The 1999 Plan authorizes the issuance ofup to 4,500,000 shares of common stock in the form of stock options, stockappreciation rights (“SARs”) or restricted stock.  The 1999 Plan also authorizes the issuance ofphantom stock units (“PSUs”), including restricted stock units (“RSUs”).  The 1999 Plan is administered by theCommittee.

Historically,the primary form of equity compensation awarded under the 1999 Plan consistedof stock options, with as many of such options as permitted by law designatedas incentive stock options.  Prior to2002, such option grants were primarily performance-based, with vesting subjectto meeting performance objectives with respect to growth in EPS and net after-taxoperating income on both a compounded basis from the applicable base year andon a year-to-year basis. Primarily because of market conditions such as asustained period of declining interest rates, and a decrease in opportunitiesto grow through acquisition, most of the growth targets were not achieved, andas a result a substantial portion of the performance-based options wereforfeited, basically eliminating their longer-term incentive value toemployees. Options granted since 2002, therefore, have not beenperformance-based and instead have provided for vesting over time (generallypro rata over three years) assuming continued employment.  In addition, beginning in 2006, Bankshareschanged its practice of granting incentive stock options and, instead, chooseto grant solely non-qualified options in order to take advantage of the more favorabletax treatment to Bankshares.

Bankshareshas expensed options since the adoption of Statement of Financial AccountingStandards No. 123 in 1995, thus the 2006 change in the accounting treatment forstock options as a result of the adoption of Statement of Financial AccountingStandards No. 123(R), had minimal impact on our option granting practices.However, partially because of our decision to expense options at a time whenour competitors were not, our option grants significantly lagged ourpeers.  As a result, in 2002 we begangranting shares of restricted stock to members of senior management in additionto or in lieu of option grants, and concluded that restricted stock wouldprovide an equally motivating form of incentive compensation while permittingus to issue fewer shares, thereby reducing potential dilution. Restricted stockawards granted since that time have been both “performance-based” and “time-based.”In order for the performance-based

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restrictedstock to be earned, Bankshares must achieve certain performance goals withinthe applicable performance period covered by the awards. The recipient alsomust remain employed by Bankshares for one additional year following the awardof such shares, if earned, in order for the restricted stock to vest. Thefinancial criteria for these performance goals were approved by ourstockholders in connection with their re-approval of the 1999 Plan in 2004.

Inestablishing award levels for both options and restricted stock, we generallydo not consider current equity ownership levels of the recipients or priorawards that are fully vested. It is our belief that competitors who might tryto hire away our employees would not consider vested equity ownership inBankshares and, accordingly, to remain competitive we cannot afford to considerthat factor either.  We also want to becertain that our employees have ongoing incentives.

In2002, Bankshares made its first restricted stock grants to provide additionallong-term equity-based incentives, awarding an aggregate of 24,375 shares toour CEO and our next two highest-paid executives at the time, Mr. Reid and thehead of our affiliate bank network. In addition, we awarded an aggregate of105,000 restricted shares as part of our recruitment efforts for a new head ofInvestment and Wealth Management and a new Chief Investment Officer.

InApril 2003, the Committee awarded 90,000 shares of restricted stock to Mr.Kelly.  This award was “time-based” asopposed to performance-based, vesting in its entirety on the third anniversaryof the award date, provided only that Mr. Kelly remained employed by Bankshareson that date.  The Committee made thisaward for retention purposes and to provide additional incentive to Mr. Kellyby more closely aligning his interests with those of our stockholders.  At that time, Mr. Kelly’s equity interest inBankshares was significantly below that of other CEOs at peer companies.  In addition, based on its assessment of hisperformance during the first two years of his employment, the Committeedetermined that it was desirable to ensure Mr. Kelly’s retention for anadditional period.

InMarch 2004, based in part on the recommendation of its compensation consultantat that time (see “Compensation Consultants”, above), the Committee approvedBankshares’ first performance-based long term incentive restricted stockprogram under the 1999 Plan. Under this program (the “2004 LTIP”), seven seniorexecutive officers of Bankshares (including each of the Named Executives, otherthan Mr. Wilson, who was not employed by Bankshares at the time) had thepotential to receive restricted stock based on Bankshares achieving specifiedperformance goals over a two-year period ending December 31, 2005. The targetaward for each participant was 100% of such participant’s then-current annualsalary, payable in shares of restricted stock (valued at the closing price ofBankshares’ stock as of the last day of the performance period). The Committeecould grant awards if the compound annual growth rate of total stockholderreturn for the two-year performance period equalled or exceded 12% annually.The Committee chose this performance criteria and goal because of its clearalignment with stockholder interests. The awards were “all or nothing”, with noawards earned if the 12% threshold was not met. The performance goals for the2004 LTIP were achieved. Award recipients also were required to remain employedby Bankshares for an additional one year following the date on which the awardswere approved by the Committee in order for the restricted stock to vest.

In2006, the Committee approved a performance-based long-term incentive programunder the 1999 Plan. Under this program (the “2006 LTIP”), 14 senior executiveofficers of Bankshares (including each of the Named Executives), have thepotential to receive restricted stock units (if earned, convertible to sharesof common stock on a one-for-one basis) based on Bankshares achieving specifiedperformance goals over a three-year period. The target award for eachparticipant is a number of restricted stock units, such number determined bydividing a multiple of such participant’s annual salary as of March 29, 2006 bythe closing price of Bankshares’ common stock on the date of grant.  Based on such closing price, the value ofsuch target awards for the Named Executives were as follows: Mr. Kelly —$1,500,000; Mr. Mason — $900,000; Mr. Wilson — $900,000; Mr. Reid — $600,000;and Mr. Troupe — $600,000. Awards are earned based on the percentageimprovement (not compounded), if any, in Bankshares’ pre-tax operating earningsfor 2008 as compared to 2005.  The amountof the target award earned varies based on the amount of such percentageimprovement achieved, as follows: 15% improvement — 25% payout; 18% improvement— 50% payout; 22.5% improvement — 75% payout; 27% improvement — 100% payout;33% improvement — 125% payout; 45% or more improvement — 150% payout (maximumaward). If earned, such awards will vest one year from the date of grant if therecipient remains employed by Bankshares through such date. If the recipientvoluntarily terminates employment prior to that date or is terminatedinvoluntarily for cause, the award will be forfeited. Dividend shareequivalents accrue during the three-year performance

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periodand the one-year vesting period, and are issued in the form of additionalshares in the event the award is earned and vests. In the event of a change incontrol during the performance period, awards are deemed earned and vest at100% of the target award. As a result, upon the closing of the PNC merger, theawards will accelerate and be paid out at 100% of target. (See “Change inControl” below for a discussion of Bankshares’ philosophy with respect to theacceleration of awards in a change in control scenario.)

*OtherElements*

Secondaryelements of our executive compensation program include qualified retirementplans, supplemental retirement plans, a deferred compensation plan, certainseverance arrangements and perquisites, all of which are more fully describedin those parts of this Item 11, which follow this Compensation Discussion andAnalysis.  Our philosophy with respect tothese items is to maintain competitive overall compensation programs.  Perquisites do not constitute a significantpart of our executive compensation program. The primary perquisites for seniormanagers at or above the level of executive vice president (and equivalents)are use of a company-owned automobile, payment of certain club dues and theprovision of in-house meals. We want to encourage our senior management tobelong to a golf or social club so that they have an appropriate entertainmentforum for customers and appropriate interaction with their communities.  In addition, we continue to provide certainperquisites (such as club dues and automobile use) because historically theyhave been considered as part of the executive compensation package and webelieve that they are provided by many of our competitors.  We provide in-house meals because we alreadymaintain a corporate dining room for the purpose of entertaining customers andother visitors, and by making meals available to executives we believe that itsaves time and increases their efficiency. We annually review the perquisitesthat senior management receives. Senior management also participates inBankshares’ other benefit plans on the same terms as other employees. Theseplans include medical, dental and life insurance. Relocation benefits also arereimbursed but are individually negotiated when they occur.

**2006 Compensation**

TheCommittee met in January 2006, and again in February, to outline the processfor determining the 2006 compensation of executive management. Upon therecommendation of management, the Committee was willing to consider a newannual cash bonus program, and a new long-term incentive program utilizingrestricted stock, and asked its consultant, Cook, to work with management andits consultant, Mr. Bieler, to develop recommendations with respect to thesematters for its review. In addition, to provide information to assist it indetermining the components and levels of 2006 compensation, the Committeedirected Cook to perform a competitive assessment of Mr. Kelly’s totalcompensation and equity holdings, and to prepare “tally sheets” for the ninemost highly compensated members of senior management (including Mr. Kelly andthe other Named Executives), showing  (i)the value of total 2005 compensation paid to each individual, (ii) the value ofstock-denominated compensation held, (iii) the projected value of such equityholdings at various stock prices, and (vi) a summary of estimated benefits upontermination of employment (including upon a change in control).

Cook’sreport was delivered in March 2006. Cook’s competitive assessment of Mr. Kelly’stotal compensation and equity holdings compared Mr. Kelly’s 2005 compensationand aggregate equity compensation holdings to the 2004 equivalent information(the most recent information publicly available) with respect to the CEOs of 14peer organizations, consisting of commercial banking organizations with marketcapitalizations (as of 12/31/05) ranging from $2.1 billion to $6.0 billion(compared to $4.6 billion for Bankshares as of that date).

Cookconcluded that Mr. Kelly’s 2005 total compensation was around the 75thpercentile of peer norms, and that his total wealth from compensation-basedequity holdings relative to peers ranked below the 10th percentile. Inaddition, the report concluded that Mr. Kelly’s Supplemental Retirement Planand Change-in-Control protection were generally competitive with externalmarket norms, but that his general severance protection was below competitivenorms. It should be noted that, prior to the date of Cook’s report, Mr. Kellyhad offered to relinquish his contractual rights to a general severance (in theform of continued salary and bonus for the remainder of his one-year employmentagreement) upon termination without cause and to a cash severance payment upontermination upon a change-in-control, and that in fact these changes wereaccepted by the Committee and agreed to by Mr. Kelly and Bankshares in April2006.

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Becausethe financial performance data provided by Cook in its draft report withrespect to the peer companies did not include all of the financial results andratios typically used by securities analysts to evaluate performance in thecommercial banking industry, the Committee requested that Sandler O’Neill &Partners, L.P. (“Sandler”), Bankshares’ investment banker, provide suchinformation. Sandler’s peer group consisted of 13 of the 14 peer organizationsidentified by Cook, the lone exception being a company that had been acquiredin 2005.

Theperformance information provided to the Committee by Sandler included fivemetrics relating to valuation, 11 metrics relating to trading and operatingperformance, and a comparison of Bankshares’ 1-year, 3-year and 5-year totalshareholder returns to the peer group, a select group of Mid-Atlantic bankholding companies and a select group of regional bank holding companies.

Thevaluation metrics were: price/earnings ratio (2006 and 2007), long-term growthrate estimate in earnings per share, price/earnings ratio divided by long-termgrowth rate, price/tangible book value ratio, and premium to core depositsrate. In these categories, among the 14 companies (including Bankshares), Banksharesranked 4th, 5th, 9th, 6th, 9th and 3rd, respectively.  The relative trading and operating metricsincluded, with respect to profitability: core return on average assets, corereturn on average equity, return on average tangible equity, net interest margin,efficiency ratio, fee income ratio, year-over-year EPS growth andyear-over-year net income growth. In these categories Bankshares ranked 1st,9th, 12th, 3rd, 2nd, 9th, 3rd and 6th, respectively. In the capital measurementof tangible common equity divided by tangible assets, Bankshares ranked 1st,and in the credit quality metrics of reserves divided by non-performing assets,and non-performing assets divided by assets, Bankshares ranked 1st and 4th,respectively. Bankshares’ 1-year, 3-year and 5-year total shareholder returnsof 15.4%, 75.3% and 70.0%, respectively, compared to 7.2%, 62.2% and 83.4% forthe peer group, 7.8%, 48.9% and 77.3% for the group of Mid-Atlantic bankholding companies, and 9.4%, 77.0% and 98.9% for the group of regional bankholding companies.

TheCommittee also reviewed five years of financial highlights for Bankshares andcomparable data that showed Bankshares as (i) one of only seven bank holdingcompanies (with a market capitalization greater than $2 billion and less than$50 billion) in the country with a Net Interest Margin greater than 4.0%, ROAAgreater than 1.5%, Tangible Equity/Assets greater than 7.5% and NPAs/Assets 40bps or lower.

Withthe foregoing information as background, the Committee’s decisions regardingsenior executive officer 2006 compensation were primarily based upon anassessment of each senior executive officer’s leadership performance andpotential to enhance long-term shareholder value.  The Committee members relied upon theirjudgment about each individual - and not on rigid guidelines or formulas, orshort-term changes in business performance - in determining the amount and mixof compensation elements for each senior executive officer. Key factorsaffecting the Committee’s judgments included the nature, scope and level of theexecutive’s responsibilities; the executive’s contribution to Bankshares’financial results; the executive’s effectiveness in leading Banksharesinitiatives to improve customer service, productivity, cash flow andprofitability; the executive’s contribution to Bankshares’ commitment tocorporate responsibility, including the executive’s success in creating aculture of integrity and compliance with applicable law and Bankshares’ ethicspolicies; and the executive’s commitment to corporate citizenship.

Basedupon a belief that equity compensation should be a larger relative part of the overallcompensation mix for the most senior executives than it had historically been,based on peer evaluation, and based on the understanding that equity ownershipamongst our senior executives was lower than many of our competitors, theCommittee decided on the following targets for compensation mix:
| **Name**   | ** ** | **% Salary** | ** ** | **% Cash Bonus  Opportunity** | ** ** | **% Long-term  equity** |
|------------|------------|--------------|------------|-------------------------------|------------|-------------------------|
| Mr. Kelly  |       | 30.0         |       | 30.0                          |       | 40.0                    |
| Mr. Troupe |       | 45.0         |       | 25.0                          |       | 30.0                    |
| Mr. Mason  |       | 33.3         |       | 33.3                          |       | 33.3                    |
| Mr. Wilson |       | 33.3         |       | 33.3                          |       | 33.3                    |
| Mr. Reid   |       | 37.5         |       | 37.5                          |       | 25.0                    |

 

Furthermore,the Committee looked at the mix of equity related compensation with the beliefthat it should be comprised of reward 

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createdby stock price appreciation and reward created by long term operatingperformance.  In providing for the former,we elected to use annual stock option awards, and in the case of the latter wecreated restricted stock units in conjunction with a long-term incentive programtied to achieving benchmark results in pre-tax operating income over a threeyear period.  As we intended to issueunits to individual executives only once in any three year period, wedetermined that only one fourth of the target award would be used incalculating the equity component of total compensation in any given year inwhich an unvested award remained outstanding. In determining the mix of the equity component to each executive, weallocated a greater percentage of stock options to the most senior executives,believing that the shareholders benefited from their closer relativerelationship to the appreciation of the stock.

Decisionsconcerning specific compensation elements and total compensation paid orawarded to Bankshares’ senior executive officers, including the Chief ExecutiveOfficer, for 2006 were made within the framework described above and afterconsultation with Cook, the Committee’s independent compensation consultant.The Committee also considered each executive’s 2005 total compensation and theappropriate balance between incentives for long-term and short-termperformance. With respect to senior executive officers other than the ChiefExecutive Officer, the Committee also considered the Chief Executive Officer’sevaluation of the performance, value and contributions of each such executive.In implementing its 2006 executive compensation program in March 2006, theCommittee also considered Bankshares’ financial performance during 2005,including the 20.4% increase in net income; the 18.1% increase in dilutedearnings per share; the 8.1% increase in the stock price during 2005; thesuccessful integration of the Community Bank of Northern Virginia acquisition;the substantial increases in loans, deposits and noninterest income;achievement of even better credit quality than in 2004 (which has been the bestin the past 20 years); improvements in returns on assets and equity;improvements in the efficiency ratio; and maintenance of strong capital levels.The Committee also reviewed Bankshares’ performance relative to peers on manyof these metrics. In all cases, the specific decisions involving 2006 seniorexecutive officer compensation were ultimately based upon the Committee’sjudgment about the individual executive’s performance and potential futurecontributions and about whether each particular payment or award would providean appropriate incentive and reward for performance that would sustain andenhance long-term stockholder value.

TheCommittee makes a recommendation to the Bankshares Board of Directors, whichdetermines Mr. Kelly’s compensation. For 2006, Mr. Kelly received $950,000 insalary, a target cash bonus of $950,000 under the ACIP, non-qualified stockoptions for 120,000 shares of common stock valued at $843,142 on the date ofgrant and which become exercisable in equal installments over three years, andparticipation in the 2006 LTIP with a target award of 39,236 restricted stockunits valued at $1,500,000 on the date of grant. In addition, in March 2006,Mr. Kelly received a restricted stock grant of 104,630 shares valued at $4million on the date of grant. This award, which the Committee made forretention purposes in lieu of extending Mr. Kelly’s contract beyond its currentannual one-year renewal, vests pro rata over a four year period and is subjectto forfeiture if Mr. Kelly is terminated for cause or voluntarily terminateshis employment prior to any vesting date. The Committee based its decisions onits assessment of Mr. Kelly’s performance. This assessment included a review of significant accomplishments andstrong operating performance, as well as stock price performance during 2004and 2005, all as discussed above.

InDecember 2006, the Committee awarded 2006 bonuses to senior management at thesame levels as 2005 bonuses except for Mr. Wilson who had received a lowerbonus in 2005.  These bonuses wereawarded pursuant to the PNC Merger Agreement, and were paid in December at therequest of PNC.  No other bonuses will bepaid to these individuals in respect of 2006.

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***Compensation Committee Report***

TheCompensation Committee of the Board of Directors of Bankshares has reviewed anddiscussed the Compensation Discussion and Analysis contained in this Item 11 toAnnual Report on Form 10-K with management. Based upon that review and those discussions, the Compensation Committeerecommends to the Board of Directors that the Compensation Discussion andAnalysis be included in this Annual Report on Form 10-K.

**The Compensation Committee**

AnthonyW. Deering (Chair)

GeorgeL. Bunting, Jr.

ChristianH. Poindexter

ClaytonS. Rose

Donald J. Shepard

***Summary Compensation Table***

The following table shows all compensation earned by our ChiefExecutive Officer, our Chief Financial Officer, and the next three highestcompensated executive officers for 2006.

On January 10, 2006, Bankshares announced athree-for-two stock split on its common stock. Share numbers and per share amounts used in the Summary CompensationTable and all other tables in this Part III of Form 10-K have been adjusted togive effect to the split. 
| **Name and Principal  Position**   | ** ** | **Year** | ** ** | **Salary  (1)** | ** ** | **Bonus  (2)** | ** ** | **Stock  Awards  (3)** | ** ** | **Option  Awards  (4)** | ** ** | **Non-  Equity  Incentive  Plan  Compensation** | ** ** | **Change in  Pension  Value and  Nonqualified  Deferred  Compensation  Earnings  (5)** | ** ** | **All Other  Compensation  (6)** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|----------|------------|-----------------|------------|----------------|------------|------------------------|------------|-------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-----------|------------|
| Edward J. Kelly, III

President & CEO    |       | 2006     |       | $               | 950,000    |           | $          | 950,000                |       | $                       | 2,047,193  |                                            | $          | 881,454                                                                                          |       | $                                     | 0          |      | $          | 458,900 |   | $ | 363,077 |   | $ | 5,650,624 |   |
| Terry L. Troupe

CFO                         |       | 2006     |       | 300,000         |       | 180,000        |       | 353,231                |       | 102,975                 |       | 0                                               |       | 23,072                                                                                           |       | 83,253                                |       | 1,042,531 |       |
| Alexander T. Mason

Vice Chairman & COO  |       | 2006     |       | 750,000         |       | 750,000        |       | 963,282                |       | 486,320                 |       | 0                                               |       | 10,930                                                                                           |       | 247,631                               |       | 3,208,163 |       |
| Jay M. Wilson

Vice Chairman and CEO of  IWM |       | 2006     |       | 750,000         |       | 750,000        |       | 188,667                |       | 259,894                 |       | 5,426                                           |       | 11,115                                                                                           |       | 180,989                               |       | 2,146,061 |       |
| J. Marshall Reid

President of  MSD&T    |       | 2006     |       | 500,000         |       | 500,000        |       | 462,780                |       | 162,290                 |       | 4,478                                           |       | 27,569                                                                                           |       | 227,765                               |       | 1,884,882 |       |
|                                              |            |          |            |                 |            |                |            |                        |            |                         |            |                                                 |            |                                                                                                  |            |                                       |            |           |            |  |  |  |  |  |  |  |  |

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(1)  Includes salary deferred during 2006pursuant to Bankshares’ Nonqualified Deferred Compensation Plan. Such deferredamounts are also included in the amounts provided under the heading “ExecutiveContributions in Last FY” in the Nonqualified Deferred Compensation Tablebelow.

(2)  Represents bonus earned for 2006 andpaid in December 2006. Does not include bonuses earned in 2005 and paid inMarch 2006 in the following amounts: Mr. Kelly - $950,000; Mr. Troupe -$180,000; Mr. Mason - $750,000; Mr. Wilson - $375,000; and Mr. Reid - $500,000.

(3)  Represents the compensation costs of the2006 LTIP, RSUs and RSAs, including accrued dividends for financial reportingpurposes for the year ended December 31, 2006 under FAS 123(R), rather than anamount paid to or realized by the Named Executive.  Refer to Note No. 15 — Stock-basedCompensation Expense of the consolidated financial statements for theassumptions made in determining FAS 123(R) values.  The FAS 123(R) value as of the grant date forRSUs and RSAs are spread over the number of months of service required for thegrant to become non-forfeitable.  Inaddition, ratable amounts expensed for grants that were granted in prior years

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are included, that is, amounts in respect of grantsmade in 2003 through 2005.  There can beno assurance that the FAS 123(R) amounts will ever be realized.

(4)  Represents the compensation costs ofstock options for financial reporting purposes for the year ended December 31,2006 under FAS 123(R), rather than an amount paid to or realized by the NamedExecutive.  Refer to Note No. 15 —Stock-based Compensation Expense of the consolidated financial statements forthe assumptions made in determining FAS 123(R) values.  The FAS 123(R) value as of the grant date forstock options is spread over the number of months of service required for thegrant to become non-forfeitable.  Inaddition, ratable amounts expensed for grants that were granted in prior yearsare included, that is, amounts in respect of grants made in 2003 through2005.  There can be no assurance that theFAS 123(R) amounts will ever be realized.

(5)  Amounts shown are solely an estimate ofthe increase in actuarial present value of the Named Executive’s age 65 accruedbenefit under Bankshares’ retirement plans for 2006.  Assumptions are further described in Note No.14 — Pension and Other Postretirement Benefit Plans of the consolidatedfinancial statements.  There can be noassurance that the amounts shown will ever be realized by the Named Executives.

(6)  See the Table captioned “All OtherCompensation-2006” for a break down of these amounts, which includeperquisites, dividend equivalents and Bankshares match on 401(k) plan.  In addition to the items in that chart, the NamedExecutives are provided dental, health, vision, life insurance and long-termdisability insurance benefits, which are available to all employees.  In addition, Bankshares has a dining roomwhich operates for breakfast and lunch, is used by Bankshares employees forbusiness purposes and may be used generally by executive officers free ofcharge. The average value of a breakfast in the dining room is $15 and theaverage value of a lunch in the dining room is $30.

**All Other Compensation - 2006**

Thefollowing chart reflects certain other compensation provided to Messrs. Kelly,Troupe, Mason, Wilson and Reid.
| **Name**   | ** ** | **401(k) (1)** | ** ** | **Auto** | ** ** | **Club  Dues** | ** ** | **Cash  Balance  SERP** | ** ** | **401(k)  SERP** | ** ** | **Airfare** | ** ** | **Total** | ** ** |
|------------|------------|---------------------|------------|----------|------------|----------------|------------|-------------------------|------------|------------------|------------|-------------|------------|-----------|------------|
| Mr. Kelly  |       | $                   | 13,200     |     | $          | 9,592          |       | $                       | 20,461     |             | $          | 236,700     |       | $         | 78,900     |   | $ | 4,224 |   | $ | 363,077 |   |
| Mr. Troupe |       | 13,200              |       | 6,253    |       | 0              |       | 50,600                  |       | 13,200           |       | 0           |       | 83,253    |       |
| Mr. Mason  |       | 13,200              |       | 16,826   |       | 14,605         |       | 142,100                 |       | 60,900           |       | 0           |       | 247,631   |       |
| Mr. Wilson |       | 13,200              |       | 1,344    |       | 3,445          |       | 114,100                 |       | 48,900           |       | 0           |       | 180,989   |       |
| Mr. Reid   |       | 13,200              |       | 9,825    |       | 19,140         |       | 147,200                 |       | 38,400           |       | 0           |       | 227,765   |       |
|            |            |                     |            |          |            |                |            |                         |            |                  |            |             |            |           |            |  |  |  |  |  |  |  |

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(1) The 401(k) matching contribution is available to all employees.

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***Grants of Plan-Based Awards Table***(1)

Thefollowing table sets forth information with respect to each grant of an awardmade to each of the Named Executives in 2006 under any compensation plan.
|                                            | ** ** | ** **      | ** ** | **Estimated Future Payouts Under  Equity Incentive Plan Awards(#)** | ** ** | **All Other  Stock Awards:  Number of** | ** ** | **All Other  Option  Awards:  Number of  Securities** | ** ** | **Exercise  or Base  Price of  Option** | ** ** | **Grant Date  Fair Value of  Stock and** | ** ** |
|--------------------------------------------|------------|-----------------|------------|---------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **Name and Principal  Position** | ** ** | **Grant  Date** | ** ** | **Threshold  (2)**                                                                                | ** ** | **Target  (2)**                                        | ** ** | **Maximum  (2)**                                                | ** ** | **Shares of Stock  or Units**      | ** ** | **Underlying  Options**                                      | ** ** | **Awards  ($/Sh)** | ** ** | **Option  Awards (4)** | ** ** |
| Edward J. Kelly, III                       |       | 3/29/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 0                                                 |       | 120,000                                                      |       | $ | 38.23 |   | 982,000 |   |
| President & CEO                        |       | 3/13/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 22,590                                            |       | 0                                                            |       | 0.01 |   | 874,233 |   |
|                                            |       | 3/29/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 104,630                                           |       | 0                                                            |       | 0.01 |   | 3,998,959 |   |
|                                            |       | 4/1/06          |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 8,683                                             | (3)        | 0                                                            |       | 0.00 |   | 333,861 |   |
|                                            |       | 3/29/06         |       | 9,809                                                                                             |       | 39,236                                                 |       | 58,854                                                          |       | 0                                                 |       | 0                                                            |       | 0.00 |   | 1,499,992 |   |
| Terry L. Troupe                            |       | 3/7/06          |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 22                                                | (3)        | 0                                                            |       | 0.00 |   | 843 |   |
| CFO                                        |       | 3/13/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 6,909                                             |       | 0                                                            |       | 0.01 |   | 267,486 |   |
|                                       |       | 3/29/06         |       | 3,923                                                                                             |       | 15,694                                                 |       | 23,541                                                          |       | 0                                                 |       | 0                                                            |       | 0.00 |   | 599,982 |   |
| Alexander T. Mason                         |       | 3/29/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 0                                                 |       | 65,000                                                       |       | 38.23 |   | 532,350 |   |
| Vice Chairman & COO                    |       | 3/13/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 19,932                                            |       | 0                                                            |       | 0.01 |   | 771,368 |   |
|                                            |       | 11/1/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 1,429                                             | (3)        | 0                                                            |       | 0.00 |   | 64,162 |   |
|                                            |       | 3/29/06         |       | 5,885                                                                                             |       | 23,541                                                 |       | 35,312                                                          |       | 0                                                 |       | 0                                                            |       | 0.00 |   | 899,977 |   |
| Jay M. Wilson                              |       | 3/29/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 0                                                 |       | 65,000                                                       |       | 38.23 |   | 532,350 |   |
| Vice Chairman  and CEO of                  |       | 12/14/06        |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 10,463                                            |       | 0                                                            |       | 0.01 |   | 420,924 |   |
| IWM                                        |       | 3/29/06         |       | 5,885                                                                                             |       | 23,541                                                 |       | 35,312                                                          |       | 0                                                 |       | 0                                                            |       | 0.00 |   | 899,972 |   |
| J. Marshall Reid                           |       | 3/29/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 0                                                 |       | 20,000                                                       |       | 38.23 |   | 163,800 |   |
| President of MSD&T                     |       | 3/7/06          |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 22                                                | (3)        | 0                                                            |       | 0.00 |   | 843 |   |
|                                            |       | 3/13/06         |       | 0                                                                                                 |       | 0                                                      |       | 0                                                               |       | 10,630                                            |       | 0                                                            |       | 0.01 |   | 411,381 |   |
|                                            |       | 3/29/06         |       | 3,923                                                                                             |       | 15,694                                                 |       | 23,541                                                          |       | 0                                                 |       | 0                                                            |       | 0.00 |   | 599,982 |   |
|                                            |            |                 |            |                                                                                                   |            |                                                        |            |                                                                 |            |                                                   |            |                                                              |            |  |  |  |  |  |

----

(1) There are no amounts that need to be reported under the column “EstimatedFuture Payouts Under Non-Equity Incentive Plan Awards,” so it has not beenincluded.

(2)  Relatesonly to potential awards under the 2006 LTIP, approved on March 29, 2006.The amounts do not include dividends earned on the original balancesawarded.  The threshold amount representsthe minimum award to be paid out under the plan if minimum performancethresholds are met.  The maximum columnrepresents the largest award possible under the plan and the target columnrepresents the expected award under the plan.

(3) This represents dividend equivalent shares earned on previous awardsthat were issued upon the vesting of such award.

(4) Option compensation is based on fair value of the award as determinedusing the Black-Scholes method based on the methods used under FAS 123(R).  The value of stock awards is based on theclosing price of one share of stock on the date of issuance less anycompensation paid for the award.  Thegrant date fair value of the dividend equivalent shares is based on marketvalue of one share of common stock on the date of issuance.  In accordance with FAS 123(R) the expenserecorded for dividend equivalent shares is based on the total value of thedividend paid on the dividend payment date amortized over the remaining vestingperiod of the award.

126

----

 

Fora discussion of various elements of compensation, including compensationarrangements and an explanation of the level of salary and bonus in proportionto total compensation, see “Elements of Compensation Program” and “2006Compensation” in the Compensation Discussion and Analysis.

Allstock-based awards shown in the Grants of Plan-Based Awards Table were issuedpursuant to the 1999 Plan and the programs thereunder.  The “Estimated Future Payouts Under EquityIncentive Plan Awards” columns in that table include the potential awards underthe Company’s 2006 LTIP.  The amounts ofawards earned under the 2004 LTIP were determined at the end of 2005 and wereawarded in March of 2006 and therefore appear as part of “All Other StockAwards” column.

Weand MSD&T have entered into an agreement with Mr. Kelly pursuant to whichhe serves in his executive positions. The agreement was for an initial term offive years, which ended February 2, 2006 and is subject to annual renewalthereafter unless either Bankshares, MSD&T or Mr. Kelly provide appropriateadvance notice of termination. Mr. Kelly’s agreement has been extended by itsterms to February 2, 2008. Mr. Kelly’s annual base salary is not less than$850,000, which may be increased from time to time.  The agreement provides that his base salarywill not be less in any year than in the preceding year.  He was eligible for bonuses as a Class Iparticipant in the Annual Incentive Compensation Plan and will be eligible forbonuses as a Class I participant in the 2006 Incentive Plan.  Mr. Kelly will participate in all othercompensation plans for which he is eligible, including the retirement plansdiscussed above.

OnJune 14, 2005, we and MSD&T approved an Amended and Restated ExecutiveEmployment Agreement among Bankshares, MSD&T and Jay M. Wilson, pursuant towhich Mr. Wilson serves as our Vice Chairman of Bankshares and as Chairman andChief Executive Officer of Investment and Wealth Management of Bankshares andMSD&T. The term of this agreement is initially from January 1, 2005 throughJanuary 1, 2008 and is subject to annual renewal thereafter unless eitherBankshares, MSD&T or Mr. Wilson provide appropriate advance notice oftermination. Mr. Wilson’s annual base salary is not less than $750,000, whichmay be increased from time to time. The agreement provides that his base salarywill not be less in any year than in the preceding year. He will be eligiblefor a bonus of up to 100% of his current salary and will participate in allother compensation plans for which he is eligible, including the retirementplans discussed above.

127

----

***Outstanding Equity Awards at Fiscal Year-End***
|                                            | ** ** | **Option Awards**                                                        | ** ** | **Stock Awards**                                                                 | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| **Name and  Principal Position** | ** ** | **Number of  Securities  Underlying  Unexercised  Options  Exercisable** | ** ** | **Number of  Securities  Underlying   Unexercised  Options  Unexercisable** | ** ** | **Equity  Incentive  Plan  Awards:  Number of  Securities  Underlying  Unexercised  Unearned  Options** | ** ** | **Option  Exercise  Price** | ** ** | **Option  Expiration  Date** | ** ** | **Number  of Shares  or Units of  Stock That  Have Not  Vested** | ** ** | **Market   Value of  Shares or  Units of  Stock That  Have Not  Vested ($)** | ** ** | **Equity  Incentive  Plan  Awards:  Number of  Unearned  Shares,  Units  or Other  Rights  That  Have  Not  Vested** | ** ** | **Equity  Incentive  Plan  Awards:  Market or  Payout  Value of  Unearned  Shares,  Units or  Other  Rights  That  Have Not  Vested ($)** | ** ** |
| Edward J. Kelly, III                       |       | 3,820                                                                         | (1)        | 0                                                                                     |       | 0 |   | $ | 26.167 |   | 3/1/2011 |   |   |   |   |   |   |   |   |   |
| President & CEO                        |       | 3,679                                                                         | (1)        | 0                                                                                     |       | 0 |   | 26.167 |   | 3/1/2011 |   |   |   |   |   |   |   |   |   |
|                                            |       | 3,679                                                                         | (2)        | 0                                                                                     |       | 0 |   | 26.167 |   | 3/1/2011 |   |   |   |   |   |   |   |   |   |
|                                            |       | 3,820                                                                         | (2)        | 0                                                                                     |       | 0 |   | 26.167 |   | 3/1/2011 |   |   |   |   |   |   |   |   |   |
|                                            |       | 75,000                                                                        | (3)        | 0                                                                                     |       | 0 |   | 29.993 |   | 3/12/2012 |   |   |   |   |   |   |   |   |   |
|                                            |       | 70,666                                                                        | (4)        | 0                                                                                     |       | 0 |   | 23.073 |   | 4/1/2013 |   |   |   |   |   |   |   |   |   |
|                                            |       | 4,333                                                                         | (5)        | 0                                                                                     |       | 0 |   | 23.073 |   | 4/1/2013 |   |   |   |   |   |   |   |   |   |
|                                            |       | 65,001                                                                        | (6)        | 29,185                                                                                | (6)        | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 3,313                                                                                 | (7)        | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                            |       | 40,001                                                                        | (8)        | 77,071                                                                                | (8)        | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 2,928                                                                                 | (9)        | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 120,000                                                                               | (10)       | 0 |   | 38.23 |   | 3/29/2016 |   |   |   |   |   |   |   |   |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 22,590 | (11) | 1,056,986 |   | 39,236 | (15) | 1,835,852 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 104,630 | (12) | 4,895,638 |   | 896 | (16) | 41,924 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 538 | (13) | 25,173 |   | 0 |   | 0 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 3,153 | (14) | 147,529 |   | 0 |   | 0 |   |
| Terry L. Troupe                            |       | 7,417                                                                         | (17)       | 0                                                                                     |       | 0 |   | 16.896 |   | 3/14/2010 |   |   |   |   |   |   |   |   |   |
| CFO                                        |       | 832                                                                           | (18)       | 0                                                                                     |       | 0 |   | 16.896 |   | 3/14/2010 |   |   |   |   |   |   |   |   |   |
|                                       |       | 2,499                                                                         | (19)       | 0                                                                                     |       | 0 |   | 29.993 |   | 3/12/2012 |   |   |   |   |   |   |   |   |   |
|                                       |       | 5,001                                                                         | (20)       | 0                                                                                     |       | 0 |   | 29.993 |   | 3/12/2012 |   |   |   |   |   |   |   |   |   |
|                                       |       | 5,418                                                                         | (21)       | 0                                                                                     |       | 0 |   | 23.073 |   | 4/1/2013 |   |   |   |   |   |   |   |   |   |
|                                       |       | 9,582                                                                         | (22)       | 0                                                                                     |       | 0 |   | 23.073 |   | 4/1/2013 |   |   |   |   |   |   |   |   |   |
|                                       |       | 0                                                                             |       | 3,313                                                                                 | (7)        | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                       |       | 15,000                                                                        |       | 4,186                                                                                 | (23)       | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                       |       | 0                                                                             |       | 2,928                                                                                 | (9)        | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                       |       | 5,002                                                                         |       | 7,070                                                                                 | (24)       | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                       |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 6,909 | (11) | 323,319 |   | 15,694 | (15) | 734,322 |   |
|                                       |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 1,500 | (25) | 70,185 |   | 358 | (16) | 16,751 |   |
|                                       |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 81 | (26) | 3,790 |   | 0 |   | 0 |   |
|                                       |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 164 | (13) | 7,674 |   | 0 |   | 0 |   |
| Alexander T. Mason                         |       | 10,404                                                                        | (27)       | 0                                                                                     |       | 0 |   | 28.83 |   | 11/5/2013 |   |   |   |   |   |   |   |   |   |
| Vice Chairman & COO                    |       | 27,096                                                                        | (27)       | 0                                                                                     |       | 0 |   | 28.833 |   | 11/5/2013 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 3,313                                                                                 | (7)        | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                            |       | 25,001                                                                        | (28)       | 9,185                                                                                 | (28)       | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                            |       | 22,500                                                                        | (29)       | 42,072                                                                                | (29)       | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 2,928                                                                                 | (9)        | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 65,000                                                                                | (30)       | 0 |   | 38.23 |   | 3/29/2016 |   |   |   |   |   |   |   |   |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 19,932 | (11) | 932,618 |   | 23,541 | (15) | 1,101,483 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 475 | (13) | 22,225 |   | 538 | (16) | 25,173 |   |
| Jay M. Wilson                              |       | 2,928                                                                         | (31)       | 5,856                                                                                 | (31)       | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
| Vice Chairman and CEO of  IWM              |       | 9,572                                                                         | (31)       | 19,144                                                                                | (31)       | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                       |       | 0                                                                             |       | 65,000                                                                                | (30)       | 0 |   | 38.23 |   | 3/29/2016 |   |   |   |   |   |   |   |   |   |
|                                       |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 10,463 | (32) | 489,564 |   | 23,541 | (15) | 1,101,483 |   |
|                                       |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 0 |   | 0 |   | 538 | (16) | 25,173 |   |
| J. Marshall Reid                           |       | 7,582                                                                         | (18)       | 0                                                                                     |       | 0 |   | 16.896 |   | 3/14/2010 |   |   |   |   |   |   |   |   |   |
| President of MSD&T                     |       | 8,917                                                                         | (33)       | 0                                                                                     |       | 0 |   | 16.896 |   | 3/14/2010 |   |   |   |   |   |   |   |   |   |
|                                            |       | 19,167                                                                        | (3)        | 0                                                                                     |       | 0 |   | 29.993 |   | 3/12/2012 |   |   |   |   |   |   |   |   |   |
|                                            |       | 3,333                                                                         | (19)       | 0                                                                                     |       | 0 |   | 29.993 |   | 3/12/2012 |   |   |   |   |   |   |   |   |   |
|                                            |       | 18,166                                                                        | (34)       | 0                                                                                     |       | 0 |   | 23.073 |   | 4/1/2013 |   |   |   |   |   |   |   |   |   |
|                                            |       | 4,333                                                                         | (5)        | 0                                                                                     |       | 0 |   | 23.073 |   | 4/1/2013 |   |   |   |   |   |   |   |   |   |
|                                            |       | 20,001                                                                        | (35)       | 6,685                                                                                 | (35)       | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 3,313                                                                                 | (7)        | 0 |   | 30.167 |   | 3/3/2014 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 2,928                                                                                 | (9)        | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                            |       | 5,002                                                                         | (24)       | 7,070                                                                                 | (24)       | 0 |   | 34.147 |   | 3/7/2015 |   |   |   |   |   |   |   |   |   |
|                                            |       | 0                                                                             |       | 20,000                                                                                | (10)       | 0 |   | 38.23 |   | 3/29/2016 |   |   |   |   |   |   |   |   |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 1,500 | (25) | 70,185 |   | 15,694 | (15) | 0 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 10,630 |   | 497,378 |   | 358 |   | 0 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 253 |   | 11,838 |   | 0 |   | 734,322 |   |
|                                            |       |                                                                          |       |                                                                                  |       |   |   |   |   |   |   | 82 |   | 3,837 |   | 0 |   | 16,751 |   |
|                                            |            |                                                                               |            |                                                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)  These options were granted 3/1/2001.  They vest and become exercisable on thesecond anniversary of the grant.

(2)  These options were granted 3/1/2001.  They vest and become exercisable on thefourth anniversary of the grant.

(3)  These options were granted 3/12/2002.  They vest and become exercisable in equalinstallments (subject to rounding) on the first, second, and third anniversaryof the grant.

(4)  These options were granted 4/1/2003.  They vest and become exercisable in installments,25,001 shares on the first anniversary, 25,000 shares on the second anniversaryand 20,665 shares on the third anniversary of the grant.

(5)  These options were granted 4/1/2003. Theyvest and become exercisable on the third anniversary of the grant.

(6)  These options were granted 3/3/2004.  They vest and become exercisable ininstallments, 32,501 shares on the first anniversary, 32,500 shares on thesecond anniversary and 29,185 shares on the third anniversary of the grant.

(7)  These options were granted 3/3/2004. Theyvest and become exercisable on the third anniversary of the grant.

(8)  These options were granted 3/7/2005.  They vest and become exercisable ininstallments, 40,001 shares on the first anniversary, 40,000 shares on thesecond anniversary and 37,071 shares on the third anniversary of the grant.

(9)  These options were granted 3/7/2005. Theyvest and become exercisable on the third anniversary of the grant.

(10)  These options were granted 3/29/2006.  They vest and become exercisable in equalinstallments (subject to rounding) on the first, second, and third anniversaryof the grant.

(11)  These restricted stock awards were granted3/13/2006.  They vest and becomeexercisable on the first anniversary of the grant.

**(**12) These restricted stock units were granted 3/29/2006.  They vest inequal installments (subject to rounding) on the first, second, third, andfourth anniversary of the grant.  Even though the shares vest, they remainunissued until Mr. Kelly’s departure from the company.

(13)  These awards represent the unvested dividendson the restricted stock awards granted 3/13/2006.  They vest when the underlying awardsvest.  See footnote (11).

(14)  These awards represent the unvested dividendson the restricted stock units granted 3/29/2006.  They vest when the underlying awardsvest.  See footnote (12).

(15)  These restricted stock units were granted3/29/2006.  They are part of the 2006Long Term Incentive Plan.  The amountspresented are based on the target amount to be awarded.  The performance period under assessmentstarts 1/1/2006 and ends 12/31/2008.  Theawards then have a one year vesting period from that time.  The eventual number of shares awarded vest12/31/09.

(16)  These shares represent the unvested dividendson the restricted stock units to be awarded as part of the 2006 LTIP.  They vest when the underlying awards vest.

See footnote (15).

(17)  These options were granted 3/14/2000.  They vest and become exercisable ininstallments, 5,918 shares on the first anniversary and 1,499 shares on thethird anniversary of the grant.

(18)  These options were granted 3/14/2000.  They vest and become exercisable on the firstanniversary of the grant.

(19)  These options were granted 3/12/2002. Theyvest and become exercisable on the third anniversary of the grant.

(20)  These options were granted 3/12/2002.  They vest and become exercisable in equalinstallments, (subject to rounding) on the first and second anniversary of thegrant.

(21)  These options were granted 4/1/2003.  They vest and become exercisable ininstallments, 1,085 shares on the second anniversary and 4,333 shares on thethird anniversary of the grant.

(22)  These options were granted 4/1/2003.  They vest and become exercisable ininstallments, 5,001 shares on the first anniversary, 3,915 shares on the secondanniversary and 666 shares on the third anniversary of the grant.

(23)  These options were granted 3/3/2004.  They vest and become exercisable ininstallments, 7,500 shares on the first anniversary, 7,500 shares on the secondanniversary and 4,186 shares on the third anniversary of the grant.

(24)  These options were granted 3/7/2005.  They vest and become exercisable ininstallments, 5,002 shares on the first anniversary, 4,999 shares on the secondanniversary and 2,071 shares on the third anniversary of the grant.

(25)  These restricted stock awards were granted3/7/2005.  They vest and becomeexercisable in equal installments (subject to rounding) on the first, second,and third anniversary of the grant.  Thefirst installment has already vested, and the remaining shares are split evenlybetween the second and third installments.

(26)  These awards represent the unvested dividendson the restricted stock awards granted 3/7/2005.  They vest when the underlying awardsvest.  See footnote (25).

(27)  These options were granted 11/5/2003.  They vest and become exercisable in equalinstallments (subject to rounding) on the first, second, and third anniversaryof the grant.

(28)  These options were granted 3/3/2004.  They vest and become exercisable ininstallments, 12,501 shares on the first anniversary, 12,500 shares on thesecond anniversary and 9,185 shares on the third anniversary of the grant.

(29)  These options were granted 3/7/2005.  They vest and become exercisable ininstallments, 22,500 shares on the first anniversary, 22,500 shares on thesecond anniversary and 19,572 shares on the third anniversary of the grant.

(30)  These options were granted 3/29/2006.  They vest and become exercisable in equalinstallments (subject to rounding) on the first, second, and third anniversaryof the grant.

(31)  These options were granted 3/7/2005.  They vest and become exercisable in equalinstallments (subject to rounding) on the first, second, and third anniversaryof the grant.

(32)  These restricted stock awards were granted12/14/2006.  They vest and becomeexercisable in equal installments (subject to rounding) on the first, second,and third anniversary of the grant.

(33)  These options were granted 3/14/2000.  They vest and become exercisable ininstallments, 5,918 shares on the first anniversary and 2,999 shares on thethird anniversary of the grant.

(34)  These options were granted 4/1/2003.  They vest and become exercisable ininstallments, 7,500 shares on the first anniversary, 7,500 shares on the secondanniversary and 3,166 shares on the third anniversary of the grant.  The expiration date listed in the table isthe date the grant expires and is ten years after the date of grant.

(35)  These options were granted 3/3/2004.  They vest and become exercisable ininstallments, 10,001 shares on the first anniversary, 10,000 shares on thesecond anniversary and 6,685 shares on the third anniversary of the grant.  The expiration date listed in the table isthe date the grant expires and is ten years after the date of grant.

(36)  These options were granted 3/7/2005.  They vest and become exercisable ininstallments, 5,002 shares on the first anniversary, 4,999 shares on the secondanniversary and 37,071 shares on the third anniversary of the grant.  The expiration date listed in the table isthe date the grant expires and is ten years after the date of grant.

128

----

*Option Exercises and Stock Vested*
|                                                | ** ** | **Option Awards**                                     | ** ** | **Stock Awards (1)**            | ** ** |
|------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Name and Principal Position** | ** ** | **Number of Shares  Acquired on  Exercise** | ** ** | **Value Realized  on Exercise** | ** ** | **Number of Shares  Acquired on  Vesting** | ** ** | **Value Realized  on Vesting** | ** ** |
| Edward J. Kelly, III                           |       | 0                                                          |       | $                                         | 0          |   | 98,683 |   | $ | 3,793,731 |   |
| President & CEO                            |       |                                                       |       |                                      |       |   |   |   |   |
| Terry L. Troupe                                |       | 0                                                          |       | 0                                         |       | 772 |   | 29,585 |   |
| CFO                                            |       |                                                       |       |                                      |       |   |   |   |   |
| Alexander T. Mason                             |       | 0                                                          |       | 0                                         |       | 16,429 |   | 737,557 |   |
| Vice Chairman & COO                        |       |                                                       |       |                                      |       |   |   |   |   |
| Jay M. Wilson                                  |       | 0                                                          |       | 0                                         |       | 0 |   | 0 |   |
| Vice Chairman and CEO of  IWM                  |       |                                                       |       |                                      |       |   |   |   |   |
| J. Marshall Reid                               |       | 0                                                          |       | 0                                         |       | 772 |   | 29,585 |   |
| President of MSD&T                         |       |                                                       |       |                                      |       |   |   |   |   |
|                                                |            |                                                            |            |                                           |            |  |  |  |  |  |  |

----

(1)  This amountrepresents dividend equivalent shares released as part of the vesting of theunderlying awards.

***PensionBenefits***
| Name and Principal Position | ** ** | **Plan Name**                          | ** ** | **Number of  Years  Credited  Service** | ** ** | **Present Value  of Accumulated  Benefit  12/31/2006 (3)** | ** ** | **Payments  During Last  Fiscal Year** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Edward J. Kelly, III                       |       | Cash  Balance Pension Plan                  |       | 6.00                                         | (2)        | $                                                                         | 55,391     |                                             | $          | 0 |   |
| President & CEO                        |       | Supplemental Retirement Agreement |       | 28.00                                        | (1)        | 1,768,363                                                                 |       | 0                                                |       |
| Terry L. Troupe                            |       | Cash  Balance Pension Plan                  |       | 10.00                                        | (2)        | 129,973                                                                   |       | 0                                                |       |
| CFO                                        |       |                                        |       |                                         |       |                                                                      |       |                                             |       |
| Alexander T. Mason                         |       | Cash  Balance Pension Plan                  |       | 3.00                                         | (2)        | 29,894                                                                    |       | 0                                                |       |
| Vice Chairman & COO                    |       |                                        |       |                                         |       |                                                                      |       |                                             |       |
| Jay M. Wilson                              |       | Cash  Balance Pension Plan                  |       | 2.00                                         | (2)        | 21,078                                                                    |       | 0                                                |       |
| Vice Chairman and CEO  of IWM              |       |                                        |       |                                         |       |                                                                      |       |                                             |       |
| J. Marshall Reid                           |       | Cash  Balance Pension Plan                  |       | 14.00                                        | (2)        | 207,823                                                                   |       | 0                                                |       |
| President of MSD&T                     |       |                                        |       |                                         |       |                                                                      |       |                                             |       |
|                                            |            |                                             |            |                                              |            |                                                                           |            |                                                  |            |  |  |

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(1)  Mr. Kelly’scredited years of service under this plan begin from date he attained age25.  This was intended to restorebenefits he lost because of his departure from former jobs prior to fullretirement accruals.

(2)  Equalsnumbers of years of credited service as of December 31, 2006.  Credited service begins with the January 1subsequent to a participant’s hire date and ends with his or her last fullmonth of employment.

(3)  Represents actuarialpresent value in accordance with the same assumptions outlined in Note No. 14 —Pension and Other Postretirement Benefit Plans of the consolidated financialstatements.

Oursenior management is eligible to participate in all of the qualified retirementplans made available to our employees generally, including our employees’ CashBalance Pension Plan and the 401(k) Thrift Plan.

 

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Weentered into a nonqualified, unfunded Supplemental Retirement Agreement (the “SRA”)with Mr. Kelly upon his employment in 2001. This agreement is intended torestore benefits lost because of his departure from former jobs prior to fullretirement accruals, and to provide Mr. Kelly with a fixed level of retirementbenefits.  The SRA acts as an “umbrella”plan, as the benefit derived under the SRA’s formula is reduced by the benefitspaid under our qualified plans, our supplemental cash balance and thrift plansand Mr Kelly’s primary social security benefits.  The monthly amount of the supplementalbenefit is equal to one-twelfth of the sum of (i) the product of 0.5% of Mr.Kelly’s final average compensation multiplied by his first 10 years of service,(ii) the product of 1% of Mr. Kelly’s final average compensation multiplied byhis next 15 years of service, and (iii) the product of 3% of Mr. Kelly’s finalaverage compensation multiplied by his next 15 years of service, reduced by theoffsets above. “Final average compensation” means the average of Mr. Kelly’sannual compensation for the three full years within the final five years ofemployment that produce the highest average. Annual compensation for thispurpose includes base salary and bonus, in each case prior to reductions forelective contributions under qualified and nonqualified plans. “Years ofService” are measured from the date Mr. Kelly attained age 25. The supplementalbenefit is generally paid in the form of a single life annuity for Mr. Kelly’slife and is subject to reduction in the event of early retirement or othertermination of employment, disability or death prior to age 65. Mr. Kellyhas voluntarily agreed to consider his employment terminated, solely forpurposes of this agreement, in connection with, and upon consumation of the PNCMerger.

Noneof the other Named Executives has a supplemental retirement agreement.

***Nonqualified Deferred Compensation***
| Name                          | ** ** | **Plan  Name**     | ** ** | **Executive  Contributions   in Last FY** | ** ** | **Registrant  Contributions  in Last FY** | ** ** | **Aggregate  Earnings in  Last FY** | ** ** | **Aggregate  Withdrawals/  Distributions  In Last FY** | ** ** | **Aggregate  Balance at  Last FYE** | ** ** |
|-------------------------------|------------|--------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| Edward J. Kelly, III          |       | DCP                |       | $                                                        | 0          |                                                | $          | 0                                             |       | $                                                                | 0          |                                          | $          | 0 |   | $ | 0 |   |
| President & CEO           |       | Cash  Balance SERP |       | 0                                                        |       | 0                                                   |       | 236,700                                       |       | 0                                                                |       | 587,406                                       |       |
|                               |       | 401(K)  SERP       |       | 0                                                        |       | 0                                                   |       | 78,900                                        |       | 0                                                                |       | 222,563                                       |       |
| Terry L. Troupe               |       | DCP                |       | 0                                                        |       | 0                                                   |       | 0                                             |       | 0                                                                |       | 0                                             |       |
| CFO                           |       | Cash  Balance SERP |       | 0                                                        |       | 0                                                   |       | 50,600                                        |       | 0                                                                |       | 126,650                                       |       |
|                          |       | 401(K)  SERP       |       | 0                                                        |       | 0                                                   |       | 13,200                                        |       | 0                                                                |       | 41,800                                        |       |
| Alexander T. Mason            |       | DCP                |       | 0                                                        |       | 0                                                   |       | 0                                             |       | 0                                                                |       | 0                                             |       |
| Vice Chairman & COO       |       | Cash  Balance SERP |       | 0                                                        |       | 0                                                   |       | 142,100                                       |       | 0                                                                |       | 252,197                                       |       |
|                               |       | 401(K)  SERP       |       | 0                                                        |       | 0                                                   |       | 60,900                                        |       | 0                                                                |       | 108,710                                       |       |
| Jay M. Wilson                 |       | DCP                |       | 187,500                                                  |       | 0                                                   |       | 5,426                                         |       | 0                                                                |       | 192,926                                       |       |
| Vice Chairman and CEO  of IWM |       | Cash  Balance SERP |       | 0                                                        |       | 0                                                   |       | 114,100                                       |       | 0                                                                |       | 152,152                                       |       |
|                          |       | 401(K)  SERP       |       | 0                                                        |       | 0                                                   |       | 48,900                                        |       | 0                                                                |       | 65,365                                        |       |
| J. Marshall Reid              |       | DCP                |       | 250,000                                                  |       | 0                                                   |       | 4,478                                         |       | 0                                                                |       | 254,478                                       |       |
| President of MSD&T        |       | Cash  Balance SERP |       | 0                                                        |       | 0                                                   |       | 147,200                                       |       | 0                                                                |       | 524,647                                       |       |
|                               |       | 401(K) SERP        |       | 0                                                        |       | 0                                                   |       | 38,400                                        |       | 0                                                                |       | 161,261                                       |       |
|                               |            |                    |            |                                                          |            |                                                     |            |                                               |            |                                                                  |            |                                               |            |  |  |  |  |  |

 

Thetable above represents amounts deferred by the Named Executives pursuant toBankshares’ Deferred Compensation Plan for our officers, referred to herein asthe “DCP.”  The DCP, approved by theBoard in 2005, is unfunded and nonqualified. Generally, all executives of ourparticipating affiliates who have compensation that exceeds by a specifiedamount the compensation limit imposed by Section 401(a)(17) of the InternalRevenue Code are eligible to participate in the DCP. The number of eligibleparticipants in 2006 was 80, which included all of the Named Executives. TheDCP permits participants to elect, in the manner permitted by Section 409A ofthe Internal Revenue Code, to voluntarily defer base salary and certainincentive payments.  Participant accountsunder the DCP are credited or debited with earnings or losses based on aparticipant’s election among a number of measurement funds made available inconnection with the DCP. Subject to the requirements of Section 409A of theInternal Revenue Code, participants may elect, under certain

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circumstances,to receive distributions from the DCP while the participant is still employedwith Bankshares or one of its affiliates. With respect to distributionsfollowing separation from service, participants may elect a lump sum payment orpayment in installments, depending on the circumstances of the participant’sseparation from service.

Wesponsor an unfunded, nonqualified, supplemental Cash Balance Pension Plan (the “CashBalance SERP”), which is reflected in the above table.  All of our employees and our affiliates’employees having compensation for a calendar year in excess of the compensationlimit imposed by Section 401(a)(17) of the Internal Revenue Code fortax-qualified retirement plans ($220,000 for 2006) and who are approved forparticipation by the Board’s Employee Benefit Committee are eligibleparticipants under this plan. The number of eligible participants in 2006 was80, which included all of the Named Executives, each of whom participated inthis plan in 2006. At the end of a calendar year, the account of eachparticipant is credited with an amount equal to the difference between theamount with which the participant’s account under the cash balance pension planwould have been credited but for the compensation limitation imposed by theInternal Revenue Code, and the amount actually credited to the participant’saccount under the cash balance pension plan. In addition, if a participant’sbenefit under the cash balance pension plan is limited by Section 415 of theInternal Revenue Code and is not already provided for under this plan, anamount equal to the shortfall will be added to the participant’s account. Atthe end of a calendar year (but prior to the above credit), each participant’saccount is credited with interest equal to the average value of interest rateson 52-week U.S. Treasury Bills, determined pursuant to a fixed formula, but noless than four percent nor more than twelve percent, until the participant’saccount is fully distributed.  An accountis distributed after the participant’s termination of employment or death,either in a single-sum payment, or in equal annual installments over a periodnot to exceed ten years.

Wealso sponsor an unfunded, nonqualified supplemental Thrift Plan (the “401(k)SERP”). Generally, all vice presidents and more senior officers who participatein the 401(k) SERP, who have compensation for a calendar year in excess of thecompensation limit imposed by Section 401(a)(17) of the Internal Revenue Codefor tax qualified retirement plans ($220,000 in 2006) and who are approved forparticipation by the Board’s Employee Benefit Committee are eligibleparticipants under this plan. The number of eligible participants in 2006 was 80,which included all of the Named Executives, each of whom participated in thisplan in 2006. At the end of a calendar year, the account of each participant iscredited with an amount equal to 3% of the portion of the participant’scompensation for that calendar year that exceeds the compensation limit imposedby the Internal Revenue Code. At the end of a calendar year (but prior to theabove credit), each participant’s account is credited with interest at the perannum rate of five percent, except that interest is pro-rated for accounts thatterminate in midyear. Generally, an account is distributed in a lump sumpayment after a participant’s termination of employment or death.

Wemaintain the Cash Balance SERP and the 401(k) SERP in order that a select groupof employees, the “top hat” group, may receive benefits under these plans thatthey are precluded from receiving under our qualified plans because of IRSlimits.

***Potential Payments upon Termination or Change inControl***

*TerminationPayments*We believe thatBankshares should provide reasonable severance benefits to senior executiveswho are terminated involuntarily, unless extraordinary circumstances (such as “cause”as defined in an employment agreement, or ethical violations or otherwrongdoing) exist. We also believe that these severance benefits should betailored to reflect the individual circumstances, including length of tenure,responsibilities and past contributions of the terminated executive, thecircumstances giving rise to the termination, how long it may take (and howlikely it may be) for the executive to find comparable employment and suchother factors as we deem relevant. Thus, it is our policy (except as describedin the following paragraph and under the heading “Change of Control” below) notto enter into written severance agreements prior to or during employment, nordo we have a specific severance policy for senior executives.  In the event of an involuntary termination ofa senior executive under circumstances in which management believes severanceis warranted, and where no contractual obligation exists, management will makea recommendation to the Committee for severance based on the factors listedabove. All severance arrangements for senior executives are reviewed andapproved by the Committee in advance.

Occasionally,Bankshares has entered into written employment contracts with members of seniormanagement and other key employees. Generally, Bankshares will only do so inconnection with the recruitment of such individuals. Of the Named Executives,only Mr. Kelly and Mr. Wilson have employment agreements. Mr. Kelly’s was foran initial five-year

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term,and Mr. Wilson’s was for a three-year term. Under both agreements, upon theexpiration of the original term and on each anniversary thereof, the agreementautomatically renews for an additional one-year period unless either partygives notice to the other 90 days prior to such date that it declines suchextension. Originally, both contracts included a provision whereby in the eventof a termination without “cause” prior to their expiration, the executive wouldbe entitled to continue to receive all benefits (including salary) provided forin the agreement until the expiration of the remaining term of such agreement.The original term of Mr. Kelly’s agreement expired in February 2006 and hasrenewed automatically in accordance with its terms for an additional one yearterm, so that the current expiration date is January 31, 2008. Mr. Wilson’semployment agreement is still in its original term and will expire January 1,2008, subject to the automatic renewal provision. Bankshares’ employmentagreements with Mr. Kelly and Mr. Wilson define “cause” as proven or admitted fraudor material illegal acts, or a breach of any of the executive’s covenants ofundivided loyalty to and the performance of duties for Bankshares.

InApril 2006, Mr. Kelly and Bankshares agreed, at Mr. Kelly’s request, to amendhis employment contract to provide that all of the obligations of the Companyto Mr. Kelly thereunder (including any obligation to continue salary and otherbenefits through the unexpired term thereof) would terminate upon histermination by Bankshares for any reason, including a termination withoutcause.Generally, in the event of a termination we do not accelerate the vesting ofequity compensation. However, in instances where such termination by Banksharesis in violation of the terms of an employment agreement, or without cause asdefined in certain restricted stock agreements, the vesting of restricted stockawards is required upon termination. Our stock options do not requireacceleration upon termination for any reason other than normal retirement.

Webelieve that these severance benefits are generally more modest than thoseprovided by comparable companies (because we do not enter into formal severanceagreements prior to termination, generally do not enter into employmentagreements, and do not accelerate vesting of equity compensation), although wehave not conducted a study to confirm this. Based upon a hypotheticaltermination date of December 31, 2006, the severance benefits Bankshares wouldhave been obligated to pay to each of the Named Executives would have been as follows:
| **Name**   | ** ** | **Base  Salary** | ** ** | **Bonus** | ** ** | **Accelerated  Equity  Awards/Units** | ** ** | **Continued  Retirement  Benefits** | ** ** | **Healthcare and  Other Insurance  Benefits** | ** ** | **Other  Benefits** | ** ** | **Total** | ** ** |
|------------|------------|------------------|------------|-----------|------------|---------------------------------------|------------|-------------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|-----------|------------|
| Mr. Kelly  |       | $                | 0          |      | $          | 0                                     |       | 5,083,397                           |       | $                                                       | 0          |                | $          | 0         |       | $ | 0 |   | $ | 5,083,397 |   |
| Mr. Troupe |       | 0                |       | 0         |       | 18,821                                |       | 0                                   |       | 0                                                       |       | 0                   |       | 18,821    |       |
| Mr. Mason  |       | 0                |       | 0         |       | 29,969                                |       | 0                                   |       | 0                                                       |       | 0                   |       | 29,969    |       |
| Mr. Wilson |       | 750,000          |       | 750,000   |       | 151,130                               |       | 0                                   |       | 14,765                                                  |       | 0                   |       | 1,665,895 |       |
| Mr. Reid   |       | 0                |       | 0         |       | 27,164                                |       | 0                                   |       | 0                                                       |       | 0                   |       | 27,164    |       |
|            |            |                  |            |           |            |                                       |            |                                     |            |                                                         |            |                     |            |           |            |  |  |  |  |  |  |

 

*Changein Control Payments*We have entered intowritten agreements (“Executive Severance Agreements”) with 17 seniorexecutives, including each of the Named Executives, that provide for cashseverance and other payments to such executives in the event of theirtermination in connection with a change of control of Bankshares. We have doneso on our belief, confirmed by resolutions adopted by the Bankshares Board,that it is in the best interests of Bankshares to have the continued dedicationof such executives, despite the possibility, threat or occurrence of a changein control, and that it is necessary, in order to diminish the inevitabledistraction of such a situation, to encourage each executive’s full attentionand dedication to Bankshares currently and in the event of any threatened orpending change in control (including determinations as to the best interests ofBankshares and its stockholders should the possibility of a change in controlarise) and to provide such executives with compensation arrangements upon achange in control which would provide each of the executives with individualfinancial security in the event he or she is terminated as a result of suchchange of control and which are competitive with those of other corporations.

Historically,we entered into Executive Severance Agreements only with our CEO and GeneralCounsel.  In 2002, we began to enter intosuch agreements in connection with the recruitment of senior executives as anadditional inducement to join Bankshares. In 2003, as the number of newly-recruitedsenior executives with such agreements increased, the Committee determined thatas an equitable matter such agreements should be extended to other members ofsenior management as well. In making this decision, the Committee determinedthat, relative to the overall value of Bankshares, the potential benefitspayable under these agreements were relatively minor and that the benefitsoutweighed the additional cost.

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Pursuantto the agreements (all of which are identical, other than Mr. Kelly’s as notedbelow), in the event that during the effective period of the agreements,following a “change of control” of Bankshares, any of such executives isterminated (prior to his or her retirement date) within three years of a changeof control without “cause” or if such executive resigns for “good reason”, thenhe or she is entitled to receive a lump sum cash severance payment equal tothree times such individual’s average salary and cash bonus over the priorthree years. All of these agreements are so-called “double trigger”, whichmeans that in order to trigger the cash severance payment both of the followingmust occur: the occurrence of a “change of control” and the termination of theexecutive (either by the employer without “cause” or by the executive for “goodreason”).

Forthe purposes of these agreements, a “change of control” means any of thefollowing occurrences: (a) a person or group becomes the beneficial owner of atleast 35% of our outstanding common stock; (b) there occur certain specifiedchanges in the composition of the Board of Directors; (c) our stockholdersapprove a reorganization, merger, consolidation or statutory share exchange andsuch transaction is consummated or effective, unless after such transaction,holders of the previously outstanding common stock own specified amounts of thecombined voting power of the surviving entity; or (d) a liquidation ordissolution of Bankshares or sale of all or substantially all of our assets. “Cause”means termination upon (i) an act of personal dishonesty taken by the executiveintended to result in substantial personal enrichment of the executive at ourexpense, (ii) the executive’s willful, deliberate and continued failure toperform substantially his or her duties, which is not remedied after receipt ofwritten notice, or (iii) conviction of a felony. “Good reason” includes theassignment to the executive of any duties inconsistent with his or her statusand position as they exist immediately prior to the change of control, asubstantial failure by us to comply with our obligations to the executive underany employment arrangement with such executive, relocation of the executive’splace of employment outside of the City of Baltimore, a purported terminationof the executive not otherwise permitted under his or her employment arrangementor the failure of any potential successor to assume expressly the obligationsof the agreement.

Inaddition to the cash severance payment, because of the so-called “parachute”tax imposed by Internal Revenue Code Section 280G, we have agreed to reimburseeach member of senior management with whom we have an Executive SeveranceAgreement  for any taxes imposed as aresult of change in control benefits. We have done so because we believe thisto be consistent with competitive practices.

In March 2006, the Committee approved the amendmentof all of its Executive Severance Agreements with executives, including thosewith each of the Named Executives, to change the calculation of the cashseverance payments which may be made under the agreements. Prior to suchamendment, severance payments required under the agreements would have beencalculated at the maximum amount (when combined with amounts otherwise payableupon termination) which is deductible under Section 280G of the InternalRevenue Code, as amended. Generally, the maximum amount deductible is threetimes average base annual compensation (including salary, bonus, fringebenefits and deferred compensation) over five years. As a result of theamendment, payments required under the agreements are now calculated at threetimes the sum of (i) twelve times the average monthly base salary received bythe executive during the thirty-six month period prior to such termination,plus (ii) the average of the annual bonuses earned by the executive for thethree fiscal years preceding such termination. (Mr. Kelly’s agreement was alsoamended, at his request, to eliminate the cash severance payment in itsentirety.) The agreements continued to provide for additional payments to theexecutive to make him or her whole for the consequence of any excise taximposed upon him or her if the Section 280G limits are exceeded. However, theamendment also included a so-called “valley” provision, whereby if excise taxcan be avoided by the reduction of parachute payments to the executive (not toexceed $150,000), then the parachute payments would be reduced by the minimumamount necessary to avoid the excise tax. The amendment also clarified thedefinition of “change of control”, clarified that no payments will be madeabsent the consummation of a change of control, clarified the circumstancesunder which the agreement could be triggered in the event of a termination inadvance of a change of control, and added provisions to reflect new regulationsunder Section 409A of the Internal Revenue Code, as amended. These changes(other than the elimination of the cash severance payment in Mr. Kelly’sagreement) were made primarily to make such agreements more favorable toBankshares.

Inaddition to the cash severance payments payable under the Executive SeveranceAgreements, the ACIP provides that in the event of a change in control,  cash incentive compensation for each of theNamed Executives for the year in which such change in control occurs would vestimmediately (at 100% of target levels). Likewise, equity incentive awards underthe 2004 LTIP and the 2006 LTIP would also vest immediately in accordance withthe terms of such plans in the event of the occurrence of a change in control. Althoughindividual restricted stock and stock options agreements generally do not

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providefor automatic acceleration in the event of a change in control, our Board hasadopted a resolution in each of the past four years expressing its intent toact to protect the holders of equity incentive awards in the event of a changein control, and that such action may include, without limitation, any one ormore of the following: acceleration or change of the exercise dates of anystock options; acceleration or change of the vesting or delivery dates of anyrestricted stock grants or other awards; acceleration or change of anyperformance period; arrangements with holders of options, stock grants or otherawards for the payment of appropriate consideration to them for thecancellation and surrender of any such options, stock grants or other awards;or other measures deemed appropriate by the Compensation Committee and theBoard of Directors.

Webelieve that these levels of benefits in the event of a change in control aregenerally consistent with the general practice among our peers, although wehave not conducted a study to confirm this.

InDecember 2006 and January 2007, all of the Bankshares executives covered byExecutive Severance Agreements agreed to waive their rights under theseagreements and any applicable employment agreements in exchange for otherrights that are set forth in new agreements with PNC, which will becomeeffective only as of the closing of the PNC Merger.

Basedupon a hypothetical termination on December 31, 2006 following a change incontrol, severance benefits payable to each of the Named Executives would be asfollows:
| **Name**   | ** ** | **Cash  Severance  Payment** | ** ** | **Value of  Accelerated  Equity  Awards** | ** ** | **Tax  Gross-up** | ** ** | **Total** | ** ** |
|------------|------------|------------------------------|------------|------------------------------------------------|------------|-------------------|------------|-----------|------------|
| Mr. Kelly  |       | $                            | 0          |                                           | $          | 7,311,358         |       | $         | 3,230,000  |   | $ | 10,541,358 |   |
| Mr. Troupe |       | 1,315,466                    |       | 788,612                                        |       | 1,014,635         |       | 3,118,713 |       |
| Mr. Mason  |       | 4,155,525                    |       | 1,346,258                                      |       | 2,565,166         |       | 8,066,949 |       |
| Mr. Wilson |       | 3,900,000                    |       | 1,431,280                                      |       | 2,575,918         |       | 7,907,198 |       |
| Mr. Reid   |       | 2,508,588                    |       | 833,908                                        |       | 1,650,772         |       | 4,993,268 |       |
|            |            |                              |            |                                                |            |                   |            |           |            |  |  |  |  |

 

***Director Compensation***
| **Name**                   | ** ** | **Fees Earned or   Paid in Cash (1)** | ** ** | **Stock Awards  (2),(3)** | ** ** | **Total (4)** | ** ** |
|----------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------|------------|--------------------|------------|
| Cynthia A.  Archer         |       | $                                                                   | 56,000     |                           | $          | 28,220             |       | $ | 84,220 |   |
| R. Carl Benna(5)           |       | 50,000                                                              | (3)        | 28,220                         |       | 78,220             |       |
| Richard O.  Berndt         |       | 60,000                                                              |       | 28,220                         |       | 88,220             |       |
| Howard B.  Bowen(5)        |       | 50,000                                                              | (3)        | 28,220                         |       | 78,220             |       |
| William R.  Brody, M.D.    |       | 35,000                                                              |       | 28,220                         |       | 63,220             |       |
| Eddie C. Brown             |       | 35,000                                                              |       | 28,220                         |       | 63,220             |       |
| George I.  Bunting, Jr.    |       | 46,000                                                              |       | 28,220                         |       | 74,220             |       |
| Anthony W.  Deering        |       | 40,000                                                              |       | 28,220                         |       | 68,220             |       |
| Darrell D.  Friedman       |       | 35,000                                                              |       | 28,220                         |       | 63,220             |       |
| Freeman A.  Hrabowski, III |       | 40,000                                                              |       | 28,220                         |       | 68,220             |       |
| Robert A.  Kinsley         |       | 35,000                                                              |       | 28,220                         |       | 63,220             |       |
| Jenny G. Morgan            |       | 46,000                                                              |       | 28,220                         |       | 74,220             |       |
| Morton B.  Plant(6)        |       | 46,000                                                              |       | 28,220                         |       | 74,220             |       |
| Christian H.  Poindexter   |       | 46,000                                                              |       | 28,220                         |       | 74,220             |       |
| Clayton S. Rose            |       | 46,000                                                              |       | 28,220                         |       | 74,220             |       |
| James L. Shea              |       | 35,000                                                              |       | 28,220                         |       | 63,220             |       |
| Donald J. Shepard          |       | 35,000                                                              |       | 28,220                         |       | 63,220             |       |
|                            |            |                                                                     |            |                                |            |                    |            |  |  |  |

 

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(1)  Of the amounts in this column, the followingdirectors deferred the amounts next to their name:  Ms. Archer — $50,500; Mr. Benna - $35,000,Mr. Berndt - $60,000, Mr. Bowen - $35,000, Mr. Brown - $35,000, Mr. Deering - $40,000, Mr. Friedman -$35,000, Mr. Hrabowski - $35,000, Mr. Kinsley - $35,000, Ms. Morgan - $40,500,Mr. Rose - $40,500, Mr. Shea - $35,000 and Mr. Shepard - $35,000.

(2) Includes 750 shares of stock awarded toeach director with a Fair Market Value of $37.63 per share.

(3) All directors deferred 100% of the amount reflected in this column,except Messrs. Berndt, Brody, Bunting, Plant and Poindexter, who did not deferany of their stock awards.

(4)  Nodirector received compensation to be reported under the headings “OptionAwards,” “Non-Equity Incentive Plan Compensation,” “Change in Pension Value andNonqualified Deferred Compensation Earnings” or “All Other Compensation”.  Therefore, such columns have not beenincluded.

(5) The fees earned include $15,000 paidunder contractual obligations associated with the acquisition of F&M Bank.

(6) Mr. Plant was a director during 2006 anduntil his death on January 10, 2007.

Directorswho are employees are not compensated for their services as directors.  Effective in 2005, non-employee directorsbegan receiving an annual retainer of $35,000 in December of each year and anannual award of 750 shares of our common stock. The Chair of the AuditCommittee receives an additional retainer of $15,500 per year for serving inthis position and the other members of the Audit Committee receive anadditional retainer of $5,500 for service on the Audit Committee. The Chairs ofthe Nominating and Corporate Governance Committee and the CompensationCommittee receive an additional retainer of $5,000 per year for serving inthose positions. Non-employee directors who are also members of certainMSD&T committees receive $500 for attendance at each committee meeting.Non-employee directors may elect to receive common stock, valued at the time ofthe election date in December, in lieu of all or a portion of their annualretainer. For 2007, the director fees and annual retainer will remain the same,except that directors will receive cash in an amount up to $35,505 in lieu ofthe annual stock retainer and, assuming the closing of the PNC Merger, all directorfees (including the cash in lieu of the stock retainer) will be reduced andprorated to the closing date.

Non-employeedirectors may elect to defer all or a portion of their annual retainers andother fees into our Stock Retainer and Deferred Compensation Plan forNon-Employee Directors (the “Stock Retainer and Deferred Compensation Plan”).The Stock Retainer and Deferred Compensation Plan permits non-employeedirectors of Bankshares and our affiliates to elect, in the manner permitted bySection 409A of the Internal Revenue Code of 1986, as amended, to voluntarilydefer payment of their annual stock and cash retainers and some or all of theirfees. Amounts and stock deferred by each individual director are credited to adeferred compensation account as phantom stock units. At the close of eachcalendar quarter, the sum of cash deferred in that quarter by a director isconverted to phantom stock units by dividing such sum by the closing marketprice of our common stock, and the phantom stock units are then cumulativelycredited to the director’s account. At the close of each calendar quarter, thesum of dividend equivalents attributable to the director’s account at thebeginning of the quarter, assuming that such dividends had actually been paid,is similarly converted to additional phantom stock units and cumulativelycredited. The aggregate phantom stock units in the participant’s account arepaid in whole shares of our common stock following the date the participantceases to be a non-employee director. At the election of the participant, whichmust generally be made at the same time as the election to defer the respectivecompensation, payments may be made in a lump sum or, if the value of theparticipant’s account equals or exceeds $50,000, in installments over a periodof not more than ten years. The Stock Retainer and Deferred Compensation Plangives non-employee directors of Bankshares the option to elect to receiveshares of our common stock in lieu of the undeferred portion of their cashretainer, if in excess of $3,000, based on the value of the stock on theelection date in December.

***Compensation Committee Interlocksand Insider Participation***No member of theCompensation Committee is or ever was an officer or employee ofBankshares.  No member of theCompensation Committee is, or was during 2006, an executive officer of anothercompany whose board of directors has a comparable committee on which one of ourexecutive officers serves.

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**ITEM 12. SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

***Equity Compensation Plan Information***

Thefollowing table provides information as of December 31, 2006 with respect toour equity compensation plans.
| **Plan category**                                      | ** ** | **Number of   securities to be   issued upon   exercise of   outstanding   options, warrants   and rights (a)(1)** | ** ** | **Weighted-  average exercise   price of   outstanding   options,   warrants and   rights (b)** | ** ** | **Number of securities   remaining available for   future issuance under   equity compensation  plans (excluding   securities reflected   in column (a)) (c)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | 3,533,830                                                                                                                                                                                |       | $                                                                                                                                            | 27.59      |                                                                                                                                                                                                                                                | 1,550,898  |   |
| Equity  compensation plans not approved by security holders |       | 0                                                                                                                                                                                        |       | —                                                                                                                                       |       | 0                                                                                                                                                                                                                                                   |       |
| Total                                                       |       | 3,533,830                                                                                                                                                                                |       | $                                                                                                                                            | 27.59      |                                                                                                                                                                                                                                                | 1,550,898  |   |

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(1)  The amounts reflected in this columninclude 388,049 shares of deferred stock to be issued under our Stock Retainerand Deferred Compensation Plan for Non-Employee Directors, which are not addedto the weighted average exercise price calculation in column (b)

 

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***Stock Ownership by Directors and Named ExecutiveOfficers***

This table indicates the amount of Banksharescommon stock beneficially owned by our directors and executive officers namedin the Summary Compensation Table as of February 15, 2007. In general, “beneficialownership” includes those shares a director or named executive officer has thepower to vote or transfer, and stock options that are exercisable currently orthat become exercisable within 60 days of such date. Except as otherwise noted,the persons named in the table below have sole voting and investment power withrespect to all shares shown as beneficially owned by them. The individualsnamed in the table below did not beneficially own more than 1% of theoutstanding shares of our common stock. In addition, the directors andexecutive officers as a group did not beneficially own more than 1% of theoutstanding shares of common stock.
| **Name of Individual**                          | ** ** | **Amount of Common Stock   Beneficially Owned (1)** | ** ** | **Amount of Phantom  Stock Units Beneficially  Owned (2)** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| Cynthia A.  Archer                                        |       | 1,575                                                                             |       | 12,710                                                                              |       |
| R. Carl Benna                                             |       | 34,071                                                                            | (3)        | 3,900                                                                               |       |
| Richard O.  Berndt                                        |       | 49,151                                                                            |       | 21,224                                                                              |       |
| Howard B. Bowen                                           |       | 20,285                                                                            |       | 3,882                                                                               |       |
| William R.  Brody, M.D.                                   |       | 3,975                                                                             |       | 5,902                                                                               |       |
| Eddie C. Brown                                            |       | 5,250                                                                             |       | 3,704                                                                               |       |
| George L.  Bunting, Jr.                                   |       | 26,360                                                                            |       | -                                                                                   |       |
| Anthony W.  Deering                                       |       | 94,500                                                                            |       | 3,409                                                                               |       |
| Peter W.  Floeckher, Jr.                                  |       | 59,369                                                                            |       | -                                                                                   |       |
| Darrell D.  Friedman                                      |       | 900                                                                               |       | 9,160                                                                               |       |
| Freeman A.  Hrabowski, III                                |       | 1,035                                                                             |       | 8,844                                                                               |       |
| Edward J. Kelly,  III                                     |       | 381,480                                                                           |       | -                                                                                   |       |
| Robert A.  Kinsley                                        |       | 24,212                                                                            |       | 9,977                                                                               |       |
| Alexander T.  Mason                                       |       | 109,340                                                                           |       | -                                                                                   |       |
| Jenny G. Morgan                                           |       | 772                                                                               |       | 3,555                                                                               |       |
| Christian H.  Poindexter                                  |       | 3,862                                                                             |       | -                                                                                   |       |
| J. Marshall Reid                                          |       | 140,741                                                                           | (4)        | -                                                                                   |       |
| Clayton S. Rose                                           |       | 1,650                                                                             |       | 6,862                                                                               |       |
| James L. Shea                                             |       | 1,654                                                                             |       | 4,737                                                                               |       |
| Donald J.  Shepard                                        |       | 21,000                                                                            | (5)        | 13,709                                                                              |       |
| Jay M. Wilson                                             |       | 68,788                                                                            |       | -                                                                                   |       |
| Directors and  executive officers as a group (27 persons) |       | 1,049,970                                                                         |       | 111,575                                                                             |       |

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(1)  The numbers shown include the followingamounts of our common stock that the following individuals, and the group, havethe right to acquire, within 60 days of February 15, 2007, through the exerciseof stock options granted pursuant to Bankshares’ stock option plans or as aresult of dividend equivalent shares under our 1999 Plan:  Mr. Benna – 6,864; Mr. Bowen – 5,478; Mr.Floeckher – 52,617; Mr. Kelly – 293,134; Mr. Mason – 92,911; Mr. Reid – 98,177; and Mr. Wilson – 15,988.  All directors, nominees and executiveofficers as a group, 565,169.

(2)  The phantom stock units are derivativesecurities held for the account of the respective director under our StockRetainer and Deferred Compensation Plan for Non-Employee Directors and can beexchanged for shares of our common stock within 60 days if the person ceases tobe a director of Bankshares.

(3)  Includes 3,000 shares held by two trusts forfamily members of which Mr. Benna is trustee, but has no beneficial interest.

(4)  Includes 24,261 shares owned by his spouse.

(5)  Includes 18,750 shares owned by a familytrust of which Mr. Shepard is not trustee, but in which he has a beneficialinterest.

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***Change ofControl Transaction***

OnOctober 8, 2006, Bankshares entered into an Agreement and Plan of Merger withThe PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshareswill merge with and into PNC, with PNC as the surviving corporation in themerger.  When the merger is completed,Bankshares stockholders will receive a combination of PNC common stock and cashin exchange for their Bankshares common stock. Each share of Bankshares common stock will be converted into the rightto receive 0.4184 of a share of PNC common stock (including the relatedpreferred stock purchase rights under PNC’s May 2000 Rights Agreement) and$16.45 in cash, without interest.  Underthe formula set forth in the merger agreement, an aggregate of up to approximately54.2 million shares of PNC common stock (and an equal number of related rights)may be issued and $2.13 billion paid in the merger.  This merger was approved by Bankshares’stockholders on February 27, 2007, and received substantially all of the requiredregulatory approvals. The merger is currently expected to close in March of2007.  Pending the merger, Banksharesmust comply with the covenants contained in the merger agreement, but isgenerally continuing to operate in the ordinary course of business.

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORINDEPENDENCE**

***Transactions with Related Parties***

Inthe ordinary course of business we may use the products or services oforganizations of which our directors are officers or directors. The law firm ofVenable LLP, of which Mr. Shea is chairman, has rendered legal services toBankshares, certain of its affiliates and certain accounts of which MSD&Tis a fiduciary for aggregate payments since the beginning of 2006 ofapproximately $1.5 million.  The law firmof Gallagher, Evelius & Jones, LLP, of which Mr. Berndt is amanaging partner, has rendered services to MDS&T and certain accounts ofwhich MDS&T is a fiduciary for aggregate payments since the beginning of2006 of approximately $784,000 (of which only approximately $83,000 was paid byBankshares of its affiliates as the remainder was paid directly by MSD&T’scustomers).  Mr. Wilson is a member ofthe Advisory Board of Spring Capital Partners, L.P., and he holds a limitedpartnership interest in that entity and a carried interest in that entity’sgeneral partner.  Bankshares has invested$5.5 million in Spring Capital Partners, L.P. as of December 31, 2006, and hasa commitment to invest an additional $3.2 million. The investment and commitmentwere made prior to Mr. Wilson joining Bankshares.  Ms. Morgan is a Principal with SterlingPartners.  Bankshares has invested $3.3million in Sterling Capital as of December 31, 2006, and has a commitment toinvest and additional $3.2 million.  Theinvestment in Sterling Partners was made prior to Ms. Morgan joining SterlingPartners.  Bankshares’ Chairman and ChiefExecutive Officer, Edward J. Kelly, III is a director of the Hartford FinancialServices Group with which Bankshares had investments in bank-owned lifeinsurance of approximately $72 million as of December 31, 2006.  Inaddition, Donald J. Shepard serves as the Chairman of the Executive Board andChief Executive Officer of AEGON N.V., a holding company of insurance andinsurance-related companies with which Bankshares has an investment in bank-ownedlife insurance of approximately $40 million as of December 31, 2006.

Inthe ordinary course of business, our affiliates have made loans and extendedcredit, and expect in the future to make loans and extend credit, to ourdirectors, officers, and their associates, including entities of which theseindividuals may be a director, officer, partner, member or employee.  These loans were made substantially on thesame terms, including interest rates and collateral, as those prevailing at thetime for comparable transactions with non-affiliated persons and did notinvolve more than the normal risk of collectibility or present otherunfavorable features.  We believe thatall such transactions are in conformity with the Sarbanes-Oxley Act of 2002.

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***Director Independence***

TheBoard of Directors currently has twenty members.  The Board of Directors has determined that amajority of the Board of Directors is comprised of independent directors, asdefined in Nasdaq Rule 4200.  Ourindependent directors are: Cynthia A. Archer, R. Carl Benna, Richard O. Berndt,William R. Brody, M.D., Eddie C. Brown, George L. Bunting, Jr., Anthony W.Deering, Darrell D. Friedman, Freeman A. Hrabowski, III, Jenny G. Morgan,Christian H. Poindexter, Clayton S. Rose, James L. Shea and Donald J. Shepard.  Each member of the Audit Committee,Compensation Committee and Nominating and Corporate Governance Committee is anindependent director as independence is defined in the listing standards of theNasdaq Global Select Market.

**ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES**

***Audit Fees***

Ernst& Young LLP was our independent registered public accounting firm for 2006,and PricewaterhouseCoopers was our independent registered public accountingfirm for 2005. Aggregate fees for professional services rendered by Ernst &Young LLP for the fiscal year ended December 31, 2006 and byPricewaterhouseCoopers LLP for the fiscal year ended December 31, 2005 were asfollows:
| ** **          | ** ** | **Fiscal Year Ended   December 31, 2006** | ** ** | **Fiscal Year Ended  December 31, 2005** | ** ** |
|---------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Audit Fees          | ** ** | $                                                                  | 1,500,000  |                                                         | $          | 1,700,000 | ** ** |
| Audit-Related  Fees |       | 345,680                                                            |       | 187,000                                                      |       |
| Tax Fees            |       | 52,750                                                             |       | 152,175                                                      |       |
| All Other Fees      |       | 0                                                                  |       | 19,000                                                       |       |
| Total               |       | $                                                                  | 1,898,430  |                                                         | $          | 2,058,175 |   |

 

Audit Fees were for professional services rendered andfor the audits of our consolidated financial statements and the issuance ofcomfort letters, consents and the review of documents filed with the Securitiesand Exchange Commission. Audit-Related Fees were for assurances and relatedservices concerning the Report of Institutional Trust Controls (SAS 70) andregulatory reports on internal controls. Tax Fees were related to taxcompliance, tax planning and tax advice, including assistance with andrepresentation in tax audits. All Other Fees were for services rendered forinformation systems reviews not performed in connection with the audit,compensation and other consulting services.

Neither Ernst & Young LLP  nor PricewaterhouseCoopers LLP renderedprofessional services to us in connection with financial system design andimplementation during the years ended December 31, 2006 and 2005.

***Audit Committee Pre-Approval Policies andProcedures***

Underits charter, the Audit Committee is responsible for selecting our independentregistered public accounting firm. The principal independent registered publicaccounting firm for each year is typically selected at the Audit Committeemeeting held in January or March of each year. The Audit Committee periodicallypre-approves the engagement of the principal independent registered publicaccounting firm to perform certain defined audit and non-audit services.  These engagements include the performance ofservices in connection with the issuance of consents, comfort letters, thereview of documents filed with the Securities and Exchange Commission, andconsulting with us on accounting or control issues which may arise during theyear. The Audit Committee also periodically pre-approves the engagement of theprincipal independent registered public accounting firm to work with managementin the evaluation of tax planning and compliance matters. All other projectsinvolving the principal independent registered public accounting firm arespecifically reviewed and approved prior to the engagement of the audit firm.

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**PART IV**

**ITEM 15. EXHIBITS AND FINANCIALSTATEMENT SCHEDULES.**

The following documents are filed or furnished aspart of this report, except as indicated.

(1)   The financial statements filed herewith are listed in theaccompanying Index to Financial Statements.

(2)          FinancialStatement Schedules are omitted because of the absence of the conditions underwhich they are required or because the information called for is included inthe Consolidated Financial Statements or notes thereto.

(3)          Exhibitsfiled or furnished herewith or incorporated by reference herein are set forthin the following table prepared in accordance with Item 601 of Regulation S-K.

#### Exhibit Table

(2)          Plan of acquisition,reorganization, arrangement, liquidation or succession

a.  Agreement and Plan of Merger, dated October8, 2006, by and between  The PNCFinancial Services Group, Inc. and Mercantile Bankshares Corporation (Incorporated by reference toRegistrant’s Form 8-K, filed October 10, 2006, Exhibit 2.1, Commission File No.0-5127).

(3)          Charter and by-laws

       A.    (1)Articles of Incorporation effective May 27, 1969 (Incorporated by reference toRegistrant’s Registration Statement on Form S-1, No. 2-39545, Exhibit 3-A(1)).

(2) Articles of Amendmenteffective June 6, 1969 (Incorporated by reference to Registrant’s RegistrationStatement on Form S-1, No. 2-39545, Exhibit 3-A(2)).

(3) Articles Supplementaryeffective August 28, 1970 (Incorporated by reference to Registrant’sRegistration Statement on Form S-1, No. 2-39545, Exhibit 3-A(3)).

(4) Articles of Amendmenteffective December 14, 1970 (Incorporated by reference to Registrant’sRegistration Statement on Form S-1, No. 2-39545, Exhibit 3-A(4)).

(5) Articles Supplementaryeffective May 10, 1971 (Incorporated by reference to Registrant’s RegistrationStatement on Form S-1, No. 2-39545, Exhibit 3-A(5)).

(6) Articles Supplementaryeffective July 30, 1971 (Incorporated by reference to Registrant’s RegistrationStatement on Form S-1, No. 2-41379, Exhibit 3-A(6)).

(7) Articles of Amendment effectiveMay 8, 1986 (Incorporated by reference to Registrant’s Annual Report on Form10-K for the year ended December 31, 1993, Exhibit 3-A(7), Commission File No.0-5127).

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(8) Articles of Amendmenteffective April 27, 1988 (Incorporated by reference to Registrant’s AnnualReport on Form 10-K for the year ended December 31, 1993, Exhibit 3-A(8),Commission File No. 0-5127).

(9) Articles Supplementaryeffective September 13, 1989 (Incorporated by reference to Registrant’s Form8-K filed September 27, 1989, Exhibit B attached to Exhibit 4-A, CommissionFile No. 0-5127).

(10) Articles Supplementaryeffective January 3, 1990 (Incorporated by reference to Registrant’s Form 8-Kfiled January 9, 1990, Exhibit B attached to Exhibit 4-A, Commission File No.0-5127).

(11) Articles of Amendmenteffective April 26, 1990 (Incorporated by reference to Registrant’s AnnualReport on Form 10-K for the year ended December 31, 1990, Exhibit 3-A(11),Commission File No. 0-5127).

(12) Articles of Amendmenteffective April 30, 1997 (Incorporated by reference to Registrant’sRegistration Statement on Form S-4, No. 333-43651, Exhibit 3(i)(L)).

(13) Articles Supplementaryeffective June 9, 1999 (Incorporated by reference to Registrant’s RegistrationStatement on Form S-8, No. 333-90307, Exhibit 4.1.M).

(14)Articles Supplementary effective September 30, 1999 (Incorporated by referenceto Registrant’s Registration Statement on Form S-8, No. 333-90307, Exhibit4.1.N).

(15) Certificate of Correction effective July 3,2002, concerning Articles of Amendment effective May 8, 1986 (Incorporated byreference to Registrant’s Quarterly Report for the quarter ended September 30,2002, Exhibit 3A(15), Commission File No. 0-5127).

(16) Certificate of Correctioneffective July 3, 2002, concerning Articles of Amendment effective April 26,1990 (Incorporated by reference to Registrant’s QuarterlyReport for the quarter ended September 30, 2002, Exhibit 3A(16), CommissionFile No. 0-5127).

(17) Articles of Amendmenteffective May 19, 2006 (Incorporated by reference to Registrant’s QuarterlyReport for the quarter ended June 30, 2006, Exhibit 3A(17), Commission File No.0-5127).

***     ***B.  By-Laws of the Registrant, as amended(Incorporated by reference to Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2004, Exhibit 3.B, Commission File No. 0-5127).

(1) By-Laws of the Registrant, as amendedSeptember 11, 2006 (Incorporated by reference to Registrant’s Form 8-K,filed September 15, 2006, Exhibit 3B(1), Commission File No. 0-5127).

(4)  Instruments defining the rights of securityholders, including indentures.

A. Rights Agreement dated as of June 8, 1999between Registrant and the Rights Agent, including Form of Rights Certificateand Articles Supplementary (Incorporated by reference to Form 8-K of Registrantfiled June 11, 1999, Exhibit 4, Commission File No. 0-5127, and to Form 8-A ofRegistrant filed June 11, 1999, Exhibits 1, 2 and 3, Commission File No.0-5127).

B.  Amendment to the StockholderProtection Rights Agreement, dated as of June 8, 1999, entered into as ofOctober 8, 2006, between Mercantile Bankshares Corporation and Mercantile-SafeDeposit and Trust Company, as Rights Agent (Incorporated by reference toRegistrant’s Form 8-K, filed October 10, 2006, Exhibit 4.1, Commission File No.0-5127).

C. Indenture between Registrantand JP Morgan Chase Bank, as Trustee, dated as of April 15, 2003, relating toSubordinated Notes due 2013 (Incorporated by reference to Registrant’sRegistration Statement on Form S-4, No. 333-105238, Exhibit 4.1).

D. Form of 4.625% SubordinatedNote due 2013, Series B (Incorporated by reference to Registrant’s RegistrationStatement on Form S-4, No. 333-105238, Exhibit 4.2).

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(10) Material contracts

A.  Mercantile Bankshares Corporation andAffiliates Annual Incentive Compensation Plan, as amended and restated throughMarch 12, 2002.   (Incorporated byreference to Registrant’s Definitive Proxy Statement, filed March 22, 2003,Appendix A).

B.  Dividend Reinvestment and Stock Purchase Planof Mercantile Bankshares Corporation (Incorporated by reference to the Plantext included in Registrant’s Registration Statement on Form S-3, No.33-44376).

C.  Mercantile Bankshares Corporation andParticipating Affiliates Unfunded Deferred Compensation Plan for Directors, asamended through March 9, 2004 (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-115741, Exhibit 4.4).

D.  MercantileBankshares Corporation Employee Stock Purchase Dividend Reinvestment Plan datedFebruary 13, 1995 (Incorporated by reference to Registrant’s Annual Report onForm 10-K for the year ended December 31, 1994, Exhibit 10 I, Commission FileNo. 0-5127).

E.  MercantileBankshares Corporation (1989) Omnibus Stock Plan (Incorporated by reference toRegistrant’s Quarterly Report on Form 10-Q for the period ended September 30,1997, Exhibit 10 K, Commission File No. 0-5127).

F.  Mercantile Bankshares Corporation 1999Omnibus Stock Plan and First Amendment of Mercantile Bankshares Corporation1999 Omnibus Stock Plan (Incorporated by reference to Registrant’s DefinitiveProxy Statement, filed April 8, 2004, Appendix A).

G.  Mercantile Bankshares Corporation andParticipating Affiliates Supplemental Cash Balance Executive Retirement Plan,dated April 27, 1994, effective January 1, 1994 (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for year ended December 31, 1994,Exhibit 10 R, Commission File No. 0-5127).

H.  Mercantile Bankshares Corporation andParticipating Affiliates Supplemental 401(k) Executive Retirement Plan, datedDecember 13, 1994, effective January 1, 1995 (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the year ended December 31, 1994,Exhibit 10 S, Commission File No. 0-5127).

I.  Mercantile Bankshares Corporation StockRetainer and Deferred Compensation Plan For Non-Employee Directors(Incorporated by reference to Registrant’s Current Report on Form 8-K, filedMay 16, 2005, Exhibit 10.1, Commission File No. 0-5127).

             J.  Mercantile BanksharesCorporation Option Agreement with J. Marshall Reid, dated August 21, 1995(Incorporated by reference to Registrant’s Annual Report on Form 10-K for theyear ended December 31, 1998, Exhibit 10 R, Commission File No. 0-5127).

K.  Mercantile Bankshares Corporation OptionAgreement with Terry L. Troupe, dated September 10, 1996 (Incorporated byreference to Registrant’s Annual Report on Form 10-K for the year endedDecember 31, 1999, Exhibit 10 S, Commission File No. 0-5127).

L.  Executive Employment Agreement dated February2, 2001, among Mercantile Bankshares Corporation, Mercantile-Safe Deposit andTrust Company and Edward J. Kelly, III (Incorporated by reference to Form 8-Kof Registrant filed February 13, 2001, Exhibit 10 U, Commission File No. 0-5127),as amended by Agreement effective February 21, 2002 (Incorporated by referenceto Registrant’s annual report on Form 10-K for the year ended December 31, 2001Exhibit 10R, Commission File No. 0-5127).

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M.  Executive Severance Agreement dated February2, 2001, among Mercantile Bankshares Corporation, Mercantile-Safe Deposit andTrust Company and Edward J. Kelly, III (Incorporated by reference to Form 8-Kof Registrant filed February 13, 2001, Exhibit 10 V, Commission File No.0-5127), as amended by Agreement effective February 21, 2002 (Incorporated byReference to Registrant’s Annual Report on Form 10-K, for the year endedDecember 31, 2001, Exhibit 10S, Commission File No. 5127).

N.  Supplemental Retirement Agreement datedFebruary 2, 2001, among Mercantile Bankshares Corporation, Mercantile-SafeDeposit and Trust Company and Edward J. Kelly, III (Incorporated by referenceto Form 8-K of Registrant filed February 13, 2001, Exhibit 10 W, CommissionFile No. 0-5127).

O.  Mercantile Bankshares Corporation OptionAgreement with Edward J. Kelly, III, dated March 2, 2001 (Incorporated byreference to Registrant’s Annual Report on Form 10-K for the year endedDecember 31, 2000, Exhibit 10 X, Commission File No. 0-5127).

P.  Schedule and Form of Mercantile BanksharesCorporation Option Agreements entered into in 2000 with J. Marshall Reid(40,000 shares), and Terry L. Troupe (20,000 shares) (Incorporated by referenceto Registrant’s Annual Report on Form 10-K for the year ended December 31,2000, Exhibit 10 Y, Commission File No. 0-5127).

Q.  Executive Employment Agreement dated March19, 2002, among Mercantile Bankshares Corporation, Mercantile-Safe Deposit andTrust Company and John L. Unger (incorporated by reference to Registrant’s Form8-K filed April 3, 2002 Exhibit 10Y, Commission File No. 0-5127).

R.  Executive Severance Agreement dated March 19,2002, among Mercantile Bankshares Corporation, Mercantile-Safe Deposit andTrust Company and John L. Unger (incorporated by reference to Registrant’s Form8-K April 3, 2002, Exhibit 10Z, Commission File No. 0-5127).

S.  Mercantile Bankshares Corporation OptionAgreement with Edward J. Kelly, III, dated May 7, 2002 (incorporated byreference to Registrant’s Quarterly Report for the quarter ended June 30, 2002,Exhibit 10AA, Commission File No. 0-5127).

T.  Mercantile Bankshares Corporation OptionAgreement with J. Marshall Reid, dated May 7, 2002 (incorporated by referenceto Registrant’s Quarterly Report for the quarter ended June 30, 2002, Exhibit10BB, Commission File No. 0-5127).

U.  Mercantile Bankshares Corporation OptionAgreement with John L. Unger, dated May 7, 2002 (incorporated by reference toRegistrant’s Quarterly Report for the quarter ended June 30, 2002, Exhibit10DD, Commission File No. 0-5127).

V.  Mercantile Bankshares Corporation OptionAgreement with Terry L. Troupe, dated May 7, 2002 (incorporated by reference toRegistrant’s Quarterly Report for the quarter ended June 30, 2002, Exhibit10EE, Commission File No. 0-5127).

W.  Mercantile Bankshares Corporation RestrictedStock Agreement with Edward J. Kelly, III, dated April 29, 2002 (incorporatedby reference to Registrant’s Quarterly Report for the quarter ended June 30,2002, Exhibit 10FF, Commission File No. 0-5127).

X.  Mercantile Bankshares Corporation RestrictedStock Agreement with J. Marshall Reid, dated April 29, 2002 (incorporated byreference to Registrant’s Quarterly Report for the quarter ended June 30, 2002,Exhibit 10HH, Commission File No. 0-5127).

Y.  F&M Bancorp Restated 1983 Incentive StockOption Plan (Incorporated by reference to Registrant’s Registration Statementon Form S-8, No. 333-108123, Exhibit 4.4).

Z.  F&M Bancorp 1995 Stock Option Plan(Incorporated by reference to Registrant’s Registration Statement on Form S-8,No. 333-108123, Exhibit 4.5).

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AA. F&M Bancorp 1999Employee Stock Option Plan (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.6).

BB. F&M Bancorp 1999 StockOption Plan for Non-Employee Directors (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.7)

CC. Patapsco Valley Bancshares,Inc. Incentive Stock Option Plan (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.8).

DD. Patapsco Valley Bancshares,Inc. Directors’ Stock Option Plan (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.9).

EE. Patapsco Valley Bancshares,Inc. Employee Stock Purchase Plan (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.10).

FF. Monocracy Bancshares, Inc.1994 Stock Incentive Plan (Incorporated by reference to Registrant’sRegistration Statement on Form S-8, No. 333-108123, Exhibit 4.11).

GG. Monocracy Bancshares, Inc.1997 Independent Directors’ Stock Option Plan (Incorporated by reference toRegistrant’s Registration Statement on Form S-8, No. 333-108123, Exhibit 4.12).

HH. Executive EmploymentAgreement dated as of February 1, 2002 by and between Mercantile-Safe Depositand Trust Company and John J. Pileggi (Incorporated by reference to Registrant’sAnnual report on Form 10-K for the year ended December 31, 2004, Exhibit 10.UU,Commission File No. 0-5127).

II. Executive SeveranceAgreement dated as of February 1, 2002 by and between Mercantile-Safe Depositand Trust Company and John J. Pileggi (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 2003, Exhibit 10.VV,Commission File No. 0-5127).

JJ. Executive EmploymentAgreement dated as of January 13, 2003 by and between Mercantile-Safe Depositand Trust Company and Michael M. Paese (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 2003, Exhibit 10.WW,Commission File No. 0-5127).

KK. Executive SeveranceAgreement dated as of March 10, 2004 by and between Mercantile BanksharesCorporation and Peter W. Floeckher (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the year ended December 31, 2003, Exhibit 10.XX,Commission File No. 0-5127).

LL. Executive SeveranceAgreement dated as of March 10, 2004 by and among Mercantile BanksharesCorporation, Mercantile-Safe Deposit and Trust Company and Deborah A. Kakaris(Incorporated by reference to Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2003, Exhibit 10.YY, Commission File No. 0-5127).

MM. Executive SeveranceAgreement dated as of March 10, 2004 by and between Mercantile BanksharesCorporation and Priscilla S. Hoblitzell (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the year ended December 31, 2003,Exhibit 10.ZZ, Commission File No. 0-5127).

NN. Amended and RestatedExecutive Employment Agreement dated June 14, 2005 by and among Registrant,Mercantile-Safe Deposit and Trust Company and Jay M. Wilson (Incorporated byreference to Registrant’s Form 8-K, filed June 17, 2005, Exhibit 10.1,Commission File No. 0-5127).

OO. Amended and RestatedExecutive Severance Agreement dated June 14, 2005 by and among Registrant,Mercantile-Safe Deposit and Trust Company and Jay M. Wilson (Incorporated byreference to Registrant’s Form 8-K, filed June 17, 2005, Exhibit 10-2,Commission File No. 0-5127).

PP. Lease Agreement by and between MBC Realty, LLC andMercantile-Safe Deposit and Trust Company dated as of November 19, 2004 andeffective as of December 13, 2005 (Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the Year Ended December 31, 2004, Exhibit 10.PP,Commission File No. 0-5127).

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QQ. Membership InterestsPurchase Agreement (MBC Realty, LLC) by and between Registrant and Harbor GroupInternational L.L.C. dated as of October 20, 2004 (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the Year Ended December 31, 2004,Exhibit 10.QQ, Commission File No. 0-5127).

RR. First Amendment toMembership Interests Purchase Agreement (MBC Realty, LLC) by and betweenRegistrant and Harbor Group, International, L.L.C. dated as of November 18,2004 (Incorporated by reference to Registrant’s Annual Report on Form 10-K forthe Year Ended December 31, 2004, Exhibit 10.RR, Commission File No. 0-5127).

SS. Form of Option Agreementfor grants made under the Mercantile Bankshares Corporation 1999 Omnibus StockPlan (Incorporated by reference to Registrant’s Annual Report on Form 10-K forthe Year Ended December 31, 2004, Exhibit 10.SS, Commission File No. 0-5127).

TT. Form of Restricted StockAward Agreement for grants made under the Mercantile Bankshares Corporation1999 Omnibus Stock Plan (Incorporated by reference to Registrant’s AnnualReport on Form 10-K for the Year Ended December 31, 2004, Exhibit 10.TT,Commission File No. 0-5127).

UU. Mercantile BanksharesCorporation 2004 Restricted Stock Program, as amended(Incorporated by reference to Registrant’sAnnual Report on Form 10-K for the Year Ended December 31, 2005, Exhibit 10.UU,Commission File No. 0-5127).

VV. Executive SeveranceAgreement effective as of November 5, 2003 by and between Registrant andAlexander T. Mason (Incorporated by reference to Registrant’s Annual Report onForm 10-K for the Year Ended December 31, 2004, Exhibit 10.VV, Commission FileNo. 0-5127).

WW. Executive SeveranceAgreement effective as of August 15, 2002 by and between Registrant and KevinA. McCreadie (Incorporated by reference to Registrant’s Annual Report on Form10-K for the Year Ended December 31, 2004, Exhibit 10.WW, Commission File No.0-5127).

XX. Executive EmploymentAgreement effective as of August 15, 2002 by and among Registrant, MercantileCapital Advisors, Inc. and Kevin A. McCreadie (Incorporated by reference toRegistrant’s Annual Report on Form 10-K for the Year Ended December 31, 2004,Exhibit 10.XX, Commission File No. 0-5127).

YY. Mercantile BanksharesCorporation Deferred Compensation Plan (Incorporated by reference to Registrant’sCurrent Report on Form 8-K, filed March 14, 2005, Exhibit 10.1, Commission FileNo. 0-5127).

ZZ. Form of MercantileBankshares Corporation Restricted Stock Unit Award Agreement with Edward J.Kelly, III, dated March 29, 2006 (Incorporated by reference toRegistrant’s Quarterly Report for the quarter ended March 30, 2006, Exhibit10.ZZ, Commission File No. 0-5127).

AAA. Form of Restricted StockUnit Award Agreement for grants made under the Mercantile BanksharesCorporation Omnibus Stock Plan, 2006 Long-Term Incentive Program (Incorporatedby reference to Registrant’s Quarterly Report for the quarter ended March 30,2006, Exhibit 10 AAA, Commission File No. 0-5127).

BBB. Amendment to ChiefExecutive Officer’s Employment Agreement, Amendment and Restatement of ChiefExecutive Officer’s Executive Severance Agreement and Amendment to OtherExecutive Officers’ Executive Severance Agreements (Incorporated by referenceto Registrant’s Current Report on Form 8-K, filed April 4, 2006 and as amendedOn Registrant’s Current Report on Form 8-K/A, dated April 7, 2006, Commission File 0-5127).

CCC. Mercantile Bankshares Corporation Annual Cash Incentive Plan,adopted May 9, 2006 (Incorporated by reference to Registrant’s Form 8-K, filedMay 15, 2006, Exhibit 10.1, Commission File No. 0-5127).

DDD. Amendment Number One to Restricted Stock Unit Award Agreement byand between Mercantile Bankshares Corporation and Edward J. Jelly, III dated asof March 29, 2006, entered into as of October 8, 2006 (Incorporated byreference to Registrant’s Form 8-K, filed October 10, 2006, Exhibit 10.1,Commission File No. 0-5127).

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(14) Code of Business Conduct and Ethics asamended to date (Incorporated by reference to Registrant’s Current Report onForm 8-K, filed June 19, 2006, Exhibit 14, Commission File No. 0-5127).

(21) Subsidiaries of the Registrant (filedherewith).

(23) Consent of Independent Registered Public AccountingFirms

A.  Consent ofErnst & Young LLP (filed herewith).

B.  Consent of PricewaterhouseCoopers LLP (filedherewith).

(24) Power of Attorney dated March 1, 2007 (filed herewith).

(31)Certifications pursuant to Section 302 of the Sarbanes Oxley Act of 2002A. Certification of the Chief Executive Officer of Mercantile BanksharesCorporation (filed herewith).B.  Certification of the Chief FinancialOfficer of Mercantile Bankshares Corporation (filed herewith).

(32) Certifications pursuant to Section 906 of theSarbanes Oxley Act of 2002A.  Certificate of the Chief ExecutiveOfficer of Mercantile Bankshares Corporation (furnished herewith).B.  Certificate of the Chief FinancialOfficer of Mercantile Bankshares Corporation (furnished herewith).

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**INDEXTO FINANCIAL STATEMENTS**

Reportof Independent Registered Public Accounting Firm on Consolidated FinancialStatements is included in Item 8 of this Annual Report on Form 10-K.

Management’sReport on Internal Control Over Financial Reporting is included in Item 8of this Annual Report on Form 10-K.

Reportof Independent Registered Public Accounting Firm on Internal Control OverFinancial Reporting is included in Item 8 of this Annual Report onForm 10-K.

Reportof Independent Registered Public Accounting Firm on Consolidated FinancialStatements is included in Item 8 of this Annual Report on Form 10-K.

ConsolidatedFinancial Statements and related notes are included in Item 8 of this AnnualReport on Form 10-K, as follows:
|        | Consolidated Balance Sheets, December 31, 2006 and  2005                                                              |
|--------|-----------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                  |
|   | Statements of Consolidated Income for the years  ended December 31, 2006, 2005, and 2004                              |
|   |                                                                                                                  |
|   | Statements of Changes in Consolidated Shareholders’  Equity for the years ended December 31, 2006, 2005 and 2004 |
|   |                                                                                                                  |
|   | Statements of Consolidated Cash Flows for the years  ended December 31, 2006, 2005 and 2004                           |
|   |                                                                                                                  |
|   | Notes to Consolidated Financial Statements                                                                            |

 

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities and Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

MERCANTILE BANKSHARESCORPORATION

 
| By:    | /s/ Edward J. Kelly, III              |   | March 1, 2007 |   |
|--------|---------------------------------------|--------|---------------|--------|
|   |                                  |   |          |   |
|   | Edward J. Kelly, III                  |   |          |   |
|   | President and Chief Executive Officer |   |          |   |

 

Pursuant to the requirements of the Securities Act of1934, this report has been signed below by the following persons on behalf ofthe Registrant and in the capacities and on the dates indicated:
| Principal Executive Officer                          |   |          |
|------------------------------------------------------|--------|---------------|
|                                                 |   |          |
|                                                 |   |          |
| /s/ Edward J. Kelly, III                             |   | March 1, 2007 |
|                                                 |   |          |
| Edward J. Kelly, III                                 |   |          |
| Chairman, President and Chief Executive Officer      |   |
|                                                 |   |          |
|                                                 |   |          |
| Principal Financial Officer                          |   |          |
|                                                 |   |          |
|                                                 |   |          |
| /s/ Terry L. Troupe                                  |   | March 1, 2007 |
|                                                 |   |          |
| Terry L. Troupe                                      |   |          |
| Executive Vice President and Chief Financial Officer |   |
|                                                 |   |          |
|                                                 |   |          |
| Principal Accounting Officer                         |   |          |
|                                                 |   |          |
|                                                 |   |          |
| /s/ William T. Skinner, Jr.                          |   | March 1, 2007 |
|                                                 |   |          |
| William T. Skinner, Jr.                              |   |          |
| Senior Vice President and Controller                 |   |

 

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A majority of the Board of Directors:

CynthiaA. Archer, Richard O. Berndt, Howard B. Bowen, R. Carl Bowen, William R. Brody,Freeman A. Hrabowski III,Alexander T. Mason, Jenny G. Morgan, Christian H. Poindexter, Clayton S. Rose,James L. Shea, Donald J. Shepard and Jay M. Wilson.
| By:    | /s/ Edward J. Kelly, III             |   | March 1, 2007 |   |
|--------|--------------------------------------|--------|--------------------|--------|
|   |                                 |   |               |   |
|   | Edward J. Kelly, III                 |   |               |   |
|   | For Himself and as  Attorney-in-Fact |   |               |   |

 

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