**United
      States**


**Securities
      and Exchange Commission**


**Washington,
      D.C. 20549**





**Form
      10-KSB**





**(Mark
      One)**





**[X]**
            **ANNUAL
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934****For
                the fiscal year ended December 31, 2006****[
                ]**
            **TRANSITION
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934**





**For
      the transition period from ______________** **to
      ______________**





**Commission
      File Number 000-51765**





Bay
      National Corporation


(Name
      of
      small business issuer in its charter)





Maryland
            52-2176710(State
                or other jurisdiction of
            (I.R.S.
                Employerincorporation
                or organization)
            Identification
                No.)





2328
                West Joppa Road, Lutherville, Maryland
            21093(Address
                of principal executive offices)
            (Zip
                Code)





Issuer's
      telephone number: 410-494-2580





Securities
      registered under Section 12(b) of the Exchange Act:


Title
                of each class
            Name
                of each exchange on which registeredCommon
                stock, par value $0.01 per share
            The
                Nasdaq Stock Market LLC





Securities
      registered under Section 12(g) of the Exchange Act: None





Indicate
      by checkmark if the registrant is not required to file reports pursuant to
      Section 13 or 15(d) of the Exchange Act. Yes  __  No X








Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 12 months (or for such shorter period
      that the registrant was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days.  Yes X No
      __





Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of registrant's knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB.





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the
      Exchange Act):  Yes  __  No X








The
      issuer's revenues for its most recent fiscal year were $ 20,558,172.





The
      aggregate market value of the common equity held by non-affiliates was
      $26,091,160 as of March 27, 2007, based on a sales price of $18.45 per share
      of
      Common Stock, which is the sales price at which shares of Common Stock were
      last
      sold on the Nasdaq Stock Market on March 27, 2007.




The
      number of shares outstanding of the issuer's Common Stock was 1,935,369 as
      of
      March 27, 2007.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





Portions
      of the Proxy Statement for the 2007 Annual Meeting of Stockholders of Bay
      National Corporation, to be filed with the Securities and Exchange Commission
      no
      later than 120 days after the close of the fiscal year, are incorporated by
      reference in Part III of this Annual Report on Form 10-KSB.








Transitional
      Small Business Disclosure Format (check one):





Yes  __  No X



















**BAY
        NATIONAL CORPORATION**
 
 **TABLE
        OF CONTENTS**
 
 **PART
                  I**Item
                  1.
              Description
                  of Business
              1Item
                  2.
              Description
                  of Property
              18Item
                  3.
              Legal
                  Proceedings
              19Item
                  4.
              Submission
                  of Matters to a Vote of Security
                  Holders
              19**PART
                  II**Item
                  5.
              Market
                  for Common Equity and Related Stockholder Matters
              20Item
                  6.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operation
              22Item
                  7.
              Financial
                  Statements
              51Item
                  8.
              Changes
                  in and Disagreements with Accountants on Accounting
                  and Financial Disclosure
              83Item
                  8A.
              Controls
                  and Procedures
              83Item
                  8B.
              Other
                  Information
              83**PART
                  III**Item
                  9.
              Directors,
                  Executive Officers, Promoters, Control Personal
                  and Corporate Governance; Compliance with Section 16(a) of the
                  Exchange
                  Act
              84Item
                  10.
              Executive
                  Compensation
              84Item
                  11.
              Security
                  Ownership of Certain Beneficial Owners and
                  Management and Related Stockholder Matters
              85Item
                  12.
              Certain
                  Relationships, Related Transactions and Director
                  Independence
              85Item
                  13.
              Exhibits
              86Item
                  14.
              Principal
                  Accountant Fees and Services
              88**Signatures**
              89








**PART
      I**





Item1.
      Description of Business





**BUSINESS
      OF BAY NATIONAL CORPORATION AND BAY NATIONAL BANK**





**General**





Bay
      National Corporation was incorporated under the laws of the State of Maryland
      on
      June 3, 1999, primarily to serve as a bank holding company for a proposed
      federally chartered commercial bank to be named Bay National Bank.





Bay
      National Bank commenced operations on May 12, 2000 with its main office in
      Lutherville, Maryland and a branch office in Salisbury, Maryland. Bay National
      Bank accepts checking and savings deposits and offers a wide range of commercial
      and industrial, real estate, consumer and residential mortgage
      loans.





On
      December 12, 2005, Bay National Corporation consummated the sale of a trust
      preferred securities offering in which it issued $8,248,000 of subordinated
      debt
      securities due 2036 to Bay National Capital Trust I, a Delaware statutory trust
      (the “Trust”) and an unconsolidated subsidiary formed by Bay National
      Corporation, and the Trust simultaneously issued $8,000,000 of trust preferred
      securities. The Trust also issued $248,000 of its common securities to Bay
      National Corporation. No underwriting commissions were paid in connection with
      the issuances. All of the securities were issued in a private placement exempt
      from registration under 4(2) of the Securities Act of 1933, as amended and/or
      Regulation D promulgated thereunder.





**Marketing
      Focus**





Bay
      National Bank was formed by a group of individuals active in business,
      professional, banking, financial and charitable activities in the Baltimore,
      Maryland metropolitan area and the Eastern Shore of Maryland. These individuals
      believed that the banking needs of certain segments of these communities were
      not being served adequately by existing banks. Specifically, as a result of
      bank
      mergers in the 1990s, many banks in the Baltimore metropolitan area and the
      Eastern Shore of Maryland became local branches of large regional and national
      banks. Although size gave the larger banks some advantages in competing for
      business from large corporations, including economies of scale and higher
      lending limits, the organizers believed that these “mega banks” were focused on
      a mass market approach which de-emphasized personal contact and service. The
      organizers also believed that the centralization of decision-making power at
      these large institutions had resulted in a lack of customer service. At many
      of
      these institutions, determinations were made at the "home office" by individuals
      who lacked personal contact with customers as well as an understanding of the
      customers' needs and scope of the relationship with the institution.





Bay
      National Bank’s management believes that this trend is ongoing, and continues to
      be particularly frustrating to owners of small and mid-sized businesses,
      business professionals and high net worth individuals who traditionally have
      been accustomed to dealing directly with a bank executive who had an
      understanding of their banking needs with the ability to deliver a prompt
      response.





Bay
      National Bank targets its commercial banking services to small and mid-sized
      businesses and targets its retail banking services to the owners of these
      businesses and their employees, to business professionals and high net worth
      individuals.




1





Bay
      National Bank seeks to distinguish itself by





·
            Developing
                personal relationships with its customers.





·
            Customizing
                its products to fit the needs of its customers instead of adopting
                a "one
                size fits all" mentality.





·
            Streamlining
                the decision making process.





·
            Offering
                its customers additional complementary services, such as insurance
                and
                investment advice, through relationships with strategic partners.





Bay
      National Bank’s offices are not organized in the traditional retail branch
      structure, which is transaction and "bank teller" oriented. Instead, Bay
      National Bank emphasizes a "sit-down" model where customers can choose to be
      greeted by a personal banker and taken to a private desk. Customers also have
      the option to conduct their transactions using a more traditional teller
      counter. Management believes that this approach makes service more
      individualized and enhances the banker's understanding of the customer's needs.
      Furthermore, Bay National Bank’s branch locations do not focus on capturing
      every customer within the surrounding area. Instead, they are strategically
      located in areas convenient to Bay National Bank’s target customer
      base.





**Market
      Area and Facilities**





Bay
      National Bank’s headquarters and Baltimore branch office are located at 2328
      West Joppa Road, Lutherville, Maryland 21093. Bay National Bank serves the
      Baltimore metropolitan area from that location, with its primary service area
      being Towson, Lutherville-Timonium, Cockeysville, Hunt Valley, Ruxton and Roland
      Park. Bay National Bank’s Salisbury, Maryland branch office is located at 109
      Poplar Hill Avenue, Salisbury, Maryland 21801, from which it serves Maryland’s
      Eastern Shore.





**Products
      and Services**





Loan
      Portfolio .





Bay
      National Bank offers a full range of loans, including commercial and industrial
      loans, real estate loans, consumer loans and residential mortgage and home
      equity loans. Commercial business and commercial real estate loans for
      owner-occupied properties are Bay National Bank's primary loan products,
      accounting for approximately 65% of the loan portfolio as of December 31, 2006.





Generally,
      Bay National Bank is subject to a lending limit to any one borrower of 15%
      of
      Bay National Bank’s unimpaired capital and surplus. However, management is able
      to originate loans and to participate with other lenders in loans that exceed
      Bay National Bank's lending limits.





The
      following is a description of the types of loans that Bay National Bank has
      targeted in building its loan portfolio:





·
            Commercial
                and industrial loans for business purposes including working capital,
                equipment purchases, lines of credit and government contract financing.
                Asset-based lending and accounts receivable financing are also available.
                As of December 31, 2006, these loans represented approximately 41%
                of Bay
                National Bank’s loan portfolio. In general, Bay National Bank targets
                small and mid-sized businesses in its market area with credit needs
                in the
                range of up to $5,000,000.





·
            Commercial
                real estate loans, including mortgage loans on non-residential properties,
                and land development and construction loan financing, primarily for
                owner-occupied premisesas
                well as first and second mortgage loans on commercially owned residential
                investment properties. As of December 31, 2006, these loans represented
                approximately 24% of Bay National Bank’s loan
                portfolio.







2


·
            Mortgage
                loans and residential construction loans secured by residential property,
                including first and second mortgage loans on owner occupied and investment
                properties (1 to 4 family and multi-family) owned by individuals,
                and home
                equity loans secured by single-family owner-occupied residences.
                As of
                December 31, 2006, these loans represented approximately 34% of Bay
                National Bank’s loan portfolio. Like its consumer loans, Bay National
                Bank’s residential real estate loans are targeted to business owners and
                their employees, business professionals and high net worth individuals.





·
            Consumer
                loans including automobile and personal loans. In addition, Bay National
                Bank offers personal lines of credit. As of December 31, 2006, these
                loans
                represented approximately 1% of Bay National Bank’s loan portfolio. Bay
                National Bank’s consumer loans are targeted to business owners and their
                employees, business professionals and high net worth individuals.





Bay
      National Bank originates some of its Eastern Shore residential mortgage loans
      through BNB Mortgage, LLC, a Maryland limited liability company, which is a
      joint venture between Bay National Bank and an Ocean City, Maryland real estate
      agent. Bay National Bank is responsible for all of the operations of BNB
      Mortgage, LLC. Bay National Bank’s share of net income from this entity amounted
      to $2,680 and $12,916 for the years ended December 31, 2006 and 2005,
      respectively. All loans originated by BNB Mortgage, LLC are immediately sold
      to
      Bay National Bank. These loans are then sold to third party investors in the
      same fashion as other conventional first and second residential mortgage loans
      originated by Bay National Bank.





Bay
      National Bank’s conventional first and second residential mortgage loans adhere
      to standards developed by FNMA/FHLMC. Bay National Bank sells most of its first
      and second residential mortgage loans in the secondary market. Therefore,
      management sells those loans that have a lower degree of risk, and a lower
      yield, relative to the other types of loans that Bay National Bank makes. Since
      these loans are typically sold, Bay National Bank offers these loans as well
      as
      certain residential construction loans to a broader array of individuals than
      its home equity loans and other consumer loan products. As of December 31,
      2006,
      mortgage loans held for sale totaled $1,444,303.





Deposits .





Bay
      National Bank offers a wide range of interest-bearing and non-interest-bearing
      accounts, including commercial and retail checking accounts, money market
      accounts, individual retirement accounts, interest-bearing statement savings
      accounts and certificates of deposit with fixed and variable rates and a range
      of maturity date options.





Other
      Banking and Financial Services .





Bay
      National Bank offers commercial customers cash management services such as
      sweep
      accounts, repurchase agreements, commercial paper investments, account
      reconciliation, lockbox services and wire transfers of funds. Additionally,
      Bay
      National Bank makes available telephone banking, ATM/debit cards, safe keeping
      boxes, after-hours deposit services, travelers checks, direct deposit of payroll
      and automatic drafts for various accounts. These services are provided either
      directly by Bay National Bank or through correspondent banking relationships.
      Bay National Bank does not have its own network of ATM machines. In general,
      Bay
      National Bank waives fees on a predetermined number of ATM transactions per
      month, thereby allowing its customers to use any ATM machine.





In
      addition, Bay National Bank's customers are able to access information about
      their accounts and view information about Bay National Bank's services and
      products on Bay National Bank's website, which is located at
      http://www.baynational.com. Bay National Bank’s website also permits customers
      to make transfers of funds among accounts, pay bills and send e-mail to Bay
      National Bank personnel.




3




Bay
      National Bank offers, through strategic partners, investment advisory, risk
      management and employee benefit services. Through these affiliations, banking
      clients can receive a full range of financial services, including investment
      advice, personal and business insurance products and employee benefit products
      such as pension and 401(k) plan administration. To the extent permitted by
      applicable regulations, the strategic partners may share fees and commissions
      with Bay National Bank. As of December 31, 2006, Bay National Bank had not
      entered in to any such fee arrangements. When sufficient volume is developed
      in
      any of these lines of business, Bay National Bank may provide these services
      if
      permitted by applicable regulations.





**Competition**





In
      both
      the Baltimore metropolitan area and on Maryland's Eastern Shore, Bay National
      Bank faces strong competition from large banks headquartered within and outside
      of Maryland. Bay National Bank also competes with other community banks, savings
      and loan associations, credit unions, mortgage companies, finance companies
      and
      others providing financial services. In addition, insurance companies,
      securities brokers and other non-bank entities or their affiliates may provide
      services, which historically have been considered banking in nature.





Many
      of
      Bay National Bank’s competitors can finance extensive advertising campaigns,
      maintain extensive branch networks and technology investments, and offer
      services, which Bay National Bank cannot offer or chooses not to offer. Also,
      larger institutions have substantially higher lending limits than Bay National
      Bank. Some of Bay National Bank’s competitors have other advantages, such as tax
      exemption in the case of credit unions, and lesser regulation in the case of
      mortgage companies and finance companies.





**Employees**





As
      of
      March 27, 2007, Bay National Bank employed fifty-seven individuals. Thirty-three
      people operate from Bay National Bank’s headquarters and banking office in
      Lutherville, Maryland, fourteen people operate from the Towson, Maryland
      residential lending office and ten people from the Salisbury, Maryland banking
      office. Bay National Corporation has no employees.





**SUPERVISION
      AND REGULATION**





**General**





Bay
      National Corporation and Bay National Bank are subject to extensive regulation
      under state and federal banking laws and regulations. These laws impose specific
      requirements and restrictions on virtually all aspects of operations and
      generally are intended to protect depositors, not stockholders. The following
      discussion is only a summary and readers should refer to particular statutory
      and regulatory provisions for more detailed information. In addition, management
      cannot predict the nature or the extent of the effect on our business and
      earnings that new federal or state legislation may have in the future.





**Bay
      National Corporation**





*Federal
      Bank Holding Company Regulation.* Bay
      National Corporation is a bank holding company registered under the Bank Holding
      Company Act of 1956, as amended, and is subject to supervision by the Federal
      Reserve Board. As a bank holding company, Bay National Corporation is required
      to file with the Federal Reserve Board an annual report and such other
      additional information as the Federal Reserve Board may require by statute.
      The
      Federal Reserve Board may also examine Bay National Corporation and each of
      its
      subsidiaries.





The
      Federal Reserve Board must approve, among other things, the acquisition by
      a
      bank holding company of control of more than 5% of the voting shares, or
      substantially all the assets, of any bank or bank holding company or the merger
      or consolidation by a bank holding company with another bank holding company.
      Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994,
      the restrictions on interstate acquisitions of banks by bank holding companies
      were repealed as of September 29, 1995. The effect of the repeal of these
      restrictions is that, subject to certain time and deposit base requirements,
      Bay
      National Corporation may acquire a bank located in Maryland or any other state,
      and a bank holding company located outside of Maryland can acquire any
      Maryland-based bank holding company or bank.






4





Unless
      it
      chooses to become a financial holding company, as further described below,
      a
      bank holding company is prohibited from acquiring control of any voting shares
      of any company which is not a bank or bank holding company and from engaging
      directly or indirectly in any activity other than banking, or managing or
      controlling banks or furnishing services for its authorized subsidiaries. There
      are limited exceptions. A bank holding company may, for example, engage in
      activities which the Federal Reserve Board has determined by order or regulation
      to be so closely related to banking or managing or controlling banks as to
      be
      "properly incident thereto." In making such a determination, the Federal Reserve
      Board is required to consider whether the performance of such activities can
      reasonably be expected to produce benefits to the public, such as convenience,
      increased competition or gains in efficiency, which outweigh possible adverse
      effects, such as undue concentration of resources, decreased or unfair
      competition, conflicts of interest or unsound banking practices. The Federal
      Reserve Board is also empowered to differentiate between activities commenced
      de
      novo and activities commenced by the acquisition, in whole or in part, of a
      going concern. Some of the activities that the Federal Reserve Board has
      determined by regulation to be closely related to banking include servicing
      loans, performing certain data processing services, acting as a fiduciary,
      investment or financial advisor, and making investments in corporations or
      projects designed primarily to promote community welfare.




Subsidiary
      banks of a bank holding company are subject to certain restrictions imposed
      by
      statute on any extensions of credit to the bank holding company or any of its
      subsidiaries, or investments in their stock or other securities, and on taking
      such stock or securities as collateral for loans to any borrower. Further,
      a
      bank holding company and any subsidiary bank are prohibited from engaging in
      certain tie-in arrangements in connection with the extension of credit. The
      Federal Reserve Board adopted amendments to its Regulation Y, creating
      exceptions to the Bank Holding Company Act's anti-tying prohibitions that give
      bank subsidiaries of holding companies greater flexibility in packaging products
      and services with their affiliates.





In
      accordance with Federal Reserve Board policy, Bay National Corporation is
      expected to act as a source of financial strength to Bay National Bank and
      to
      commit resources to support Bay National Bank in circumstances in which Bay
      National Corporation might not otherwise do so. The Federal Reserve Board may
      require a bank holding company to terminate any activity or relinquish control
      of a non-bank subsidiary (other than a non-bank subsidiary of a bank) upon
      the
      Federal Reserve's determination that such activity or control constitutes a
      serious risk to the financial soundness or stability of any subsidiary
      depository institution of the bank holding company. Further, federal bank
      regulatory authorities have additional discretion to require a bank holding
      company to divest itself of any bank or non-bank subsidiary if the agency
      determines that divestiture may aid the depository institution's financial
      condition.





On
      November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley
      Act
      of 1999 (“GLBA”). Effective March 11, 2000, pursuant to authority granted under
      the GLBA, a bank holding company may elect to become a financial holding company
      and thereby engage in a broader range of financial and other activities than
      are
      permissible for traditional bank holding companies. In order to qualify for
      the
      election, all of the depository institution subsidiaries of the bank holding
      company must be well capitalized and well managed, as defined by regulation,
      and
      all of its depository institution subsidiaries must have achieved a rating
      of
      satisfactory or better with respect to meeting community credit needs.





Pursuant
      to the GLBA, financial holding companies are permitted to engage in activities
      that are "financial in nature" or incidental or complementary thereto and not
      a
      substantial risk to the safety and soundness of the depository institution
      or
      the financial system in general, as determined by the Federal Reserve Board.
      The
      GLBA identifies several activities as "financial in nature," including, among
      others, insurance underwriting and agency, investment advisory services,
      merchant banking and underwriting, and dealing or making a market in securities.
      Being designated a financial holding company will allow insurance companies,
      securities brokers and other types of financial companies to affiliate with
      and/or acquire depository institutions.






5





As
      a bank
      holding company with consolidated assets of more than $150,000,000, Bay National
      Corporation also is subject to certain risk-based capital guidelines imposed
      on
      bank holding companies by the Federal Reserve Board to insure the holding
      company’s capital adequacy. See "Item 1. Description of Business - Supervision
      and Regulation - Bay National Bank - Capital Adequacy Guidelines" below for
      details.





The
      status of Bay National Corporation as a registered bank holding company under
      the Bank Holding Company Act does not exempt it from certain federal and state
      laws and regulations applicable to corporations generally, including, without
      limitation, certain provisions of the federal securities laws.





*State
      Bank Holding Company Regulation.* Bay
      National Corporation is a Maryland-chartered bank holding company and is subject
      to various restrictions on its activities as set forth in Maryland law, in
      addition to those restrictions set forth in federal law.





Under
      Maryland law, a bank holding company that desires to acquire a Maryland
      state-chartered bank or trust company, a federally chartered bank with its
      main
      office in Maryland, or a bank holding company that has its principal place
      of
      business in Maryland, must file an application with the Maryland Commissioner
      of
      Financial Regulation (the "Commissioner"). In approving the application, the
      Commissioner must consider whether the acquisition may be detrimental to the
      safety and soundness of the entity being acquired or whether the acquisition
      may
      result in an undue concentration of resources or a substantial reduction in
      competition in Maryland. The Commissioner may not approve an acquisition if,
      on
      consummation of the transaction, the acquiring company, together with all its
      insured depository institution affiliates, would control 30% or more of the
      total amount of deposits of insured depository institutions in Maryland. The
      Commissioner has authority to adopt by regulation a procedure to waive this
      requirement for good cause. In a transaction for which the Commissioner's
      approval is not required due to an exemption under Maryland law, or for which
      federal law authorizes the transaction without application to the Commissioner,
      the parties to the acquisition must provide written notice to the Commissioner
      at least 15 days before the effective date of the acquisition.





**Bay
      National Bank**





*General.* Bay
      National Bank, as a national banking association whose accounts are insured
      by
      the Bank Insurance Fund ("BIF") of the Federal Deposit Insurance Corporation
      ("FDIC") up to the maximum legal limits, is subject to regulation, supervision
      and regular examinations by the Office of the Comptroller of the Currency
      ("OCC"). Bay National Bank is a member of the Federal Reserve System and, as
      such, is subject to certain regulations issued by the Federal Reserve Board.
      Bay
      National Bank also is subject to applicable banking provisions of Maryland
      law
      insofar as they do not conflict with or are not preempted by federal law. The
      regulations of these various agencies govern most aspects of Bay National Bank's
      business, including setting required reserves against deposits, loans,
      investments, mergers and acquisitions, borrowing, dividends, and location and
      number of branch offices.





The
      GLBA
      authorizes expanded activities for national banks, but requires (with the
      exception of underwriting municipal revenue bonds and other state and local
      obligations) that any expanded activities be conducted in a new entity called
      a
“financial subsidiary” that is a subsidiary of the bank rather than the bank
      itself. A financial subsidiary may engage in any activities in which a financial
      holding company or a financial holding company’s non-bank subsidiaries can
      engage, except that a financial subsidiary may not underwrite most insurance,
      engage in real estate development or conduct merchant banking activities. A
      financial subsidiary may be established through acquisition or *de
      novo* .


6


In
      order
      for a national bank to operate a financial subsidiary, it must be well
      capitalized and well managed, have a satisfactory or better rating with respect
      to meeting community credit needs and the aggregate assets of all of the bank’s
      financial subsidiaries may not exceed 45% of the total assets of the bank,
      subject to certain exceptions. Existing authority of the OCC and the FDIC to
      review subsidiary activities is preserved.





Banking
      is a business which depends on interest rate differentials. In general, the
      differences between the interest paid by a bank on its deposits and its other
      borrowings and the interest received by a bank on loans extended to its
      customers and securities held in its investment portfolio constitute the major
      portion of a bank's earnings. Thus, the earnings and growth of Bay National
      Bank
      will be subject to the influence of economic conditions generally, both domestic
      and foreign, and also on the monetary and fiscal policies of the United States
      and its agencies, particularly the Federal Reserve Board, which regulates the
      supply of money. We cannot predict the nature and timing of changes in such
      policies and their impact on Bay National Bank.





*Branching
      and Interstate Banking.* Beginning
      on June 1, 1997, the federal banking agencies were authorized to approve
      interstate bank merger transactions without regard to whether such a transaction
      is prohibited by the law of any state, unless the home state of one of the
      banks
      has opted out of the interstate bank merger provisions of the Riegle-Neal
      Interstate Banking and Branching Efficiency Act of 1994. Furthermore, under
      the
      Riegle-Neal Act, interstate acquisitions of branches are permitted if the law
      of
      the state in which the branch is located permits such acquisitions. The
      Riegle-Neal Act also authorizes the OCC and FDIC to approve interstate branching
      de novo by national and non-member banks, respectively, but only in states
      which
      specifically allow for such branching.





The
      District of Columbia, Maryland, Delaware and Pennsylvania have all enacted
      laws
      which permit interstate acquisitions of banks and bank branches and permit
      out-of-state banks to establish de novo branches.





*Gramm-Leach-Bliley
      Act.* The
      GLBA
      altered substantially the statutory framework for providing banking and other
      financial services in the United States of America. The GLBA, among other
      things, eliminated many of the restrictions on affiliations among banks and
      securities firms, insurance firms, and other financial service providers. A
      bank
      holding company that qualifies as a financial holding company or a subsidiary
      of
      a bank that qualifies as a financial subsidiary is permitted to engage in
      activities that are financial in nature or incidental or complementary to a
      financial activity. The activities that the GLBA expressly lists as financial
      in
      nature include insurance activities, providing financial and insurance advisory
      services, underwriting services, and limited merchant banking activities. To
      become eligible for these expanded activities, a bank holding company must
      be
      approved by the Federal Reserve Board as a financial holding company.




The
      GLBA
      also provides new protections against the transfer and use by financial
      institutions of consumers’ nonpublic personal information. A financial
      institution must provide to its customers, at the beginning of the customer
      relationship and annually thereafter, the institution’s policies and procedures
      regarding the handling of customers’ nonpublic personal financial information.
      The new privacy provisions generally prohibit a financial institution from
      providing a customer’s personal financial information to unaffiliated third
      parties unless the institution discloses to the customer that the information
      may be so provided and the customer is given the opportunity to opt out of
      such
      disclosure.





*Capital
      Adequacy Guidelines.* The
      Federal Reserve Board, the OCC and the FDIC have all adopted risk-based capital
      adequacy guidelines by which they assess the adequacy of capital in examining
      and supervising banks and bank holding companies and in analyzing bank
      regulatory applications. Risk-based capital requirements determine the adequacy
      of capital based on the risk inherent in various classes of assets and
      off-balance sheet items.





Since
      December 31, 1992, national banks and bank holding companies have been expected
      to meet a minimum ratio of total qualifying capital (the sum of core capital
      (Tier 1) and supplementary capital (Tier 2)) to risk-weighted assets (a "Total
      Risk-Based Capital Ratio") of 8%. At least half of this amount (4%) should
      be in
      the form of Tier 1 capital. These requirements apply to Bay National Bank and
      Bay National Corporation.






7





Tier
      1
      capital generally consists of the sum of common stockholders' equity and
      perpetual preferred stock (subject in the case of the latter to limitations
      on
      the kind and amount of such stock which may be included as Tier 1 capital),
      less
      goodwill, without adjustment in accordance with Statement of Financial
      Accounting Standards No. 115. Tier 2 capital consists of the following: hybrid
      capital instruments, perpetual preferred stock which is not otherwise eligible
      to be included as Tier 1 capital, term subordinated debt and intermediate-term
      preferred stock, and, subject to limitations, general allowances for loan
      losses. Assets are adjusted under the risk-based guidelines to take into account
      different risk characteristics, with the categories ranging from 0% (requiring
      no risk-based capital) for assets such as cash, to 100% for the bulk of assets
      which are typically held by a commercial bank, including certain multi-family
      residential and commercial real estate loans, commercial business loans and
      consumer loans. Residential first mortgage loans on one-to-four-family
      residential real estate and certain seasoned multi-family residential real
      estate loans, which are not 90 days or more past-due or non-performing and
      which
      have been made in accordance with prudent underwriting standards, are assigned
      a
      50% level in the risk-weighing system, as are certain privately issued
      mortgage-backed securities representing indirect ownership of such loans.
      Off-balance sheet items also are adjusted to take into account certain risk
      characteristics.





In
      addition to the risk-based capital requirements, the OCC and the FDIC have
      established a minimum 3% Leverage Capital Ratio (Tier 1 capital to total
      adjusted assets) requirement for the most highly-rated national banks, with
      an
      additional cushion of at least 100 to 200 basis points for all other national
      banks, which effectively increases the minimum Leverage Capital Ratio for such
      other banks to 4%-5% or more. Under the applicable regulations, highest-rated
      banks and bank holding companies are those that the OCC and the FDIC determine
      are not anticipating or experiencing significant growth and have well
      diversified risk, including no undue interest rate risk exposure, excellent
      asset quality, high liquidity, good earnings and, in general, those which are
      considered a strong banking organization. A national bank or bank holding
      company that has less than the minimum Leverage Capital Ratio requirement must
      submit, to the applicable regulator for review and approval of a reasonable
      plan
      describing the means and timing by which the bank will achieve its minimum
      Leverage Capital Ratio requirement. A national bank or bank holding company
      which fails to file such a plan is deemed to be operating in an unsafe and
      unsound manner and could be subject to a cease-and-desist order.





The
      OCC's
      and FDIC’s regulations also provide that any insured depository institution with
      a Leverage Capital Ratio less than 2% is deemed to be operating in an unsafe
      or
      unsound condition. Operating in an unsafe or unsound manner could lead the
      FDIC
      to terminate deposit insurance. However, such an institution will not be subject
      to an enforcement proceeding solely on account of its capital ratios if it
      has
      entered into and is in compliance with a written agreement with the OCC and
      FDIC
      to increase its Leverage Capital Ratio to such level as the OCC or FDIC deems
      appropriate and to take such other action as may be necessary for the
      institution to be operated in a safe and sound manner. The capital regulations
      also provide, among other things, for the issuance by the OCC or the FDIC or
      their respective designee(s) of a capital directive, which is a final order
      issued to a bank that fails to maintain minimum capital or to restore its
      capital to the minimum capital requirement within a specified time period.
      Such
      directive is enforceable in the same manner as a final cease-and-desist order.





*Prompt
      Corrective Action.* Each
      federal banking agency is required to implement a system of prompt corrective
      action for institutions which it regulates. Under applicable regulations, a
      bank
      will be deemed to be: (i) "well capitalized" if it has a Total Risk-Based
      Capital Ratio of 10% or more, a Tier 1 Risk-Based Capital Ratio of 6% or more,
      a
      Leverage Capital Ratio of 5% or more and is not subject to any written capital
      order or directive; (ii) "adequately capitalized" if it has a Total Risk-Based
      Capital Ratio of 8% or more, a Tier 1 Risk-Based Capital Ratio of 4% or more
      and
      a Leverage Capital Ratio of 4% or more (3% under certain circumstances) and
      does
      not meet the definition of “well capitalized”); (iii) "undercapitalized" if it
      has a Total Risk-Based Capital Ratio that is less than 8%, a Tier 1 Risk-Based
      Capital Ratio that is less than 4% or a Leverage Capital Ratio that is less
      than
      4% (3.3% under certain circumstances); (iv) "significantly undercapitalized"
      if
      it has a Total Risk-Based Capital Ratio that is less than 6%, a Tier 1
      Risk-Based Capital Ratio that is less than 3% or a Leverage Capital Ratio that
      is less than 3%; and (v) "critically undercapitalized" if it has a ratio of
      tangible equity to total assets that is equal to or less than 2%. Bay National
      Bank is "well capitalized" as of December 31, 2006.






8




An
      institution generally must file a written capital restoration plan which meets
      specified requirements with an appropriate federal banking agency within 45
      days
      of the date the institution receives notice or is deemed to have notice that
      it
      is undercapitalized, significantly undercapitalized or critically
      undercapitalized. The federal banking agency must provide the institution with
      written notice of approval or disapproval within 60 days after receiving the
      capital restoration plan, subject to extensions by the applicable agency.





An
      institution which is required to submit a capital restoration plan must
      concurrently submit a performance guaranty by each company that controls the
      institution. Such guaranty is limited to the lesser of (i) an amount equal
      to 5%
      of the institution's total assets at the time the institution was notified
      or
      deemed to have notice that it was undercapitalized or (ii) the amount necessary
      at such time to restore the relevant capital measures of the institution to
      the
      levels required for the institution to be classified as adequately capitalized.
      Such a guaranty expires after the federal banking agency notifies the
      institution that it has remained adequately capitalized for each of four
      consecutive calendar quarters. An institution which fails to submit a written
      capital restoration plan within the requisite period, including any required
      performance guaranty, or fails in any material respect to implement a capital
      restoration plan, is subject to the restrictions in Section 38 of the Federal
      Deposit Insurance Act which are applicable to significantly undercapitalized
      institutions.





Immediately
      upon becoming undercapitalized, an institution becomes subject to statutory
      provisions which (i) restrict payment of capital distributions and management
      fees; (ii) require that the appropriate federal banking agency monitor the
      condition of the institution and its efforts to restore its capital; (iii)
      require submission of a capital restoration plan; (iv) restrict the growth
      of
      the institution's assets; and (v) require prior approval of certain expansion
      proposals. The appropriate federal banking agency for an undercapitalized
      institution also may take any number of discretionary supervisory actions if
      the
      agency determines that any of these actions is necessary to resolve the problems
      of the institution at the least possible long-term cost to the deposit insurance
      fund, subject, in certain cases, to specified procedures. These discretionary
      supervisory actions include requiring the institution to raise additional
      capital, restricting transactions with affiliates, requiring divestiture of
      the
      institution or the sale of the institution to a willing purchaser, and any
      other
      supervisory action that the agency deems appropriate. Significantly
      undercapitalized and critically undercapitalized institutions are subject to
      these and additional mandatory and permissive supervisory actions.





A
      critically undercapitalized institution will be placed in conservatorship or
      receivership within 90 days unless the FDIC formally determines that forbearance
      from such action would better protect the deposit insurance fund. Unless the
      FDIC or other appropriate federal banking regulatory agency makes specific
      further findings and certifies that the institution is viable and is not
      expected to fail, an institution that remains critically undercapitalized on
      average during the four calendar quarters after the date it becomes critically
      undercapitalized must be placed in receivership. The general rule is that FDIC
      will be appointed as receiver within 90 days after a bank becomes critically
      undercapitalized unless extremely good cause is shown and the federal regulators
      agree to an extension. In general, good cause is defined as capital that has
      been raised and is immediately available for infusion into the bank except
      for
      certain technical requirements that may delay the infusion for a period of
      time
      beyond the 90 day time period.





Additionally,
      under Section 11(c)(5) of the FDIA, a conservator or receiver may be appointed
      for an institution where: (i) an institution’s obligations exceed its assets;
      (ii) there is substantial dissipation of the institution’s assets or earnings as
      a result of any violation of law or any unsafe or unsound practice; (iii) the
      institution is in an unsafe or unsound condition; (iv) there is a willful
      violation of a cease-and-desist order; (v) the institution is unable to pay
      its
      obligations in the ordinary course of business; (vi) losses or threatened losses
      deplete all or substantially all of an institution’s capital, and there is no
      reasonable prospect of becoming “adequately capitalized” without assistance;
      (vii) there is any violation of law or unsafe or unsound practice or condition
      that is likely to cause insolvency or substantial dissipation of assets or
      earnings, weaken the institution’s condition, or otherwise seriously prejudice
      the interests of depositors or the insurance fund; (viii) an institution ceases
      to be insured; (ix) the institution is undercapitalized and has no reasonable
      prospect that it will become adequately capitalized, fails to become adequately
      capitalized when required to do so, or fails to submit or materially implement
      a
      capital restoration plan; or (x) the institution is critically undercapitalized
      or otherwise has substantially insufficient capital.






9





*Regulatory
      Enforcement Authority.* The
      Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA")
      included substantial enhancement to the enforcement powers available to federal
      banking regulators. This enforcement authority included, among other things,
      the
      ability to assess civil money penalties, to issue cease-and-desist or removal
      orders and to initiate injunctive actions against banking organizations and
      institution-affiliated parties, as defined in FIRREA. In general, these
      enforcement actions may be initiated for violations of laws and regulations
      and
      unsafe or unsound practices. Other actions or inactions may provide the basis
      for enforcement action, including misleading or untimely reports filed with
      regulatory authorities. FIRREA significantly increased the amount of and grounds
      for civil money penalties and requires, except under certain circumstances,
      public disclosure of final enforcement actions by the federal banking agencies.





*Deposit
      insurance.* The FDIC
      has adopted a risk-based deposit insurance assessment system. The FDIC assigns
      an institution to one of three capital categories based on the institution's
      financial information, as of the reporting period ending seven months before
      the
      assessment period, consisting of (i) well capitalized, (ii) adequately
      capitalized or (iii) undercapitalized, and one of three supervisory
      subcategories within each capital group. The supervisory subgroup to which
      an
      institution is assigned is based on a supervisory evaluation provided to the
      FDIC by the institution's primary federal regulator and information that the
      FDIC determines to be relevant to the institution's financial condition and
      the
      risk posed to the deposit insurance funds. An institution's assessment rate
      depends on the capital category and supervisory subcategory to which it is
      assigned. Assessment rates for BIF insured deposits currently range from 5
      basis
      points to 43 basis points. Bay National Bank was assigned to a capital and
      supervisory subcategory that had an assessment rate of 0 in 2006 and has not
      yet
      been assigned to a capital and supervisory subcategory for 2007. In addition,
      the FDIC imposes assessments to help pay off the $780 million in annual interest
      payments on the approximately $8.1 billion Financing Corporation noncallable
      bonds issued in the late 1980s as part of the government rescue of the thrift
      industry. The FDIC is authorized to raise the assessment rates in certain
      circumstances, including to maintain or achieve a designated reserve ratio
      for
      BIF deposits. The FDIC has exercised its authority to raise rates in the past
      and may raise insurance premiums in the future. If such action is taken by
      the
      FDIC, it could have an adverse effect on the earnings of Bay National Bank.





Under
      the
      Federal Deposit Insurance Act, insurance of deposits may be terminated by the
      FDIC upon a finding that the institution has engaged in unsafe or unsound
      practices, is in an unsafe or unsound condition to continue operations or has
      violated any applicable law, regulation, rule, order or condition imposed by
      the
      FDIC.





*Transactions
      with Affiliates and Insiders.* Bay
      National Bank is subject to the provisions of Section 23A and 23B of the Federal
      Reserve Act and Regulation W of the Federal Reserve Bank, which place limits
      on
      the amount of loans or extensions of credit to affiliates (as defined in the
      Federal Reserve Act), investments in or certain other transactions with
      affiliates and on the amount of advances to third parties collateralized by
      the
      securities or obligations of affiliates. The law and regulation limit the
      aggregate amount of transactions with any individual affiliate to 10% of the
      capital and surplus of Bay National Bank and also limits the aggregate amount
      of
      transactions with all affiliates to 20% of capital and surplus. Loans and
      certain other extensions of credit to affiliates are required to be secured
      by
      collateral in an amount and of a type described in the regulation, and the
      purchase of low quality assets from affiliates is generally prohibited.






10





The
      law
      and Regulation W, among other things, prohibit an institution from engaging
      in
      certain transactions with certain affiliates (as defined in the Federal Reserve
      Act) unless the transactions are on terms substantially the same, or at least
      as
      favorable to such institution and/or its subsidiaries, as those prevailing
      at
      the time for comparable transactions with non-affiliated entities. In the
      absence of comparable transactions, such transactions may only occur under
      terms
      and circumstances, including credit standards that in good faith would be
      offered to or would apply to non-affiliated companies. In addition, under
      Regulation W:





·
            a
                bank and its subsidiaries may not purchase a low-quality asset from
                an
                affiliate;


·
            covered
                transactions and other specified transactions between a bank or its
                subsidiaries and an affiliate must be on terms and conditions that
                are
                consistent with safe and sound banking practices; and


·
            with
                some exceptions, each loan or extension of credit by a bank to an
                affiliate must be secured by collateral with a market value ranging
                from
                100% to 130%, depending on the type of collateral, of the amount
                of the
                loan or extension of credit.





Regulation
      W generally excludes all nonbank and nonsavings association subsidiaries of
      banks from treatment as affiliates, except to the extent that the Federal
      Reserve Board decides to treat these subsidiaries as affiliates.





Bay
      National Bank also is subject to the restrictions contained in Section 22(h)
      of
      the Federal Reserve Act and the Federal Reserve Board's Regulation O thereunder
      on loans to executive officers, directors and principal stockholders. Under
      Section 22(h), loans to a director, an executive officer or a greater-than-10%
      stockholder of a bank as well as certain affiliated interests of any of the
      foregoing may not exceed, together with all other outstanding loans to such
      person and affiliated interests, the loans-to-one-borrower limit applicable
      to
      national banks (generally 15% of the institution's unimpaired capital and
      surplus), and all loans to all such persons in the aggregate may not exceed
      the
      institution's unimpaired capital and unimpaired surplus. Regulation O also
      prohibits the making of loans in an amount greater than $25,000 or 5% of capital
      and surplus but in any event not over $500,000, to directors, executive officers
      and greater-than-10% stockholders of a bank, and their respective affiliates,
      unless such loans are approved in advance by a majority of the Board of
      Directors of the bank with any "interested" director not participating in the
      voting. Further, Regulation O requires that loans to directors, executive
      officers and principal stockholders be made on terms substantially the same
      as
      those that are offered in comparable transactions to unrelated third parties
      unless the loans are made pursuant to a benefit or compensation program that
      is
      widely available to all employees of the bank and does not give preference
      to
      insiders over other employees. Regulation O also prohibits a depository
      institution from paying overdrafts over $1,000 of any of its executive officers
      or directors unless they are paid pursuant to written pre-authorized extension
      of credit or transfer of funds plans.





All
      of
      Bay National Bank’s loans to its and Bay National Corporation’s executive
      officers, directors and greater-than-10% stockholders, and affiliated interests
      of such persons, comply with the requirements of Regulation W and 22(h) of
      the
      Federal Reserve Act and Regulation O.





*Loans
      to One Borrower.* As
      a
      national bank, Bay National Bank is subject to the statutory and regulatory
      limits on the extension of credit to one borrower. Generally, the maximum amount
      of total outstanding loans that a national bank may have to any one borrower
      at
      any one time is 15% of the bank's unimpaired capital and surplus. A national
      bank may lend an additional 10% on top of the 15% if the amount that exceeds
      15%
      of the bank's unimpaired capital and surplus is fully secured by readily
      marketable collateral.





*Liquidity.* Bay
      National Bank is subject to the reserve requirements of Federal Reserve Board
      Regulation D, which applies to all depository institutions with transaction
      accounts or non-personal time deposits. Specifically, as of December 21, 2006,
      amounts in transaction accounts above $8,500,000 and up to $45,800,000 must
      have
      reserves held against them in the ratio of 3 percent of the amount. Amounts
      above $45,800,000 require reserves of $1,119,000 plus 10 percent of the amount
      in excess of $45,800,000. Bay National Bank is in compliance with the applicable
      liquidity requirements.






11





*Dividends* .  The
      amount of dividends that may be paid by Bay National Bank to Bay National
      Corporation depends on its earnings and capital position and is limited by
      statute, regulations and policies. As a national bank, Bay National Bank may
      not
      pay dividends from its paid-in surplus. All dividends must be paid out of
      undivided profits then on hand, after deducting expenses, including provisions
      for loan losses and bad debts. In addition, a national bank is prohibited from
      declaring a dividend on its shares of common stock until its surplus equals
      its
      stated capital, unless there has been transferred to surplus no less than
      one-tenth of the bank’s net profits for the preceding two consecutive half-year
      periods (in the case of an annual dividend). OCC approval is required if the
      total of all dividends declared by a national bank in any calendar year exceeds
      the total of its net profits for that year combined with its retained net
      profits for the preceding two years, less any required transfers to surplus.
      In
      addition, Bay National Bank may not pay a dividend if, after paying the
      dividend, it would be undercapitalized.





*Community
      Reinvestment Act.* The
      Community Reinvestment Act ("CRA") requires that, in connection with
      examinations of financial institutions within their respective jurisdictions,
      the Federal Reserve Board, the FDIC, the OCC or the Office of Thrift Supervision
      shall evaluate the record of the financial institutions in meeting the credit
      needs of their local communities, including low and moderate income
      neighborhoods, consistent with the safe and sound operation of those
      institutions. The CRA does not establish specific lending requirements or
      programs for financial institutions nor does it limit an institution's
      discretion to develop the types of products and services that it believes are
      best suited to its particular community, consistent with the CRA. An
      institution's CRA activities are considered in, among other things, evaluating
      mergers, acquisitions and applications to open a branch or facility as well
      as
      determining whether the institution will be permitted to exercise certain of
      the
      powers allowed by the GLBA. The CRA also requires all institutions to make
      public disclosure of their CRA ratings. Bay National Bank received a
“satisfactory” rating in its latest CRA examination conducted in May
      2003.





*USA
      PATRIOT Act.*  Under
      the
      Uniting and Strengthening America by Providing Appropriate Tools Required to
      Intercept and Obstruct Terrorism Act, commonly referred to as the “USA Patriot
      Act” or the “Patriot Act”, financial institutions are subject to prohibitions
      against specified financial transactions and account relationships, as well
      as
      enhanced due diligence standards intended to detect, and prevent, the use of
      the
      United States financial system for money laundering and terrorist financing
      activities. The Patriot Act requires financial institutions, including banks,
      to
      establish anti-money laundering programs, including employee training and
      independent audit requirements, meet minimum standards specified by the act,
      follow minimum standards for customer identification and maintenance of customer
      identification records, and regularly compare customer lists against lists
      of
      suspected terrorists, terrorist organizations and money launderers.





The
      U.S.
      Treasury Department (“Treasury”) has issued a number of implementing regulations
      that apply to various requirements of the USA Patriot Act to financial
      institutions such as Bay National Bank. Those regulations impose new obligations
      on financial institutions to maintain appropriate policies, procedures and
      controls to detect, prevent and report money laundering and terrorist financing.
      Treasury is expected to issue additional regulations that will further clarify
      the USA Patriot Act’s requirements.




Failure
      of a financial institution to comply with the USA Patriot Act’s requirements
      could have serious legal and reputational consequences for the institution.
      The
      Company has adopted appropriate policies, procedures and controls to address
      compliance with the requirements of the USA Patriot Act under the existing
      regulations and will continue to revise and update its policies, procedures
      and
      controls to reflect changes required by the USA Patriot Act and Treasury’s
      regulations.





The
      costs
      or other effects of the compliance burdens imposed by the Patriot Act or future
      anti-terrorist, homeland security or anti-money laundering legislation or
      regulations cannot be predicted with certainty.






12





*Check
      21.* On
      October 28, 2003, President Bush signed into law the Check Clearing for the
      21st
      Century Act, also known as “Check 21.” The new law, which became effective on
      October 28, 2004, gives “substitute checks,” such as a digital image of a check
      and copies made from that image, the same legal standing as the original paper
      check. Some of the major provisions include:




·
            allowing
                check truncation without making it
                mandatory;


·
            requiring
                that every financial institution communicate to accountholders in
                writing
                a description of its substitute check processing program and their
                rights
                under the law;


·
            retaining
                in place the previously mandated electronic collection and return
                of
                checks between financial institutions only when individual agreements
                are
                in place;


·
            requiring
                that when accountholders request verification, financial institutions
                produce the original check (or a copy that accurately represents
                the
                original) and demonstrate that the account debit was accurate and
                valid;
                and


·
            requiring
                recrediting of funds to an individual’s account on the next business day
                after a consumer proves that the financial institution has
                erred.





*Consumer
      Credit Reporting.* On
      December 4, 2003, President George W. Bush signed the Fair and Accurate Credit
      Transactions Act amending the federal Fair Credit Reporting Act. These
      amendments to the Fair Credit Reporting Act (the “FCRA Amendments”) became
      effective in 2004. The FCRA Amendments include, among other things:





·
            requirements
                for financial institutions to develop policies and procedures to
                identify
                potential identity theft and, upon the request of a consumer, place
                a
                fraud alert in the consumer's credit file stating that the consumer
                may be
                the victim of identity theft or other
                fraud;


·
            for
                entities that furnish information to consumer reporting agencies
                (which
                would include us), requirements to implement procedures and policies
                regarding the accuracy and integrity of the furnished information,
                and
                regarding the correction of previously furnished information that
                is later
                determined to be inaccurate; and


·
            a
                requirement for mortgage lenders to disclose credit scores to
                consumers.




The
      FCRA
      Amendments also prohibit a business that receives consumer information from
      an
      affiliate from using that information for marketing purposes unless the consumer
      is first provided a notice and an opportunity to direct the business not to
      use
      the information for such marketing purposes (the “opt-out”), subject to certain
      exceptions. We do not share consumer information among our affiliated companies
      for marketing purposes, except as allowed under exceptions to the notice and
      opt-out requirements. Because none of our affiliates is currently sharing
      consumer information with any other affiliate for marketing purposes, the
      limitations on sharing of information for marketing purposes do not have a
      significant impact on us.





*Federal
      Deposit Insurance Reform.* On
      February 8, 2006, President Bush signed the Federal Deposit Insurance Reform
      Act
      of 2005 (“FDIRA”). Among other things, FDIRA changes the Federal deposit
      insurance system by:




·
            raising
                the coverage level for retirement accounts to
                $250,000;


·
            indexing
                deposit insurance coverage levels for inflation beginning in
                2012;


·
            prohibiting
                undercapitalized financial institutions from accepting employee benefit
                plan deposits;


·
            merging
                the Bank Insurance Fund and Savings Association Insurance Fund into
                a new
                Deposit Insurance Fund (the “DIF”);
                and


·
            providing
                credits to financial institutions that capitalized the FDIC prior
                to 1996
                to offset future assessment
                premiums.






13




FDIRA
      also authorizes the FDIC to revise the current risk-based assessment system,
      subject to notice and comment and caps the amount of the DIF at 1.50% of
      domestic deposits. The FDIC must issue cash dividends, awarded on a historical
      basis, for the amount of the DIF over the 1.50% ratio. Additionally, if the
      DIF
      exceeds 1.35% of domestic deposits at year-end, the FDIC must issue cash
      dividends, awarded on a historical basis, for half of the amount of the excess.




The
      FDIC
      was required to adopt rules implementing the various provisions of FDIRA by
      November 5, 2006. The rules adopted include:




·
            Inflation
                Index; Certain Retirement Accounts and Employee Benefit Plan Accounts
                (effective 10/12/2006);


·
            One-time
                Assessment Credit (effective
                11/17/2006);


·
            Assessment
                Dividends (effective 1/1/2007);


·
            Operational
                Processes Governing the FDIC’s Deposit Insurance Assessment Statement
                (effective 1/1/2007);


·
            Risk-Based
                Assessment System (effective
                1/1/2007);


·
            Designated
                Reserve Ratio (effective 1/1/2007);
                and


·
            Official
                FDIC Sign and Advertising of FDIC Membership (effective
                11/13/2007).




*Other
      Regulations.* ** Interest
      and other charges we collect or contract for are subject to state usury laws
      and
      federal laws concerning interest rates. For example, under the Service Members
      Civil Relief Act, which amended the Soldiers’ and Sailors’ Civil Relief Act of
      1940, a lender is generally prohibited from charging an annual interest rate
      in
      excess of 6% on any obligation of a borrower who is on active duty with the
      United States military.




Our
      loan
      operations are also subject to federal laws applicable to credit transactions,
      such as the following:




·
            The
                Federal Truth-In-Lending Act, governing disclosures of credit terms
                to
                consumer borrowers;




·
            The
                Home Mortgage Disclosure Act of 1975, requiring financial institutions
                to
                provide information to enable the public and public officials to
                determine
                whether a financial institution is fulfilling its obligation to help
                meet
                the housing needs of the community it
                serves;




·
            The
                Equal Credit Opportunity Act, prohibiting discrimination on the basis
                of
                race, creed or other prohibited factors in extending
                credit;




·
            The
                Fair Debt Collection Act, governing the manner in which consumer
                debts may
                be collected by collection agencies;
                and




·
            The
                rules and regulations of the various federal agencies charged with
                the
                responsibility of implementing these federal
                laws.




Our
      deposit operations are subject to the following:




·
            The
                Right to Financial Privacy Act, which imposes a duty to maintain
                confidentiality of consumer financial records and prescribes procedures
                for complying with administrative subpoenas of financial records;
                and




·
            The
                Electronic Funds Transfer Act and Regulation E issued by the Federal
                Reserve Board to implement that act, which govern automatic deposits
                to
                and withdrawals from deposit accounts and customers' rights and
                liabilities arising from the use of automated teller machines and
                other
                electronic banking services.






14




*Proposed
      Legislation and Regulatory Actions.* New
      regulations and statutes are regularly proposed that contain wide-ranging
      proposals for altering the structures, regulations, and competitive
      relationships of the nation’s financial institutions. We cannot predict whether
      or in what form any proposed regulation or statute will be adopted or the extent
      to which our business may be affected by any new regulation or
      statute.




*Effect
      Of Governmental Monetary Policies.*  Our
      earnings are affected by domestic economic conditions and the monetary and
      fiscal policies of the United States government and its agencies. The Federal
      Reserve Board’s monetary policies have had, and are likely to continue to have,
      an important impact on the operating results of commercial banks through its
      power to implement national monetary policy in order, among other things, to
      curb inflation or combat a recession. The monetary policies of the Federal
      Reserve Board affect the levels of bank loans, investments and deposits through
      its control over the issuance of United States government securities, its
      regulation of the discount rate applicable to member banks and its influence
      over reserve requirements to which member banks are subject. We cannot predict
      the nature or impact of future changes in monetary and fiscal
      policies.




**FORWARD
      LOOKING STATEMENTS**





Some
      of
      the matters discussed in this annual report including under the captions
“Business of Bay National Corporation and Bay National Bank,” and “Management’s
      Discussion And Analysis Of Financial Condition And Results Of Operations”
include forward-looking statements. These forward-looking statements include
      statements regarding profitability, liquidity, allowance for loan losses,
      interest rate sensitivity, market risk and financial and other goals.
      Forward-looking statements often use words such as “believe,” “expect,” “plan,”
“may,” “will,” “should,” “project,” “contemplate,” “anticipate,” “forecast,”
“intend”, or other words of similar meaning. You can also identify them by the
      fact that they do not relate strictly to historical or current
      facts.  When
      you
      read a forward-looking statement, you should keep in mind the risk factors
      described below and any other information contained in this annual report which
      identifies a risk or uncertainty. Bay National Corporation’s actual results and
      the actual outcome of Bay National Corporation’s expectations and strategies
      could be different from that described in this annual report because of these
      risks and uncertainties and you should not put undue reliance on any
      forward-looking statements. All forward-looking statements speak only as of
      the
      date of this filing, and Bay National Corporation undertakes no obligation
      to
      make any revisions to the forward-looking statements to reflect events or
      circumstances after the date of this filing or to reflect the occurrence of
      unanticipated events.





**RISK
      FACTORS**





You
      should carefully consider the following risks, along with the other information
      contained in this annual report. The risks and uncertainties described below
      are
      not the only ones that may affect Bay National Corporation. Additional risks
      and
      uncertainties may also adversely affect our business and operations including
      those discussed in Item 6 - Management’s Discussion and Analysis of Financial
      Condition and Results of Operations. If any of the following events actually
      occur, our business and financial results could be materially adversely
      affected.




Bay
      National Corporation and Bay National Bank depend heavily on one key employee,
      Mr. Hugh W. Mohler, and business would suffer if something were to happen to
      Mr.
      Mohler . **** Mr.
      Mohler is the Chairman, President and Chief Executive Officer of Bay National
      Bank. If he were to leave for any reason, Bay National Corporation’s and Bay
      National Bank’s business would suffer because he has banking experience and
      relationships with clients and potential clients that would not be easy to
      replace. In addition, because Bay National Bank’s business is relationship
      driven, the loss of an employee who has primary contact with one or more of
      Bay
      National Bank’s clients could cause Bay National Bank to lose those clients'
      business, possibly resulting in a decline in revenues.






15





If
      our
      allowance for credit losses is not sufficient to cover actual loan losses,
      our
      earnings could decrease. We make
      various assumptions and judgments about the collectibility of our loan
      portfolio, including the creditworthiness of our borrowers and the value of
      collateral for the repayment of many of our loans. In determining the amount
      of
      the allowance for credit losses, we review, among other things, our loans and
      our loss and delinquency experience, and we evaluate economic conditions. If
      our
      assumptions are incorrect, our allowance for credit losses may not be sufficient
      to cover losses inherent in our loan portfolio, resulting in additions to our
      allowance.





We
      are
      particularly susceptible to this risk because we are a relatively new bank
      and
      have experienced significant growth over the past few years. In general, loans
      do not begin to show signs of credit deterioration or default until they have
      been outstanding for some period of time, a process referred to as “seasoning.”
As a result, a portfolio of older loans will usually behave more predictably
      than a newer portfolio. Because a large portion of our loan portfolio is
      relatively new, the current level of delinquencies and defaults may not be
      representative of the level that will prevail when the portfolio becomes more
      seasoned, which may be higher than current levels. If delinquencies and defaults
      increase, we may be required to increase our provision for loan losses.





Material
      additions to our allowance would materially decrease our net income. In
      addition, bank regulators periodically review our allowance for credit losses
      and may require us to increase our provision for loan losses or recognize
      further loan charge-offs. Any increase in our allowance for credit losses or
      loan charge-offs may have a material adverse effect on our results of operations
      and financial condition.




Bay
      National Bank’s lending strategy involves risks resulting from the choice of
      loan portfolio .
      Bay
      National Bank's loan strategy emphasizes commercial business loans and
      commercial real estate loans. At December 31, 2006, such loans accounted for
      approximately 65% of the loan portfolio. Commercial business and commercial
      real
      estate loans generally carry a higher degree of credit risk than do residential
      mortgage loans because of several factors including larger loan balances,
      dependence on the successful operation of a business or a project for repayment,
      or loan terms with a balloon payment rather than full amortization over the
      loan
      term.





Bay
      National Bank’s lending limit may limit its growth and the growth of Bay
      National Corporation .
      Bay
      National Bank is limited in the amount it can loan to a single borrower by
      the
      amount of its capital. Specifically, under current law, Bay National Bank may
      lend up to 15% of its unimpaired capital and surplus to any one borrower. Bay
      National Bank’s lending limit is significantly less than that of many of its
      competitors and may discourage potential borrowers who have credit needs in
      excess of Bay National Bank’s lending limit from conducting business with Bay
      National Bank.





Bay
      National Bank faces substantial competition which could adversely affect its
      ability to attract depositors and borrowers .
      Bay
      National Bank operates in a competitive market for financial services and faces
      intense competition from other institutions both in making loans and in
      attracting deposits. Many of these institutions have been in business for many
      years, are significantly larger, have established customer bases, have greater
      financial resources and lending limits than Bay National Bank, and are able
      to
      offer certain services that Bay National Bank is not able to offer. If Bay
      National Bank cannot attract deposits and make loans at a sufficient level,
      its
      operating results will suffer, as will its opportunities for growth.





Government
      regulation could restrict Bay National Corporation’s or Bay National Bank’s
      growth or cause Bay National Corporation or Bay National Bank to incur higher
      costs .
      Bay
      National Corporation and Bay National Bank operate in a highly regulated
      environment and are subject to examination, supervision and comprehensive
      regulation by several federal and state regulatory agencies. Banking
      regulations, designed primarily for the safety of depositors, may limit the
      growth of Bay National Bank and the return to investors by restricting
      activities such as the payment of dividends; mergers with, or acquisitions
      by,
      other institutions; investments; loans and interest rates; interest rates paid
      on deposits; and the creation of branch offices. Laws and regulations could
      change at any time, and changes could adversely affect Bay National
      Corporation’s and Bay National Bank’s business. In addition, the cost of
      compliance with regulatory requirements could adversely affect Bay National
      Corporation’s and Bay National Bank’s ability to operate profitably.






16





Bay
      National Bank's ability to compete may suffer if it cannot take advantage of
      technology to provide banking services or if its customers fail to embrace
      that
      technology .
      Bay
      National Bank’s business strategy relies less on customers' access to a large
      branch network and more on access to technology and personal relationships.
      Further, the market for financial services is increasingly affected by advances
      in technology, including developments in telecommunications, data processing,
      computers, automation, Internet-based banking and tele-banking. Bay National
      Bank’s ability to compete successfully may depend on the extent to which Bay
      National Bank can take advantage of technological changes and the extent to
      which Bay National Bank’s customers embrace technology to complete their banking
      transactions.





Because
      we currently serve limited market areas, we could be more adversely affected
      by
      an economic downturn in our market areas than our larger competitors which
      are
      more geographically diverse. Currently, our primary market area is limited to the Baltimore metropolitan
      area
      and Maryland’s Eastern Shore. If either of these areas suffer an economic
      downturn, our business and financial condition may be severely affected. Our
      larger competitors serve a more geographically diverse market area, parts of
      which may not be affected by the same economic conditions that exist in our
      primary market areas.





If
      economic conditions deteriorate, our results of operations and financial
      condition could be adversely affected as borrowers’ ability to repay loans
      declines and the value of the collateral securing our loans
      decreases. Our
      financial results may be adversely affected by changes in prevailing economic
      conditions, including decreases in real estate values, changes in interest
      rates
      which may cause a decrease in interest rate spreads, adverse employment
      conditions, the monetary and fiscal policies of the federal government and
      other
      significant external events. Because a significant portion of our loan portfolio
      is comprised of real estate related loans, decreases in real estate values
      could
      adversely affect the value of property used as collateral. Adverse changes
      in
      the economy also may have a negative effect on the ability of our borrowers
      to
      make timely repayments of their loans, which would have an adverse impact on
      our
      earnings.





Our
      profitability depends on interest rates and changes in monetary policy may
      impact us. Our
      results of operations depend to a large extent on our “net interest income,”
which is the difference between the interest expense incurred in connection
      with
      our interest-bearing liabilities, such as interest on deposit accounts, and
      the
      interest income received from our interest-earning assets, such as loans.
      Interest rates, because they are influenced by, among other things, expectations
      about future events, including the level of economic activity, federal monetary
      and fiscal policy and geo-political stability, are not predictable or
      controllable. In addition, competitive factors heavily influence the interest
      rates we can earn on our loan and investment portfolios and the interest rates
      we pay on our deposits. Community banks are often at a competitive disadvantage
      in managing their cost of funds compared to the large regional, super-regional
      or national banks that have access to the national and international capital
      markets. These factors influence our ability to maintain a stable interest
      margin.





The
      costs of being a public company are proportionately higher for small companies
      like us due to the requirements of the Sarbanes-Oxley Act .
      The
      Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated
      by
      the Securities and Exchange Commission have increased the scope, complexity,
      and
      cost of corporate governance, reporting, and disclosure practices. These
      regulations are applicable to our company. We expect to experience increasing
      compliance costs, including costs related to internal controls, as a result
      of
      the Sarbanes-Oxley Act. These necessary costs are proportionately higher for
      a
      company of our size and will affect our profitability more than that of some
      of
      our larger competitors.




17


Item
      2.  Description of Property





Baltimore





Our
      Baltimore branch and administrative offices are located at 2328 West Joppa
      Road,
      Lutherville, Maryland 21093. Currently, we lease space in the basement (1,429
      square feet), the first floor (4,067 square feet) and the third floor (6,206
      square feet) of this building. The basement space is currently used for training
      and storage purposes, 947 square feet of the first floor space is currently
      used
      for administrative office space, 2,355 square feet of the first floor space
      is
      used for the Lutherville branch office and the third floor space is used for
      Bay
      National Corporation and Bay National Bank’s administrative offices.
      Approximately 765 square feet of the first floor space, previously sublet,
      will
      be used for additional administrative office space. The current lease expires
      on
      February 28, 2010, and we have the right to extend the lease for one five-year
      term to February 28, 2015.





As
      of
      December 31, 2006, Bay National Corporation was paying rent of $349,268 per
      year, or $29,106 per month for all of the leased space in the building. For
      the
      March 2007 to February 2008 lease year, Bay National Corporation will pay annual
      rent of $359,746, or $29,979 per month. For each lease year thereafter,
      including any lease years during any renewal term, the yearly base rent will
      increase by 3%. The rent includes Bay National Corporation’s share of taxes and
      building operating costs.





Beginning
      November 15, 2004, Bay National Corporation sublet approximately 765 square
      feet
      of the space on the first floor for a term through December 31, 2006 at a
      monthly rent for the first year of $1,893, which amount increased at the rate
      of
      3% per year. This space is currently being converted for use by Bay National
      Corporation and Bay National Bank in order to accommodate current and future
      growth as the sublease terminated on December 31, 2006.





The
      Landlord, Joppa Green II Limited Partnership, LLLP, is beneficially owned by
      the
      MacKenzie Companies. Gary T. Gill, who has been a director of Bay National
      Corporation and Bay National Bank since January 2003, is the president and
      chief
      executive officer of the MacKenzie Companies. See “Item 12 - Certain
      Relationships and Related Transactions, and Director Independence.”





On
      July
      19, 2006, Bay National Bank agreed, beginning October 1, 2006, to lease 4,317
      square feet of space on the first floor of a building located at 1122 Kenilworth
      Drive, Towson, Maryland for its Baltimore residential mortgage operation.
      Pursuant to the lease agreement, the Bank agreed to an initial lease term of
      five years and two months, terminating on November 30, 2011. The Bank was also
      provided the right to renew
      the
      lease for one additional five-year term. As part of this agreement, the
      aggregate rent due under the lease is $8,454 monthly from December 2006 through
      November 2007. For each lease year thereafter, including any lease years during
      any renewal term, the yearly base rent will increase by 3% .





Salisbury





On
      September 16, 1999, Bay National Corporation entered into a lease agreement
      for
      Bay National Bank's Salisbury, Maryland branch office, which is located at
      109
      Poplar Hill Avenue, Salisbury Maryland 21801 in a two-story building containing
      approximately 2,500 square feet of office space. This lease, which became
      effective as of September 1, 1999, was for a term of five years with Bay
      National Corporation having the option to extend the term for three five-year
      renewal terms.





Bay
      National Corporation exercised its option to extend this lease which will now
      terminate on August 31, 2009, unless extended. During the new lease term, Bay
      National Corporation is paying monthly rent of approximately $2,292, plus all
      real estate taxes and utilities. Pursuant to this lease, Bay National
      Corporation has a right of first refusal to purchase the building in the event
      the landlord receives a bona fide offer to sell. This property is owned by
      John
      R. Lerch, who has been a director of Bay National Corporation and Bay National
      Bank since their formation. See “Item 12 - Certain Relationships and Related
      Transactions, and Director Independence.”






18





On
      September 1, 2002, Bay National Corporation entered into a lease agreement
      for
      Bay National Bank's Salisbury, Maryland mortgage division office, which is
      located at 318 East Main Street, Salisbury Maryland 21801. The leased space
      consists of two office suites totaling approximately 420 square feet. This
      lease, which became effective as of January 1, 2003, was for a term of one
      year
      with Bay National Corporation having the option to extend the term for one
      additional one-year renewal term. Bay National Corporation renewed the lease
      for
      an additional one year term effective as of January 1, 2004. During the initial
      lease term and the renewal term, Bay National Corporation paid monthly rent
      of
      $700. The lease expired on December 31, 2004 and reverted to a monthly rental
      arrangement. On January 1, 2005, Bay National Corporation obtained an additional
      200 square feet in the same building. The total space of 620 square feet was
      rented on a month to month basis at a cost of $1,000 per month through November
      2005 at which time the additional 200 square feet was returned to the landlord.
      The remaining 420 square feet is currently rented on a month to month basis
      at a
      cost of $700 per month. The landlord is responsible for all real estate taxes
      and utilities.





Item3.
      Legal Proceedings





There
      are
      no pending legal proceedings to which Bay National Corporation or Bay National
      Bank is a party or to which any of their properties are subject, nor are there
      proceedings known to Bay National Corporation to be contemplated by any
      governmental authority. There are no material proceedings known to Bay National
      Corporation, pending or contemplated, in which any director, officer or
      affiliate or any principal security holder of Bay National Corporation is a
      party adverse to Bay National Corporation or Bay National Bank or has a material
      interest adverse to Bay National Corporation or Bay National Bank.





Item
      4. Submission of Matters to a Vote of Security
      Holders





No
      matter
      was submitted during the fourth quarter of the year ended December 31, 2006
      to a
      vote of security holders of Bay National Corporation.


19





**PART
      II**





Item
      5. Market for Common Equity and Related Stockholder
      Matters





As
      of
      March 27, 2007, the number of holders of record of Bay National Corporation’s
      common stock was approximately 380. Bay National Corporation’s common stock is
      currently traded on the NASDAQ Capital Market under the symbol "BAYN."





Bay
      National Corporation completed an initial public offering (“IPO”) of its common
      stock on April 30, 2000. Stock prices subsequent to the IPO are based upon
      limited trading on the Over the Counter Bulletin Board (“OTCBB”) prior to May
      15, 2006 and on the NASDAQ Capital Market subsequent to that date. The following
      table reflects the high and low sales information for the periods presented.
      Quotations reflect inter-dealer prices, without retail mark-up, mark-down,
      or
      commission and may not represent actual transactions.





2006
              Bid
                or Sales Price Range
            
            2005
              Bid
                Price RangeQuarter
            
            Low
            
            High
            
            Low
            
            High1st
            
            $
            17.90
            
            $
            23.00
            
            $
            13.20
            
            $
            15.252nd
            
            
            17.90
            
            
            19.50
            
            
            14.50
            
            
            19.753rd
            
            
            18.50
            
            
            19.55
            
            
            17.25
            
            
            21.004th
            
            
            18.53
            
            
            20.54
            
            
            18.80
            
            
            23.00





To
      date,
      Bay National Corporation has not declared or paid any dividends on its common
      stock. Management anticipates that Bay National Corporation will retain all
      earnings, if any, in order to provide more funds to operate and expand Bay
      National Corporation’s business and, therefore, Bay National Corporation has no
      plans to pay any cash dividends at least until its profitability exceeds the
      level necessary to support capital growth in excess of regulatory capital needs.
      If Bay National Corporation decides to pay dividends in the future, its ability
      to do so will depend on the ability of Bay National Bank to pay dividends to
      Bay
      National Corporation. In addition, management would consider a number of other
      factors before deciding to pay dividends, including Bay National Corporation’s
      earnings prospects, financial condition and cash needs.





The
      amount of dividends that may be paid by Bay National Bank to Bay National
      Corporation depends on Bay National Bank's earnings and capital position and
      is
      limited by statute, regulations and regulatory policies. As a national bank,
      Bay
      National Bank may not pay dividends from its permanent capital. All cash
      dividends must be paid out of undivided profits then on hand, after deducting
      expenses, including provisions for credit losses and bad debts. In addition,
      a
      national bank is prohibited from declaring a cash dividend on its shares of
      common stock until its surplus equals its stated capital, unless there has
      been
      transferred to surplus no less than one-tenth of the bank's net profits for
      the
      preceding two consecutive half-year periods (in the case of an annual dividend).
      OCC approval is required if the total of all cash dividends declared by a
      national bank in any calendar year exceeds the total of its net profits for
      that
      year combined with its retained net profits for the preceding two years, less
      any required transfers to surplus. In addition, Bay National Bank may not pay
      a
      dividend if, after paying the dividend, it would be “undercapitalized” as
      defined in the applicable regulations.








20


SELECTED
      FINANCIAL DATA


AS
      OF
      DECEMBER 31, 2006, 2005, 2004, 2003 and 2002


(dollars
      in thousands, except per share data)





**2006**
            
            **2005**
            
            **2004**
            
            ******2003**
            
            ******2002**Total
                assets
            
            $
            254,805
            
            $
            209,966
            
            $
            170,763
            
            $
            122,328
            
            $
            84,609Cash
                and due from banks
            
            
            2,348
            
            
            1,461
            
            
            1,403
            
            
            573
            
            
            363Federal
                funds sold and other overnight investments
            
            
            31,550
            
            
            6,033
            
            
            16,709
            
            
            17,487
            
            
            11,753Investment
                securities available for sale
            
            
            698
            
            
            1,540
            
            
            1,544
            
            
            1,548
            
            
            948Federal
                Reserve Bank stock
            
            
            607
            
            
            452
            
            
            313
            
            
            313
            
            
            276Federal
                Home Loan Bank stock
            
            
            510
            
            
            342
            
            
            243
            
            
            168
            
            
            80Loans,
                net
            
            
            214,841
            
            
            196,590
            
            
            149,217
            
            
            101,049
            
            
            70,045Deposits
            
            
            224,149
            
            
            182,573
            
            
            153,927
            
            
            108,531
            
            
            76,079Short-term
                borrowings
            
            
            1,545
            
            
            1,444
            
            
            1,381
            
            
            1,222
            
            
            507Note
                payable
            
            
            -
            
            
            -
            
            
            1,250
            
            
            -
            
            
            -Subordinated
                debt
            
            
            8,000
            
            
            8,000
            
            
            -
            
            
            -
            
            
            -Stockholders’
                equity
            
            
            18,842
            
            
            16,214
            
            
            13,419
            
            
            12,067
            
            
            7,610Common
                shares outstanding
            
            
            1,935,369
            
            
            1,924,436
            
            
            1,917,710
            
            
            1,862,710
            
            
            1,242,020Book
                value per share
            
            $
            9.74
            
            $
            8.43
            
            $
            7.00
            
            $
            6.48
            
            $
            6.13Ratio
                of interest earning assets to interest bearing liabilities
            
            
            126.40
            %
            
            126.38
            %
            
            124.95
            %
            
            127.61
            %
            
            127.68
            %Stockholders’
                equity as a percentage of assets
            
            
            7.39
            %
            
            7.72
            %
            
            7.86
            %
            
            9.86
            %
            
            8.99
            %





SELECTED
      FINANCIAL RATIOS


FOR
      THE
      YEARS ENDED DECEMBER 31, 2006, 2005, 2004, 2003 and 2002





**Weighted
                average yield/rate on:**
            
            **2006**
            
            **2005**
            
            
            **2004**
            
            
            ******2003**
            
            
            ******2002**Loans
                and loans held for sale
            
            9.12
            %
            7.46
            %
            
            5.89
            %
            
            5.98
            %
            
            6.52
            %Investments
                and interest bearing cash balances
            
            3.79
            %
            2.27
            %
            
            1.11
            %
            
            .80
            %
            
            1.36
            %Deposits
                and borrowings
            
            4.31
            %
            2.96
            %
            
            2.17
            %
            
            2.26
            %
            
            2.84
            %Net
                interest spread
            
            4.40
            %
            4.12
            %
            
            3.14
            %
            
            2.81
            %
            
            2.80
            %Net
                interest margin
            
            5.27
            %
            4.74
            %
            
            3.60
            %
            
            3.29
            %
            
            3.43
            %





SELECTED
      OPERATIONAL DATA


FOR
      THE
      YEARS ENDED DECEMBER 31, 2006, 2005, 2004, 2003 and 2002


(dollars
      in thousands, except per share data)





**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Interest
                income
            
            $
            19,781
            
            $
            12,983
            
            $
            7,624
            
            $
            5,520
            
            $
            3,486Interest
                expense
            
            
            7,823
            
            
            4,294
            
            
            2,464
            
            
            1,937
            
            
            1,367Net
                interest income
            
            
            11,958
            
            
            8,689
            
            
            5,160
            
            
            3,583
            
            
            2,119Provision
                for credit losses
            
            
            203
            
            
            1,179
            
            
            560
            
            
            415
            
            
            405Net
                interest income after provision for credit losses
            
            
            11,755
            
            
            7,510
            
            
            4,600
            
            
            3,168
            
            
            1,714Non-interest
                income
            
            
            777
            
            
            750
            
            
            539
            
            
            626
            
            
            479Non-interest
                expenses
            
            
            8,424
            
            
            6,171
            
            
            4,337
            
            
            3,786
            
            
            3,185Income
                (loss) before income taxes
            
            
            4,108
            
            
            2,089
            
            
            802
            
            
            8
            
            
            (992
            )Income
                tax (expense) benefit
            
            
            (1,678
            )
            
            655
            
            
            -
            
            
            -
            
            
            -Net
                income (loss)
            
            $
            2,430
            
            $
            2,744
            
            $
            802
            
            $
            8
            
            $
            (992
            )PER
                COMMON SHAREBasic
                net income (loss) per share
            
            $
            1.25
            
            $
            1.43
            
            $
            .43
            
            $
            .00
            
            $
            (.80
            )Diluted
                net income (loss) per share
            
            $
            1.20
            
            $
            1.37
            
            $
            .41
            
            $
            .00
            
            $
            (.80
            )Average
                shares outstanding (Basic)
            
            
            1,938,110
            
            
            1,922,580
            
            
            1,877,929
            
            
            1,660,348
            
            
            1,242,020Average
                shares outstanding (Diluted)
            
            
            2,018,209
            
            
            2,002,225
            
            
            1,936,693
            
            
            1,682,905
            
            
            1,242,020


21





Item6.
 Management’s
      Discussion and Analysis of Financial
      Condition and Results of Operations





The
      following discussion of Bay National Corporation’s financial condition and
      results of operations should be read in conjunction with Bay National
      Corporation’s consolidated financial statements, the notes thereto and the other
      information included in this annual report.





This
      discussion and analysis provides an overview of the financial condition and
      results of operations of Bay National Corporation ("Parent") and its national
      bank subsidiary, Bay National Bank ("Bank"), (collectively the "Company"),
      as of
      December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005,
      and
      2004.





Certain
      reclassifications have been made to amounts previously reported to conform
      to
      the classifications made in 2006.




**General**





The
      Parent was incorporated on June 3, 1999 under the laws of the State of Maryland
      to operate as a bank holding company of the Bank. The Bank commenced operations
      on May 12, 2000.





The
      principal business of the Company is to make loans and other investments and
      to
      accept time and demand deposits. The Company’s primary market areas are in the
      Baltimore Metropolitan area and on Maryland’s Eastern Shore, although the
      Company’s business development efforts generate business outside of these areas.
      The Company offers a broad range of banking products, including a full line
      of
      business and personal savings and checking accounts, money market demand
      accounts, certificates of deposit, and other banking services. The Company
      funds
      a variety of loan types including commercial and residential real estate loans,
      commercial term loans and lines of credit, consumer loans, and letters of credit
      with an emphasis on meeting the borrowing needs of small businesses. The
      Company’s target customers are small and mid-sized businesses, business owners,
      professionals and high net worth individuals.





**Overview**





The
      Company continued a pattern of strong growth during the year ended December
      31,
      2006. This growth has resulted in improved operating results as compared to
      prior years. Key measurements for the year ended December 31, 2006 include
      the
      following:





·
            Total
                assets at December 31, 2006 increased by 21.4% to $254.8 million
                as
                compared to $210.0 million as of December 31, 2005.





·
            Net
                loans outstanding increased by 9.3% from $196.6 million as of December
                31,
                2005 to $214.8 million as of December 31,
                2006.





·
            At
                December 31, 2006, the Company had one nonperforming loan with a
                fully
                paid loan balance and unpaid fees of approximately $13,000. We believe
                an
                appropriate allowance for credit losses continues to be
                maintained.





·
            Deposits
                at December 31, 2006 were $224.1 million, an increase of $41.6 million
                or
                22.8% from December 31, 2005.





·
            During
                March 2006, the Company began using brokered certificates of deposit
                through the Promontory Financial Network. This network provides the
                Company with the ability to offer its customers access to FDIC-insured
                deposit products in aggregate amounts exceeding current insurance
                limits.
                When the Company places funds through the certificate of deposit
                account
                registry service (CDARS) on behalf of a customer, it receives matching
                deposits through the network. The Company also has the ability to
                raise
                deposits directly through the network. These deposits are considered
                “Brokered Deposits” for bank regulatory purposes. As of December 31, 2006,
                the Company had approximately $4.6 million of CDARS deposits
                outstanding.






22





·
            The
                Company realized net income of $2,429,828 for the year ended December
                31,
                2006. This compares to net income of $2,744,330 and $802,264 for
                the years
                ended December 31, 2005 and 2004, respectively. Included in the results
                of
                the year ended December 31, 2006 was income tax expense of $1,678,358
                compared to an income tax benefit of $655,000 recorded in
                2005.





·
            Net
                interest income, the Company’s main source of income, was $12.0 million
                for the year ended December 31, 2006 compared to $8.7 million and
                $5.2
                million for the years ended December 31, 2005 and 2004, respectively.
                This
                represents increases of 37.6% and 131.8% over the two prior years.





·
            Net
                loan charge-offs were $27,931 for the year ended December 31, 2006.
                Net
                charge-offs since the inception of the Bank in 2000 were
                $32,892.





·
            Non-interest
                income for the year ended December 31, 2006 increased by $26,740
                or 3.6%
                as compared to the year ended December 31,
                2005.





·
            Non-interest
                expense increased by $2,253,398 or 36.5% for the year ended December
                31,
                2006, as compared to the year ended December 31, 2005.





·
            The
                market price of our common stock ended the year at $19.20, down 8.6%
                from
                the closing price of $21.00 on December 31,
                2005.





A
      detailed discussion of the factors leading to these changes can be found in
      the
      discussion below.





**Results
      of Operations**





OVERVIEW





The
      Company recorded net income of $2,429,828 for the year ended December 31, 2006.
      This compares to $2,744,330 reported for the year ended December 31, 2005,
      a
      decrease of $314,502 due to a $2,033,358 negative swing in income taxes
      resulting from recognition of a $655,000 tax benefit in 2005 and the recognition
      of income tax expense of $1,678,358 in 2006. The Company reported net income
      of
      $802,264 for the year ended December 31, 2004. This significant improvement
      in
      results for the periods is due to the continued strong growth of the loan
      portfolio, as well as significant improvement in margins resulting from a rising
      interest rate environment.





Bay
      National Bank’s mortgage origination operations, located in Lutherville and
      Salisbury, Maryland, originate conventional first and second residential
      mortgage loans and construction and rehabilitation loans. Bay National Bank
      sells most of its first and second residential mortgage loans in the secondary
      market and typically recognizes a gain on the sale of these loans after the
      payment of commissions to the loan origination officer. Since its inception
      in
      February 2001, the Salisbury mortgage division has been a significant
      contributor to operating results. The Lutherville mortgage operation was
      initiated in February 2005 and began to contribute to the Company’s overall
      profitability during the second half of 2005. For the years ended December
      31,
      2006, 2005 and 2004, gains on the sale of mortgage loans totaled $573,387,
      $512,047 and $244,716, respectively. G ains
      on
      the sale of mortgage loans marginally increased for the year ended December
      31,
      2006 as compared to the same period in 2005 due to a slowdown in the real estate
      markets in both of the Company’s primary market areas.






23




The
      level
      of gains on the sale of mortgage loans increased in 2005 as compared to 2004
      due
      to the addition of the Lutherville origination operation, which focuses on
      construction and rehabilitation loans that will be modified to permanent
      financing upon completion of the project. The permanent financing is then sold
      in the secondary market. We believe that this type of residential lending is
      less sensitive to the fluctuations in interest rates.





During
      the second quarter of 2004, the Company introduced a new loan program for
      conventional first lien and second lien residential mortgage loans. Under this
      program, the Company purchases a 100% participation in mortgage loans originated
      by a mortgage company in the Baltimore metropolitan area. These participations
      are for loans which a secondary market investor has committed to purchase.
      The
      participations are typically held for a period of three to four weeks before
      being sold to the secondary market investor. This holding period represents
      the
      amount of time taken by the secondary market investor to review the loan files
      for completeness and accuracy. During this holding period, the Company earns
      interest on these loans at a rate indexed to the prime rate.





The
      primary risk to the Company from this program is that the secondary market
      investor may decline to purchase the loans due to documentary deficiencies
      or
      errors. The Company attempts to manage this risk by conducting a thorough review
      of the documentation prior to purchasing the participation. If the secondary
      market investor declines to purchase the loan, the Company could attempt to
      sell
      the loan to other investors or hold the loan in its loan portfolio. As of
      December 31, 2006, the Company had no loans outstanding under this program,
      which are normally classified as held for sale. The Company earned $264,299
      of
      interest on this program during 2006 and $751,803 during 2005. The activity
      in
      this program declined significantly in 2006 as the originating mortgage company
      utilized other available funding sources.





Management
      expects continued improvement in operating results as asset levels continue
      to
      grow. However, actual results will be subject to the volatility of the provision
      for credit losses, which is related to loan growth, the impact of interest
      rate
      changes, which can reduce margins, the continued success of the Lutherville
      mortgage lending programs, and the volatility of existing mortgage loan
      production, which is sensitive to economic and interest rate
      fluctuations.





NET
      INTEREST INCOME / MARGINS





Net
      interest income is the difference between income on earning assets and the
      cost
      of funds supporting those assets. Earning assets are composed primarily of
      loans, investments, and federal funds sold. Interest-bearing deposits and other
      borrowings make up the cost of funds. Non-interest bearing deposits and capital
      are also funding sources. Changes in the volume and mix of earning assets and
      funding sources along with changes in associated interest rates determine
      changes in net interest income.





Interest
      income from loans and investments for the year ended December 31, 2006 was
      $19,780,839, compared to $12,982,706 and $7,623,564 for the years ended December
      31, 2005 and 2004, respectively. The 52.4% increase over 2005, and the 159.5%
      increase over 2004, is directly related to the 23.8% increase in average
      interest earning assets from 2005 and the 58.3% increase in average interest
      earning assets from 2004. The change in interest income was also impacted by
      changes in average yields due to a rising interest rate environment in 2006
      and
      2005. The yields on these assets rose from 5.31 %
      for the
      year ended December 31, 2004 to 7.08% for the year ended December 31, 2005
      and
      to 8.71% for the year ended December 31, 2006.





The
      percentage of average interest-earning assets represented by loans was 92.3%,
      92.5% and 88.0% for the years ended December 31, 2006, 2005, and 2004,
      respectively. For the year ended December 31, 2006, the average yield on the
      loan portfolio was 9.12%, as compared to 7.46% for the year ended December
      31,
      2005 and 5.89% for the year ended December 31, 2004. Loan yields have increased
      primarily as a result of seventeen 0.25% increases in the target federal funds
      rate, from 1.00% at June 25, 2003 to 5.25% effective June 29, 2006. As can
      be
      seen by the yields discussed above, these increases had a significant impact
      on
      the Company’s operating results. The timing and amount of the impact on loan
      yields of changes to the federal funds rates varies from period to period as
      a
      result of differences in the mix of fixed rate loans to variable rate loans
      at
      any point in time.






24





The
      average yield on the investment portfolio and other earning assets such as
      federal funds sold was 3.79% for the year ended December 31, 2006 as compared
      to
      2.27% and 1.11% for the years ended December 31, 2005 and 2004, respectively.
      The fluctuations in the average yields were a direct result of the Federal
      Reserve actions discussed above as well as an increase in the holdings of
      Federal Reserve and Federal Home Loan Bank of Atlanta stocks, which pay dividend
      yields greater than the prevailing federal funds rate. The percentage of average
      interest-earning assets represented by investments was 7.7%, 7.5% and 12.0%
      for
      the years ended December 31, 2006, 2005, and 2004, respectively.





Interest
      expense from deposits and borrowings for the year ended December 31, 2006 was
      $7,822,700 compared to $4,294,146 and $2,464,209 for the years ended December
      31, 2005 and 2004, respectively. The 82.2% increase over 2005 and the 217.5%
      increase over 2004 are directly related to the 25.1% increase in average
      interest-bearing liabilities from 2005 and the 59.5% increase in average
      interest-bearing liabilities from 2004. Interest expense was also impacted
      by
      changes in average rates paid due to the increasing interest rate environment.
      The average rates paid on these liabilities changed from 2.17% for the year
      ended December 31, 2004 to 2.96% for the year ended December 31, 2005 to 4.31%
      for the year ended December 31, 2006. Average rates paid increased during 2006
      as a result of the rising interest rate environment during this period as well
      as the effect of incurring a full year of interest on the subordinated debt
      at
      an effective rate of 7.55%. Management has observed pressure to increase rates
      paid on deposits as the target for the federal funds rate has risen. Management
      expects that this pressure will continue if rates continue to rise.





The
      following tables set forth, for the periods indicated, information regarding
      the
      average balances of interest-earning assets and interest-bearing liabilities,
      the amount of interest income and interest expense, and the resulting yields
      on
      average interest-earning assets and rates paid on average interest-bearing
      liabilities. Average balances are also provided for non-interest-earning assets
      and non-interest-bearing liabilities.





No
      tax
      equivalent adjustments were made and no income was exempt from federal income
      taxes. All average balances are daily average balances. The amortization of
      loan
      fees is included in computing interest income; however, such fees are not
      material.





25





**Year
                Ended December 31, 2006****Average**
              **Balance**
            
            **Interest**
              **and
                fees**
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            209,637,043
            
            $
            19,117,244
            
            
            9.12
            %Investment
                securities
            
            
            2,151,124
            
            
            105,625
            
            
            4.91Federal
                funds sold and other overnight investments
            
            
            15,366,594
            
            
            557,970
            
            
            3.63Total
                Earning Assets
            
            
            227,154,761
            
            
            19,780,839
            
            
            8.71
            %Less:
                Allowance for credit losses
            
            
            (3,029,070
            )Cash
                and due from banks
            
            
            2,089,474Premises
                and equipment, net
            
            
            952,629Accrued
                interest receivable and other assets
            
            
            2,761,444Total
                Assets
            
            $
            229,929,238LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            61,312,209
            
            
            2,208,830
            
            
            3.60
            %Regular
                savings deposits
            
            
            6,327,802
            
            
            67,402
            
            
            1.07Time
                deposits
            
            
            103,935,678
            
            
            4,856,379
            
            
            4.67Short-term
                borrowings
            
            
            1,935,743
            
            
            86,522
            
            
            4.47Subordinated
                debt
            
            
            8,000,000
            
            
            603,567
            
            
            7.55Total
                interest-bearing liabilities
            
            
            181,511,432
            
            
            7,822,700
            
            
            4.31
            %Net
                interest income and spread
            
            
            
            
            $
            11,958,139
            
            
            4.40
            %Non-interest-bearing
                demand deposits
            
            
            29,145,397Accrued
                expenses and other liabilities
            
            
            1,701,423Stockholders’
                equity
            
            
            17,570,986Total
                Liabilities and Stockholders’ Equity
            
            $
            229,929,238Interest
                and fee income/earning assets
            
            
            8.71
            %Interest
                expense/earning assets
            
            
            3.44Net
                interest margin
            
            
            5.27
            %Return
                on Average Assets
            
            
            1.06
            %Return
                on Average Equity
            
            
            13.83
            %Average
                Equity to Average Assets
            
            
            7.64
            %





26





**Year
                Ended December 31, 2005****Average**
              **Balance**
            
            **Interest**
              **and
                fees**
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            169,811,066
            
            $
            12,671,707
            
            
            7.46
            %Investment
                securities
            
            
            2,343,007
            
            
            86,267
            
            
            3.68Federal
                funds sold and other overnight investments
            
            
            11,340,021
            
            
            224,732
            
            
            1.98Total
                Earning Assets
            
            
            183,494,094
            
            
            12,982,706
            
            
            7.08
            %Less:
                Allowance for credit losses
            
            
            (2,064,604
            )Cash
                and due from banks
            
            
            1,328,362Premises
                and equipment, net
            
            
            708,549Accrued
                interest receivable and other assets
            
            
            900,832Total
                Assets
            
            $
            184,367,233LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            56,170,562
            
            
            1,064,126
            
            
            1.89
            %Regular
                savings deposits
            
            
            5,643,798
            
            
            36,572
            
            
            .65Time
                deposits
            
            
            77,785,133
            
            
            2,957,821
            
            
            3.80Short-term
                borrowings
            
            
            3,630,729
            
            
            115,810
            
            
            3.19Note
                payable
            
            
            1,426,027
            
            
            91,709
            
            
            6.43Subordinated
                debt
            
            
            438,356
            
            
            28,108
            
            
            7.20Total
                interest-bearing liabilities
            
            
            145,094,605
            
            
            4,294,146
            
            
            2.96
            %Net
                interest income and spread
            
            
            
            
            $
            8,688,560
            
            
            4.12
            %Non-interest-bearing
                demand deposits
            
            
            24,032,958Accrued
                expenses and other liabilities
            
            
            884,689Stockholders’
                equity
            
            
            14,354,981Total
                Liabilities and Stockholders’ Equity
            
            $
            184,367,233Interest
                and fee income/earning assets
            
            
            7.08
            %Interest
                expense/earning assets
            
            
            2.34Net
                interest margin
            
            
            4.74
            %Return
                on Average Assets
            
            
            1.49
            %Return
                on Average Equity
            
            
            19.12
            %Average
                Equity to Average Assets
            
            
            7.79
            %








27





**Year
                Ended December 31, 2004****Average**
              **Balance**
            
            **Interest**
              **and
                fees**
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            126,212,414
            
            $
            7,431,368
            
            
            5.89
            %Investment
                securities
            
            
            2,038,432
            
            
            45,173
            
            
            2.22Federal
                funds sold and other overnight investments
            
            
            15,232,288
            
            
            147,023
            
            
            0.97Total
                Earning Assets
            
            
            143,483,134
            
            
            7,623,564
            
            
            5.31
            %Less:
                Allowance for credit losses
            
            
            (1,473,985
            )Cash
                and due from banks
            
            
            909,590Premises
                and equipment, net
            
            
            641,550Accrued
                interest receivable and other assets
            
            
            534,261Total
                Assets
            
            $
            144,094,550LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            46,627,122
            
            
            509,308
            
            
            1.09
            %Regular
                savings deposits
            
            
            4,363,244
            
            
            28,396
            
            
            0.65Time
                deposits
            
            
            61,184,843
            
            
            1,901,183
            
            
            3.11Short-term
                borrowings
            
            
            1,475,148
            
            
            19,020
            
            
            1.29Note
                payable
            
            
            129,098
            
            
            6,302
            
            
            4.88Subordinated
                debt
            
            
            -
            
            
            -
            
            
            -Total
                interest-bearing liabilities
            
            
            113,779,445
            
            
            2,464,209
            
            
            2.17
            %Net
                interest income and spread
            
            
            
            
            $
            5,159,355
            
            
            3.14
            %Non-interest-bearing
                demand deposits
            
            
            17,391,401Accrued
                expenses and other liabilities
            
            
            515,639Stockholders’
                equity
            
            
            12,408,055Total
                Liabilities and Stockholders’ Equity
            
            $
            144,094,550Interest
                and fee income/earning assets
            
            
            5.31
            %Interest
                expense/earning assets
            
            
            1.71Net
                interest margin
            
            
            3.60
            %Return
                on Average Assets
            
            
            0.56
            %Return
                on Average Equity
            
            
            6.47
            %Average
                Equity to Average Assets
            
            
            8.61
            %





28





RATE/VOLUME
      ANALYSIS





A
      rate/volume analysis, which demonstrates changes in taxable-equivalent interest
      income and expense for significant assets and liabilities, appears below. The
      calculation of rate, volume and rate/volume variances is based on a procedure
      established for bank holding companies by the Securities and Exchange
      Commission. Rate, volume and rate/volume variances presented for each component
      may not total to the variances presented on totals of interest income and
      interest expense because of shifts from year to year in the relative mix of
      interest-earning assets and interest-bearing liabilities.





Year
                ended December 31,2006
                vs. 2005
              Due
                to variances inTotal
            
            Rates
            
            Volumes
            
            Rate/
                VolumeInterestincome
                on:Loans
                and loans held for sale
            
            $
            6,445,537
            
            $
            2,813,722
            
            $
            2,971,909
            
            $
            659,906Investment
                Securities
            
            
            19,358
            
            
            28,780
            
            
            (7,065
            )
            
            (2,357
            )Federal
                funds sold and other overnight investments
            
            
            333,238
            
            
            187,031
            
            
            79,797
            
            
            66,410Total
                interest income
            
            
            6,798,133
            
            
            3,029,533
            
            
            3,044,641
            
            
            723,959Interest
                expense on:Interest-bearing
                demand deposits
            
            
            1,144,704
            
            
            959,471
            
            
            97,406
            
            
            87,827Regular
                savings deposits
            
            
            30,830
            
            
            23,544
            
            
            4,433
            
            
            2,853Time
                deposits
            
            
            1,898,558
            
            
            676,678
            
            
            994,388
            
            
            227,492Short-term
                borrowings
            
            
            (29,288
            )
            
            46,473
            
            
            (54,065
            )
            
            (21,696
            )Note
                payable
            
            
            (91,709
            )
            
            (91,709
            )
            
            (91,709
            )
            
            91,709Subordinated
                debt
            
            
            575,459
            
            
            4,964
            
            
            484,863
            
            
            85,632Total
                interest expense
            
            
            3,528,554
            
            
            1,619,421
            
            
            1,435,316
            
            
            473,817Net
                interest income
            
            $
            3,269,579
            
            $
            1,410,112
            
            $
            1,609,325
            
            $
            250,142








Year
                ended December 31,2005
                vs. 2004
              Due
                to variances inTotal
            
            Rates
            
            Volumes
            
            Rate/
                VolumeInterestincome
                on:Loans
                and loans held for sale
            
            $
            5,240,339
            
            $
            1,986,904
            
            $
            2,567,082
            
            $
            686,353Investment
                Securities
            
            
            41,094
            
            
            29,880
            
            
            6,749
            
            
            4,465Federal
                funds sold and other overnight investments
            
            
            77,709
            
            
            154,844
            
            
            (37,568
            )
            
            (39,567
            )Total
                interest income
            
            
            5,359,142
            
            
            2,171,628
            
            
            2,536,263
            
            
            651,251Interest
                expense on:Interest-bearing
                demand deposits
            
            
            554,818
            
            
            374,022
            
            
            104,243
            
            
            76,553Regular
                savings deposits
            
            
            8,176
            
            
            (122
            )
            
            8,334
            
            
            (36
            )Time
                deposits
            
            
            1,056,638
            
            
            425,403
            
            
            515,817
            
            
            115,418Short-term
                borrowings
            
            
            96,790
            
            
            28,033
            
            
            27,793
            
            
            40,964Note
                payable
            
            
            85,407
            
            
            2,001
            
            
            63,310
            
            
            20,096Subordinated
                Debt
            
            
            28,108
            
            
            -
            
            
            -
            
            
            28,108Total
                interest expense
            
            
            1,829,937
            
            
            829,337
            
            
            719,497
            
            
            281,103Net
                interest income
            
            $
            3,529,205
            
            $
            1,342,291
            
            $
            1,816,766
            
            $
            370,148




PROVISION
      FOR CREDIT LOSSES





The
      provision for credit losses was $202,931 for the year ended December 31, 2006,
      as compared to $1,178,866 for the year ended December 31, 2005, and $559,596
      for
      the year ended December 31, 2004. The provision was lower than the same periods
      in the prior year due to the fact that the loan portfolio grew at a slower
      pace
      in 2006 and the relative risk mix of the portfolio declined as the Company
      successfully reduced or eliminated some riskier loans from its portfolio. The
      provision for 2005 was higher than the prior year due to the fact that an
      additional $500,000 provision was established in the fourth quarter of 2005
      as a
      result of the downgrading of one credit. For additional information regarding
      the methodology used to determine the provision for credit losses see the
      Management Discussion and Analysis section entitled “Allowance for Credit Losses
      and Credit Risk Management.”






29





NON-INTEREST
      INCOME





Non-interest
      income consists primarily of gains on the sale of mortgage loans, deposit
      account service charges and cash management fees. For the year ended December
      31, 2006, the Company realized non-interest income in the amount of $777,333
      as
      compared to $750,593 and $538,847 for the years ended December 31, 2005 and
      2004, respectively.





Gains
      on
      the sale of mortgage loans of $573,387 represented 73.8% of non-interest income
      for the year ended December 31, 2006. This compares to gains on the sale of
      mortgage loans of $512,047 or 68.2% of total non-interest income for the year
      ended December 31, 2005 and $244,716 or 45.4% of total non-interest income
      for
      the year ended December 31, 2004. The marginal increase for the year ended
      December 31, 2006 as compared to the prior year was achieved even though there
      has been a general decline in home purchase and refinance activity in the
      Company’s markets. The level of gains on the sale of mortgage loans increased
      significantly from 2004 because the Company added additional residential
      construction and mortgage capabilities with the opening of the Lutherville
      mortgage operation in February 2005. This was achieved through the hiring of
      a
      team of eight individuals, including originators, processors and servicers
      who
      have extensive experience in the industry and the Company’s market area.
      Additional increases in interest rates, or a slow down in the housing market,
      could impact the Company’s ability to generate non-interest income associated
      with mortgage loan production.




Service
      charges on deposit accounts totaled $148,042 for the year ended December 31,
      2006, as compared to $188,276 and $237,980 for the years ended December 31,
      2005
      and 2004, respectively. The decreases of 21.4% over 2005 and 37.8% over 2004
      can
      be primarily attributed to a decline in the level of overdraft fees charged
      on
      transaction accounts. This decline occurred as the average level of overdrawn
      balances declined by approximately 59% for the twelve-month period ended
      December 31, 2006 as compared to the same period in 2005. The decline is a
      result of the Company’s ongoing emphasis on attracting relationships that tend
      to maintain higher account balances.





The
      Company will continue to seek ways to expand its sources of non-interest income.
      In the future, the Company may enter into fee arrangements with strategic
      partners that offer investment advisory services, risk management and employee
      benefit services. No assurance can be given that such fee arrangements will
      be
      obtained or maintained.





NON-INTEREST
      EXPENSE





The
      components of non-interest expense were as follows:





**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**Salaries
                and employee benefits
            
            $
            5,431,989
            
            $
            3,627,630
            
            $
            2,442,774Occupancy
                expenses
            
            
            506,323
            
            
            420,866
            
            
            312,550Furniture
                and equipment expenses
            
            
            342,261
            
            
            304,132
            
            
            255,547Legal
                and professional fees
            
            
            245,412
            
            
            154,476
            
            
            175,757Data
                processing and other outside services
            
            
            701,422
            
            
            655,726
            
            
            582,396Advertising
                and marketing related expenses
            
            
            512,709
            
            
            445,482
            
            
            212,237Other
                expenses
            
            
            684,239
            
            
            562,645
            
            
            355,081Total
                non-interest expenses
            
            $
            8,424,355
            
            $
            6,170,957
            
            $
            4,336,342






30





2006
      compared to 2005





Non-interest
      expense for the year ended December 31, 200 6
      totaled
      $8,424,355 compared to $6,170,957 for the year ended December 31, 2005. The
      increase of $2,253,398, or 36.5%, was primarily due to increases in salaries
      and
      employee benefit expenses, which represented 64.5% and 58.8% of non-interest
      expenses for the years ended December 31, 2006 and 2005, respectively.





Salaries
      and benefits increased by $1,804,359 or 49.7% , which was related to staffing
      growth, including the addition of a Senior Credit Officer in January 2006 and
      a
      Senior Business Development Officer in June 2006, as well as staffing growth
      in
      residential real estate lending, private banking, commercial account portfolio
      managers and other operational support. These additions were made to continue
      to
      expand the Bank’s market presence, as well as to manage the growth of the loan
      and deposit portfolios and support increased operational volume. Occupancy
      expenses increased by $85,457, or 20.3%, due in part to scheduled rent increases
      and increased rental expenses associated with new space obtained to accommodate
      a larger Baltimore banking office and the Baltimore mortgage operation.





Legal
      and
      professional fees increased $90,936, or 58.9% resulting from legal fees incurred
      in connection with the drafting of executive employment agreements and legal
      assistance with the development of a commercial paper program, as well as an
      increase in internal and external audit fees related to Company growth and
      management’s desire to more frequently assess more complex functions such as
      information technology controls and residential lending compliance. Management
      expects that professional fees will continue to rise in 2007 due to the costs
      associated with using outside consultants to facilitate the review and
      documentation of the Company’s internal control over financial reporting
      pursuant to Section 404 of the Sarbanes-Oxley Act of 2002.





The
      $45,696, or 7.0%, increase in data processing and other outside services
      resulted from increased costs paid during 2006 for enhancements to the Company’s
      information technology maintenance and security infrastructure, human resource
      consulting, and higher printing expenses related to increased regulatory
      filings. The increased regulatory filings were required when the Company
      registered its securities under Section 12 of the Securities Exchange Act of
      1934, as amended (the “Exchange Act”) in connection with listing its common
      stock on the NASDAQ Capital Market during the first quarter of 2006.




The
      $38,129, or 12.5%, increase in furniture and equipment expenses is related
      to
      increased costs associated with expanded staffing and facilities. Advertising
      and marketing related expenses increased $67,227, or 15.1%, which was related
      to
      an increase in the number of marketing events conducted and the number of
      business development professionals. The increase of $121,594, or 21.6%, in
      all
      other expenses relates to various costs associated with the increased size
      and
      complexity of the Company.





The
      banking industry utilizes the “efficiency ratio” as a key measure of expense
      management and overall operating efficiency. This ratio is computed by dividing
      non-interest expense by the sum of net interest income before the loan loss
      provision and non-interest income. The Company’s efficiency ratio was 66.1% for
      the year ended December 31, 2006 compared to 65.4% for the year ending December
      31, 2005. The increase from the prior year was driven by increased expenses
      not
      matching up to revenue growth.







31





Substantially
      all of the occupancy costs in 2006 were paid to directors of Bay National
      Corporation or entities controlled by directors of Bay National Corporation.
      Management believes that the terms of these leases are at least as favorable
      as
      could be obtained from independent third parties. However, management has not
      conducted a recent market analysis to confirm this. For a discussion of the
      terms of the leases with these persons, see “Item 12 - Certain Relationships and
      Related Transactions, and Director Independence.”





2005
      compared to 2004





Non-interest
      expense for the year ended December 31, 200 5
      totaled
      $6,170,957 compared to $4,336,342 for the year ended December 31, 2004. The
      increase of $1,834,615, or 42.3%, was primarily due to increases in salaries
      and
      employee benefit expenses, occupancy expenses, data processing and other outside
      services, advertising and marketing related expenses, furniture and equipment
      expenses and other expenses.





Salaries
      and benefits increased by $1,184,856 or 48.5% as a result of staffing growth
      related to the addition of the Lutherville mortgage operation as well as
      staffing to increase marketing efforts, manage the growth of the loan and
      deposit portfolios and support increased operational volume. Occupancy expenses
      increased by $108,316, or 34.7%, due in part to scheduled rent increases and
      increased rental expenses associated with new space obtained to facilitate
      the
      expansion of the Company’s corporate offices and to accommodate the new
      Lutherville mortgage lending group.





The
      $73,330, or 12.6%, increase in data processing and other outside services
      resulted from increased data and item processing costs paid to external service
      providers. The costs include one-time expenses of approximately $45,000 incurred
      in conjunction with the Bank’s planned change of core processors that occurred
      in May 2005, approximately $24,000 of recruiting fees paid to hire additional
      staff, and approximately $8,000 of systems support costs incurred to facilitate
      network infrastructure changes required for a Bank processing system upgrade.
      The costs associated with purchasing additional hardware and software to support
      increased staffing were offset by savings on the new core processing contract,
      which provides for lower unit costs on a volume driven pricing structure.





The
      $48,585, or 19.0%, increase in furniture and equipment expenses is related
      to
      increased costs associated with expanded staffing and facilities. Advertising
      and marketing related expenses increased $233,245, or 109.9%, which was related
      to an increase in the number of marketing events conducted and the number of
      business development professionals as well as a total of $125,000 increase
      in
      funds set aside for charitable contributions to the Baltimore Community
      Foundation Donor Advised Fund and the Community Foundation of the Eastern Shore
      Donor Advised Fund established by the Bank. The increase of $186,283, or 35.1%,
      in all other expenses relates to various costs associated with the increased
      size and complexity of the Company.





The
      Company’s efficiency ratio was 65.4% for the year ended December 31, 2005
      compared to 76.1% for the year ending December 31, 2004. The improved ratio
      from
      the prior year was driven by strong revenue growth and prudent management of
      the
      Company’s cost structure.





INCOME
      TAXES





For
      the
      year ended December 31, 2006, the Company recorded income tax expense of
      $1,678,358 compared to a tax benefit of $655,000 for the year ended December
      31,
      2005.





For
      financial reporting purposes, taxable income for the years ended December 31,
      2005 and 2004 was offset by the Company’s net operating loss carryforwards
      available in those years. The 2005 liability was offset by the recognition
      of a
      deferred tax asset of $1,083,000, resulting in the net tax benefit of $655,000
      for the year ended December 31, 2005.






32





The
      use
      of the net operating loss carryforward and the recognition of net deferred
      income tax assets had a positive effect on 2005 earnings. Prior to 2005, the
      Company had not recorded any income tax expense or benefit. Recognizing income
      tax expense in 2006 had a detrimental effect on reported earnings.





At
      December 31, 2006, the Company continues to have approximately $1,650,000 of
      Maryland net operating loss carryforwards (a possible net tax benefit of
      $115,000) for the unconsolidated state tax return for Bay National Corporation.
      Unless Bay National Corporation generates income from its own operations (i.e.,
      unrelated to Bay National Bank), these operating loss carryforwards will expire
      in 2019 and 2021.


33


**Financial
      Condition**





COMPOSITION
      OF THE BALANCE SHEET





Total
      assets of the Company were $254,804,847 as of December 31, 2006, compared to
      total assets of $209,966,335 as of December 31, 2005. This represents growth
      of
      approximately $44.8 million, or 21. 4%,
      since
      December 31, 2005. The growth in assets was funded by growth in deposits and
      earnings. Deposits at December 31, 2006 were $224,148,952 as compared to
      deposits of $182,573,086 at December 31, 2005. Deposit growth directly resulted
      from the marketing efforts of officers and directors of the Bank. Management
      has
      set the interest rates paid on deposits to be competitive in the market and
      has
      continued to increase marketing activities throughout the year.





As
      of
      December 31, 2006, loans including
      loans held for sale (net of a $3,175,000 allowance for credit losses), totaled $214,840,678. This represents an increase of $18,250,717, or 9.3%, from December
      31, 2005. Essentially all of this growth is a result of residential construction
      and rehabilitation lending generated by the Lutherville residential lending
      group established in February 2005. Excluding Lutherville residential
      construction and rehabilitation loans, loan growth was flat due to significant pay downs and payoffs. A total of approximately $40.1 million in
      loans that were outstanding as of December 31, 2005 were paid off during 2006.
      This activity, combined with normal fluctuations in revolving credit balances
      and installment payments on amortizing loans, offset most of the approximately
      $46.6 million in new loans funded during that same period.





The
      composition of the loan portfolio as of December 31, 2006 was approximately
      $88.5 million of commercial loans (excluding real estate loans), $3.3 million
      of
      consumer loans and $124.8 million of real estate loans excluding $1,444,303 of mortgage loans held for sale. The
      composition of the loan portfolio as of December 31, 2005 was approximately
      $75.6 million of commercial loans (excluding real estate loans), $2.9 million
      of
      consumer loans and $103.6 million of real estate loans excluding $17,509,064 of mortgage loans held for sale. Growth in the loan portfolio is
      a
      direct result of the addition of the Lutherville mortgage group as well as
      the
      marketing efforts of bank employees, members of the Board of Directors and
      the
      Baltimore and Salisbury Advisory Boards. The mix of loans shifted to a higher
      concentration in real estate as a result of the Lutherville mortgage group’s
      production.





The
      Company will continue to emphasize prudent growth through the hiring of
      experienced commercial lenders and the development and use of referral sources
      including accountants, lawyers and existing customers, as well as members of
      the
      Board of Directors and the Baltimore and Salisbury Advisory Boards.





Funds
      not
      extended in loans are held in cash and due from banks, and various investments
      including federal funds sold and other overnight investments, United States
      Treasury securities, Federal Reserve Bank stock and Federal Home Loan Bank
      stock. These investments totaled $35,712,830 as of December 31, 2006 compared
      to
      $9,828,447 as of December 31, 2005. Other than the investments in Federal
      Reserve Bank stock and Federal Home Loan Bank stock, totaling $1,117,100 and
      $794,440 at December 31, 2006 and 2005, respectively, all investments have
      maturities of 90 days or less. The Treasury securities are used to collateralize
      repurchase agreements which are classified as short-term borrowings under which
      $300,000 and $916,158 were outstanding as of December 31, 2006 and December
      31,
      2005, respectively. As of December 31, 2006, approximately $334,000 of Treasury
      securities were pledged as collateral for uninsured deposits held for a
      municipal government. Management has made a decision to maintain liquidity
      in
      the investment portfolio in order to ensure that funds are readily available
      to
      fund the growth of the loan portfolio or to fund the maturity of higher cost
      national time deposits.





Total
      capital at December 31, 2006 was $18,842,493 as compared to $16,214,078 at
      December 31, 2005. The
      increase in capital is primarily a result of the positive operating results
      for
      the year ended December 31, 2006.








34





COMPOSITION
      OF LOAN PORTFOLIO





Because
      yields on loans typically exceed the yields on investments, the Company’s
      business strategy is to continue to increase the overall level of loans, as
      well
      as maintain a relatively high percentage of loans to total earning assets.
      Increasing loans and loans as a percentage of total earning assets will maximize
      the net interest margin. As of December 31, 2006 and 2005, loans represented
      86.73% and 95.98% of total earning assets, respectively.





The
      following table sets forth the composition of the principal balances of the
      Company's loan portfolio as of December 31, 2006, 2005, 2004, 2003, and 2002,
      respectively.





**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Real
                Estate - Home Equity Line of Credit
            
            $
            19,963,116
            
            $
            21,067,964
            
            $
            24,548,506
            
            $
            16,078,166
            
            $
            9,960,943Real
                Estate - Construction
            
            
            76,889,997
            
            
            47,933,768
            
            
            12,968,251
            
            
            8,101,017
            
            
            3,700,389Real
                Estate - Mortgage
            
            
            27,903,399
            
            
            34,542,931
            
            
            27,854,130
            
            
            13,687,709
            
            
            7,816,997Loans
                Held for Sale
            
            
            1,444,303
            
            
            17,509,064
            
            
            9,613,162
            
            
            923,825
            
            
            2,818,500Commercial
            
            
            88,491,722
            
            
            75,626,825
            
            
            73,836,994
            
            
            61,868,002
            
            
            42,566,165Consumer
            
            
            3,323,141
            
            
            2,909,409
            
            
            2,205,556
            
            
            1,657,081
            
            
            4,033,767Total
                Loans
            
            $
            218,015,678
            
            $
            199,589,961
            
            $
            151,026,599
            
            $
            102,315,800
            
            $
            70,896,761





The
      following table sets forth the percentages
      of loans in each category for the Company's loan portfolio as of December 31,
      2006, 2005, 2004, 2003, and 2002, respectively.





**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Real
                Estate - Home Equity Line of Credit
            
            
            9.16
            %
            
            10.55
            %
            
            16.25
            %
            
            15.71
            %
            
            14.05
            %Real
                Estate - Construction
            
            
            35.27
            
            
            24.02
            
            
            8.59
            
            
            7.92
            
            
            5.22Real
                Estate - Mortgage
            
            
            12.80
            
            
            17.31
            
            
            18.44
            
            
            13.38
            
            
            11.03Loans
                Held for Sale
            
            
            0.66
            
            
            8.77
            
            
            6.37
            
            
            .90
            
            
            3.97Commercial
            
            
            40.59
            
            
            37.89
            
            
            48.89
            
            
            60.47
            
            
            60.04Consumer
            
            
            1.52
            
            
            1.46
            
            
            1.46
            
            
            1.62
            
            
            5.69Total
                Loans
            
            
            100.00
            %
            
            100.00
            %
            
            100.00
            %
            
            100.00
            %
            
            100.00
            %





The
      following table sets forth the maturity distribution for the Company's loan
      portfolio at December 31, 200 6.
      Some
      of the loans may be renewed or repaid prior to maturity. Therefore, the
      following table should not be used as a forecast of future cash
      flows.





**Within
                one**
              **year**
            
            **One
                to**
              **three
                years**
            
            **Three
                to**
              **five
                years**
            
            **Over
                five**
              **years**Real
                Estate - Home Equity Line of Credit
            
            $
            19,963,116
            
            $
            -
            
            $
            -
            
            $
            -Real
                Estate - Construction
            
            
            72,493,311
            
            
            4,090,021
            
            
            306,665
            
            
            -Real
                Estate - Mortgage
            
            
            16,320,927
            
            
            8,048,428
            
            
            3,472,188
            
            
            61,856Loans
                Held for Sale
            
            
            1,444,303
            
            
            -
            
            
            -
            
            
            -Commercial
            
            
            60,043,656
            
            
            14,992,589
            
            
            10,492,601
            
            
            2,962,876Consumer
            
            
            2,528,852
            
            
            758,314
            
            
            35,975
            
            
            -Total
            
            $
            172,794,165
            
            $
            27,889,352
            
            $
            14,307,429
            
            $
            3,024,732Fixed
                interest rate
            
            $
            58,210,286
            
            $
            27,889,352
            
            $
            14,307,429
            
            $
            3,024,732Variable
                interest rate
            
            
            113,139,576
            
            
            -
            
            
            -
            
            
            -Loans
                Held for Sale
            
            
            1,444,303
            
            
            -
            
            
            -
            
            
            -Total
            
            $
            172,794,165
            
            $
            27,889,352
            
            $
            14,307,429
            
            $
            3,024,732






35





The
      scheduled repayments as shown above are reported in the maturity category in
      which the payment is due, except for the adjustable rate loans, which are
      reported in the period of repricing.





The
      Company's loan portfolio composition as of December 31, 200 6
      reflects a 51.90% concentration in variable rate loans. Loans held for sale
      total $1,444,303 or 0.66% of the Company's loan portfolio. Fixed rate loans
      total $103,431,799 or 47.44% of the Company's loan portfolio. Interest rates
      on
      variable rate loans adjust to the current interest rate environment, whereas
      fixed rates do not allow this flexibility. Loans held for sale are expected
      to
      be sold in three months or less and as a result are not materially impacted
      by
      interest rate fluctuations. If interest rates were to increase in the future,
      the interest earned on the variable rate loans would improve, and, if rates
      were
      to fall, the interest earned would decline. See "Liquidity and Interest Rate
      Sensitivity."





The
      office rs
      and
      directors of the Company, including their related companies, had outstanding
      loans from the Bank of $11,245,284 at December 31, 2006 and $8,059,647 at
      December 31, 2005. All loans made to officers and directors, including their
      related companies, are made on substantially the same terms, including interest
      rates and collateral, as those prevailing at the time for comparable
      transactions with unaffiliated third parties and do not involve more than the
      normal risk of repayment or present other unfavorable features.





ALLOWANCE
      FOR CREDIT LOSSES AND CREDIT RISK MANAGEMENT





Originating
      loans involves a degree of risk that credit losses will occur in varying amounts
      according to, among other factors, the type of loans being made, the
      credit-worthiness of the borrowers over the term of the loans, the quality
      of
      the collateral for the loan, if any, as well as general economic conditions.
      The
      Company charges the provision for credit losses to earnings to maintain the
      total allowance for credit losses at a level considered by management to
      represent its best estimate of the losses known and inherent in the portfolio
      that are both probable and reasonable to estimate, based on, among other
      factors, prior loss experience, volume and type of lending conducted, estimated
      value of any underlying collateral, economic conditions (particularly as such
      conditions relate to the Company’s market area), regulatory guidance, peer
      statistics, management’s judgment, past due loans in the loan portfolio, loan
      charge off experience and concentrations of risk (if any). The Company charges
      losses on loans against the allowance when it is believed that collection of
      loan principal is unlikely. Recoveries on loans previously charged off are
      added
      back to the allowance.





Management
      uses a loan grading system where all loans are graded based on management's
      evaluation of the risk associated with each loan. A factor, based on the loan
      grading, is applied to the loan balance to reserve for potential losses. In
      addition, management judgmentally establishes an additional nonspecific reserve.
      The nonspecific portion of the allowance reflects management's estimate of
      probable inherent but undetected losses within the portfolio due to
      uncertainties in economic conditions, delays in obtaining information, including
      unfavorable information about a borrower's financial condition, the difficulty
      in identifying triggering events that correlate perfectly to subsequent loss
      rates and risk factors that have not yet manifested themselves in loss
      allocation factors.





The
      reserve factors used are based on management’s judgment as to appropriate
      reserve percentages for various categories of loans, and management adjusts
      those values based on the following: historical losses in each category,
      historical and current delinquency in each category, underwriting standards
      in
      each category, comparison of losses and delinquencies to peer group performance
      and an assessment of the likely impact of economic and other external conditions
      on the performance of each category.





A
      test of
      the adequacy of the allowance for credit losses is performed and reported to
      the
      Board of Directors on a monthly basis. Management uses the information available
      to make a determination with respect to the allowance for credit losses,
      recognizing that the determination is inherently subjective and that future
      adjustments may be necessary depending upon, among other factors, a change
      in
      economic conditions of specific borrowers or generally in the economy and new
      information that becomes available. However, there are no assurances that the
      allowance for credit losses will be sufficient to absorb losses on nonperforming
      assets or that the allowance will be sufficient to cover losses on nonperforming
      assets in the future.






36





The
      allowance for credit losses as of December 31, 2006 and December 31, 2005 was
      $3,175,000 and $3,000,000, respectively. The amount equates to 1.46% and 1.50%
      of outstanding loans, including loans held for sale, as of December 31, 2006
      and
      2005, respectively. The decreased percentage was due to the decreased level
      of
      risk in the loan portfolio. Bay National Corporation has no exposure to foreign
      countries or foreign borrowers. Management believes that the allowance for
      loan
      losses is adequate for each period presented.





The
      following table represents an analysis of the activity in the allowance for
      credit losses for the periods presented:





**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Balance
                at beginning of year
            
            $
            3,000,000
            
            $
            1,810,000
            
            $
            1,266,500
            
            $
            851,500
            
            $
            447,000Provision
                for credit losses
            
            
            202,931
            
            
            1,178,866
            
            
            559,596
            
            
            415,000
            
            
            404,500Loan
                charge-offsCommercial
            
            
            (37,931
            )
            
            -
            
            
            (15,222
            )
            
            -
            
            
            -Consumer
            
            
            -
            
            
            -
            
            
            (2,134
            )
            
            -
            
            
            -Loan
                recoveriesCommercial
            
            
            10,000
            
            
            11,134
            
            
            1,260
            
            
            -
            
            
            -Net
                recoveries (charge-offs)
            
            
            (27,931
            )
            
            11,134
            
            
            (16,096
            )
            
            -
            
            
            -Balance
                at end of year
            
            $
            3,175,000
            
            $
            3,000,000
            
            $
            1,810,000
            
            $
            1,266,500
            
            $
            851,500





The
      following table presents the allocation of the allowance for credit losses,
      reflecting use of the methodology presented above for the periods
      presented:





**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Real
                Estate - Home Equity Line of Credit
            
            $
            100,811
            
            $
            106,986
            
            $
            122,918
            
            $
            80,370
            
            $
            52,720Real
                Estate - Construction
            
            
            1,482,349
            
            
            469,580
            
            
            150,346
            
            
            86,252
            
            
            33,961Real
                Estate - Mortgage
            
            
            177,116
            
            
            214,601
            
            
            179,798
            
            
            133,109
            
            
            84,548Loans
                Held for Sale
            
            
            7,222
            
            
            87,545
            
            
            48,066
            
            
            -
            
            
            -Commercial
            
            
            1,281,491
            
            
            2,046,219
            
            
            1,279,472
            
            
            954,623
            
            
            626,699Consumer
            
            
            16,693
            
            
            10,275
            
            
            11,032
            
            
            10,324
            
            
            26,256Unallocated
            
            
            109,318
            
            
            64,794
            
            
            18,368
            
            
            1,822
            
            
            27,316Total
                Allowance
            
            $
            3,175,000
            
            $
            3,000,000
            
            $
            1,810,000
            
            $
            1,266,500
            
            $
            851,500





The
      unallocated portion of the allowance for credit losses increased in 2006. This
      occurred because the Company calculates an overall reserve level while the
      underlying portfolio experienced a moderate shift in the mix of loans by risk
      grade and the real estate market softened in both of the Company’s primary
      market areas. The shift in the mix of loans by risk grade is a normal result
      of
      the addition of new loans, the decrease in balances of more mature loans and
      the
      ongoing reassessment of all loans.





37


The
      following table sets forth the percentages of loans in each category for the
      Company's loan portfolio as of December 31, 2006, 2005, 2004, 2003, and 2002,
      respectively.





**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Real
                Estate - Home Equity Line of Credit
            
            
            9.16
            %
            
            10.55
            %
            
            16.25
            %
            
            15.71
            %
            
            14.05
            %Real
                Estate - Construction
            
            
            35.27
            
            
            24.02
            
            
            8.59
            
            
            7.92
            
            
            5.22Real
                Estate - Mortgage
            
            
            12.80
            
            
            17.31
            
            
            18.44
            
            
            13.38
            
            
            11.03Loans
                Held for Sale
            
            
            0.66
            
            
            8.77
            
            
            6.37
            
            
            .90
            
            
            3.97Commercial
            
            
            40.59
            
            
            37.89
            
            
            48.89
            
            
            60.47
            
            
            60.04Consumer
            
            
            1.52
            
            
            1.46
            
            
            1.46
            
            
            1.62
            
            
            5.69Total
                Loans
            
            
            100.00
            %
            
            100.00
            %
            
            100.00
            %
            
            100.00
            %
            
            100.00
            %





NONPERFORMING
      LOANS AND OTHER DELINQUENT ASSETS





Management
      performs reviews of all delinquent loans. Management will generally classify
      loans as non-accrual when collection of full principal and interest under the
      original terms of the loan is not expected or payment of principal or interest
      has become 90 days past due. Classifying a loan as non-accrual results in the
      Company no longer accruing interest on such loan and reversing any interest
      previously accrued but not collected. A non-accrual loan may be restored to
      accrual status when delinquent principal and interest payments are brought
      current and future monthly principal and interest payments are expected to
      be
      collected. The Company will recognize interest on non-accrual loans only when
      received. As of December 31, 2006 and 2005, the Company did not have any
      non-accrual loans.





Any
      property acquired by the Company as a result of foreclosure on a mortgage loan
      will be classified as "real estate owned" and will be recorded at the lower
      of
      the unpaid principal balance or fair value at the date of acquisition and
      subsequently carried at the lower of cost or net realizable value. Any required
      write-down of the loan to its net realizable value will be charged against
      the
      allowance for credit losses. Upon foreclosure, the Company generally will
      require an appraisal of the property and, thereafter, appraisals of the property
      on at least an annual basis with external inspections on at least a quarterly
      basis. As of December 31, 2006 and
      2005, the
      Company held no real estate acquired as a result of foreclosure.





The
      Company applies the provisions of Statements of Financial Accounting Standards
      No. 114 ("SFAS No. 114"), "Accounting by Creditors for Impairment of a Loan,"
      as
      amended by Statements of Financial Accounting Standards No. 118 ("SFAS No.
      118"), "Accounting by Creditors for Impairment of a Loan-Income Recognition
      and
      Disclosure." SFAS No. 114 and SFAS No. 118 require that impaired loans, which
      consist of all modified loans and other loans for which collection of all
      contractual principal and interest is not probable, be measured based on the
      present value of expected future cash flows discounted at the loan's effective
      interest rate, or at the loan's observable market price or the fair value of
      the
      collateral if the loan is collateral dependent. If the measure of the impaired
      loan is less than the recorded investment in the loan, an impairment is
      recognized through a valuation allowance and corresponding provision for credit
      losses. The Company considers consumer loans as homogenous loans and thus does
      not apply the SFAS No. 114 impairment test to these loans. Impaired loans will
      be written off when collection of the loan is doubtful.





The
      Company had no impaired loans as of December
      31, 2004, 2003 and 2002, respectively. As of December 31, 2006 the Company
      had
      one non accrual loan with a fully paid principal balance and unpaid fees of
      approximately $13,000 compared to an unpaid principal balance and fees of
      approximately $1.7 million as of December 31, 2005. This loan is classified
      as
      impaired and a specific credit loss allowance totaled approximately $13,000
      and
      $500,000 as of December 31, 2006 and 2005, respectively. Management
      believes that the allowance for credit losses is adequate.





38




INVESTMENT
      PORTFOLIO





The
      Company has chosen to invest its available funds primarily in federal funds
      sold
      and other overnight investments. As a result, investment securities as of
      December 31, 2006, consisted of $607,300 of Federal Reserve Bank stock, $509,800
      of Federal Home Loan Bank stock and $697,526 of U.S. Treasury securities which
      mature within three months. Investment securities for the year ended December
      31, 2005, consisted of $452,340
      of Federal Reserve Bank stock, $342,100 of Federal Home Loan Bank stock and
      $1,540,386 of U.S. Treasury securities which mature within three months.





Management
      has made the decision to maintain its available funds in highly liquid assets
      because it wishes to ensure that funds are readily available to fund the growth
      of the loan portfolio. Management believes that this strategy will allow the
      Company to maximize interest margins while maintaining appropriate levels of
      liquidity.





SOURCES
      OF FUNDS





General





Deposits,
      short-term borrowings in the form of repurchase agreements, short-term
      borrowings under secured and unsecured lines of credit, borrowings under the
      subordinated debt, scheduled amortization and prepayment of loans, funds
      provided by operations and capital are the current sources of funds utilized
      by
      the Company for lending and investment activities, and other general business
      purposes.





Deposits





The
      Company offers a variety of deposit products having a range of interest rates
      and terms. The Company's deposits consist of checking accounts, savings
      accounts, money market accounts and certificates of deposit.





The
      following table sets forth the composition of the Company's deposits as of
      December 31, 2006 and December 31, 2005:




**2006**
            
            **2005**Demand
                Deposits
            
            $
            58,118,270
            
            
            25.93
            %
            $
            61,057,678
            
            
            33.44
            %Savings
            
            
            7,456,143
            
            
            3.33
            
            
            9,215,092
            
            
            5.05Money
                Market and sweep
            
            
            43,428,638
            
            
            19.37
            
            
            19,411,421
            
            
            10.63Certificates
                of deposit
            
            
            115,145,901
            
            
            51.37
            
            
            92,888,895
            
            
            50.88Total
                deposits
            
            $
            224,148,952
            
            
            100.00
            %
            $
            182,573,086
            
            
            100.00
            %





The
      mix
      of deposits shifted to a higher concentration of money market and sweep accounts
      and a decreased concentration in demand deposits and savings in 2006 compared
      to
      2005. The increased concentration in money market and sweep accounts was driven
      by the addition of personnel specifically tasked with growing the core deposit
      base and the
      desire of customers to receive higher yields on overnight funds.





Of
      the
      total deposits at December 31, 2006, $8.2 million, or 3.66%, was related to
      one
      customer as compared to $12.0 million, or 6.56%, at December 31, 2005 for this
      same customer and two others. Deposit balances relating to accounts from two
      customers, previously labeled as highly variable balance accounts, are no longer
      excluded from core deposits since their balances are no longer significant
      as of
      December 31, 2006. The deposits for the remaining large customer tends to
      fluctuate significantly; as a result, management monitors these deposits on
      a
      daily basis to ensure that liquidity levels are adequate to compensate for
      these
      fluctuations.






39




The
      following table sets forth the maturity distribution for the Company's deposits
      at December 31, 2006. Some of the deposits may be renewed or withdrawn prior
      to
      maturity. Therefore, the following table should not be used as a forecast of
      future cash flows.





**Within
                one**
              **year**
            
            **One
                to**
              **three
                years**
            
            **Three
                to**
              **five
                years**
            
            **Over
                five**
              **years**Demand
                deposits
            
            $
            58,118,270
            
            $
            -
            
            $
            -
            
            $
            -Savings
            
            
            7,456,143
            
            
            -
            
            
            -
            
            
            -Money
                Market and sweep
            
            
            43,428,638
            
            
            -
            
            
            -
            
            
            -Certificates
                of deposit
            
            
            85,092,215
            
            
            21,044,460
            
            
            9,009,226
            
            
            -Total
            
            $
            194,095,266
            
            $
            21,044,460
            
            $
            9,009,226
            
            $
            -





Certificates
      of deposit in amounts of $100,000 or more, and their remaining maturities at
      December 31, 2006, are as follows:





Three
                months or less
            
            $
            17,995,943Over
                three months through six months
            
            
            19,591,959Over
                six months through twelve months
            
            
            10,346,026Over
                twelve months
            
            
            12,844,155Total
            
            $
            60,778,083





The
      market in which the Company operates is very competitive and the rates of
      interest paid on deposits are affected by rates paid by other depository
      institutions. Management closely monitors rates offered by other institutions
      and seeks to be competitive within the market. The Company has chosen to
      selectively compete for large certificates of deposits. The Company will choose
      to pursue such deposits when expected loan growth provides for adequate spreads
      to support the cost of those funds. As of December 31, 2006, the Company had
      outstanding certificates of deposit of approximately $29.1 million that were
      either obtained through the listing of certificate of deposit rates on two
      Internet-based listing services (such deposits are sometimes referred to herein
      as national market certificates of deposit) or acquired through the CDARS
      program. The national market certificates of deposit were issued with an average
      yield of 5.02% and an average term of 33 months. Included in the $29.1 million
      are national market certificates of deposit totaling $1.4 million that have
      been
      classified as “Brokered Deposits” for bank regulatory purposes. These “Brokered
      Deposits” were issued with an average yield of 5.53% and an average term of 21
      months. As of December 31, 2005, the total certificates of deposit obtained
      through the listing of certificate of deposit rates on the Internet-based
      listing services were approximately $33.8 million, and included one “Brokered
      Deposit” with a balance at that time of $97,296. The Company has never paid
      broker fees for deposits.





In
      the
      first quarter of 2006, the Company began using brokered certificates of deposit
      through the Promontory Financial Network. Through this deposit matching network
      and its certificate of deposit account registry service (CDARS), the Company
      has
      the ability to offer its customers access to FDIC-insured deposit products
      in
      aggregate amounts exceeding current insurance limits. When the Company places
      funds through CDARS on behalf of a customer, it receives matching deposits
      through the network. The Company also has the ability to raise deposits directly
      through the network. These deposits are also considered “Brokered Deposits” for
      bank regulatory purposes. As of December 31, 2006, the Company had approximately
      $4.6 million of CDARS deposits outstanding of which $1.6 million was placed
      on
      behalf of customers and $3.0 million was raised by the Company.





Core
      deposits, which management categorizes as all deposits other than national
      market certificates of deposit, CDARS deposits and $5.2 million of the $8.2
      million deposits from the large customer described above, stood at $189,364,004
      as of December 31, 2006, up 33.5% from $141,825,926 as of December 31, 2005.
      Deposit balances relating to accounts from two customers, previously labeled
      as
      highly variable balance accounts, are no longer excluded from core deposits
      since their balances are no longer significant as of December 31, 2006. The
      increase in core deposits was due to an investment made in additional personnel
      specifically tasked with growing the core deposit base. Core deposits are
      closely monitored by management because they consider such deposits not only
      a
      relatively stable source of funding but also reflective of the growth of
      commercial and consumer depository relationships.






40




Borrowings.





On
      September 28, 2004, the Company entered into a $5.0 million, three year
      unsecured non-revolving credit facility with Drovers Bank of York, Pennsylvania,
      a division of Fulton Bank. The loan paid interest at the prime rate as offered
      by Drovers Bank. The credit facility was scheduled to expire on September 28,
      2007, at which time all outstanding amounts under the credit facility, including
      accrued but unpaid interest, would have become due and payable. The Company
      had
      the option to repay interest and principal under the credit facility at any
      time
      without premium or penalty. In December 2005, the Company terminated this credit
      facility and repaid in full the amount outstanding using $2.2 million of the
      proceeds from the private placement of $8 million of fixed interest rate trust
      preferred securities.





Short-term
      borrowings as of December 31, 2006 include
      repurchase agreements collateralized by pledges of U.S. Government Treasury
      Securities, based upon their market values, equal to 100% of the principal
      and
      accrued interest of the repurchase agreements. The outstanding balance of
      repurchase agreements decreased from $916,158 at December 31, 2005 to $300,000
      at December 31, 2006, due to one customer’s decision to invest available
      overnight funds in the Bank’s newly created Overnight Commercial Paper
      program . This
      decision is advantageous for the Bank because it eliminates the Bank’s need to
      tie up securities as collateral for deposits.





Included
      in short-term borrowings as of December 31, 2006 is $1,245,000 of borrowings
      under the previously-mentioned Overnight Commercial Paper program. These
      borrowings are unsecured and are subordinated to all deposits. Short-term
      borrowings as of December 31, 2005 included $528,000 borrowed under unsecured
      Federal Funds lines of credit.





Subordinated
      debt consists of $8
      million of fixed interest rate trust preferred securities (the “Trust Preferred
      Securities”), issued on December 12, 2005 through a Delaware trust subsidiary,
      Bay National Capital Trust I (the “Trust”). The Trust was formed for the purpose
      of issuing the Trust Preferred Securities and all of its common securities
      are
      owned by the Company. The Company purchased the common securities from the
      Trust
      for $248,000. In accordance with provisions of FIN46, the financial position
      and
      results of operations are not included in the Company’s consolidated financial
      position and results of operations.





The
      Trust
      used the proceeds of the sale of the Trust Preferred Securities and common
      securities to purchase from the Company the aggregate principal amount of
      $8,248,000 of the Company’s Fixed Rate Junior Subordinated Debt Securities Due
      2036 (the “Debt Securities”). Like the Trust Preferred Securities, the Debt
      Securities bear interest at the fixed annual rate of 7.20% until maturity.
      The
      interest expense on Trust Preferred Securities, which include amortization
      of
      issuance costs, was $603,567 in 2006. The Debt Securities mature on February
      23,
      2036, but may be redeemed at the Company’s option at any time on any February
      23, May 23, August 23 or November 23 on or after February 23, 2011, or at any
      time upon certain events, such as a change in the regulatory capital treatment
      of Debt Securities, the Trust being deemed to be an “investment company” under
      the Investment Company Act of 1940, as amended, or the occurrence of certain
      adverse tax events. Except upon the occurrence of the events described above,
      which require a redemption premium for redemptions prior to February 23, 2011,
      the Company may redeem the Debt Securities at their aggregate principal amount,
      plus accrued interest, if any.





The
      Parent is required to retain $1,000,000 of the proceeds from the Debt Securities
      for general corporate purposes (which may include making interest payments
      on
      the Debt Securities) until the earlier of (i) the date on which the retained
      funds are reduced to zero, or (ii) the date on which the Bank (or any successor)
      meets the statutory requirements to pay dividends of at least $148,464 for
      each
      of two consecutive quarters with positive retained earnings remaining after
      any
      such dividend payment. As of December 31, 2006, the Bank met the retained
      earnings requirement.




41




The
      Debt
      Securities are subordinated to the prior payment of other indebtedness of the
      Company that, by its terms, is not similarly subordinated. Although the Debt
      Securities are recorded as a liability on the Company’s balance sheet, the trust
      preferred securities qualify as Tier 1 capital, subject to regulatory guidelines
      that limit the amount included to an aggregate of 25% of Tier 1
      capital.





As
      of
      December 31, 2006, the Company maintained commitments for a total of $9.0
      million of borrowing availability under unsecured Federal Funds lines of credit
      with three separate financial institutions. The Company also had approximately
      $21.0 million of borrowing capacity with the Federal Home Loan Bank of Atlanta
      as of December 31, 2006.





INTEREST
      RATE SENSITIVITY





The
      primary objective of asset/liability management is to ensure the steady growth
      of the Company’s primary earnings component, net interest income. Net interest
      income can fluctuate with significant interest rate movements. To minimize
      the
      risk associated with these rate swings, management works to structure the
      Company’s balance sheet so that the ability exists to adjust pricing on
      interest-earning assets and interest-bearing liabilities in roughly equivalent
      amounts at approximately the same time intervals. Imbalances in these repricing
      opportunities at any point in time constitute interest rate
      sensitivity.




The
      measurement of the Company’s interest rate sensitivity, or "gap," is one of the
      principal techniques used in asset/liability management. The interest sensitive
      gap is the dollar difference between assets and liabilities which are subject
      to
      interest rate pricing within a given time period, including both floating rate
      or adjustable rate instruments, and instruments which are approaching
      maturity.





42


The
      following table sets forth the amount of the Company's interest-earning assets
      and interest-bearing liabilities as of December 31, 2006, which are expected
      to
      mature or reprice in each of the time periods shown:


**Maturity
                  or repricing within****Amount**
              
              **Percent
                  of**
                **Total**
              
              **0
                  to 3**
                **Months**
              
              **4
                  to 12**
                **Months**
              
              **1
                  to 5**
                **Years**
              
              **Over
                  5**
                **Years**Interest-earning
                  assetsFederal
                  funds sold and other overnight investments
              
              $
              31,549,900
              
              
              12.55
              %
              $
              31,549,900
              
              $
              -
              
              $
              -
              
              $
              -Loans
                  held for sale
              
              
              1,444,303
              
              
              0.57
              
              
              1,444,303
              
              
              -
              
              
              -
              
              
              -Investment
                  securities available for sale
              
              
              697,526
              
              
              0.28
              
              
              697,526
              
              
              -
              
              
              -
              
              
              -Loans
                  - Variable rate
              
              
              113,139,576
              
              
              45.01
              
              
              113,139,576
              
              
              -
              
              
              -
              
              
              -Loans
                  - Fixed rate
              
              
              103,431,799
              
              
              41.15
              
              
              18,566,541
              
              
              39,643,745
              
              
              42,196,781
              
              
              3,024,732Other
                  earning assets
              
              
              1,117,100
              
              
              0.44
              
              
              -
              
              
              -
              
              
              -
              
              
              1,117,100Total
                  interest-earning assets
              
              $
              251,380,204
              
              
              100.00
              %
              $
              165,397,846
              
              $
              39,643,745
              
              $
              42,196,781
              
              $
              4,141,832Interest-bearing
                  liabilitiesDeposits
                  - Variable rate
              
              $
              74,194,427
              
              
              37.30
              %
              $
              74,194,427
              
              $
              -
              
              $
              -
              
              $
              -Deposits
                  - Fixed rate
              
              
              115,145,901
              
              
              57.90
              
              
              25,591,256
              
              
              59,500,959
              
              
              30,053,686
              
              
              -Short-term
                  borrowings - variable rate
              
              
              1,545,000
              
              
              0.78
              
              
              1,545,000
              
              
              -
              
              
              -
              
              
              -Subordinated
                  debt
              
              
              8,000,000
              
              
              4.02
              
              
              -
              
              
              -
              
              
              -
              
              
              8,000,000Total
                  interest-bearing liabilities
              
              $
              198,885,328
              
              
              100.00
              %
              $
              101,330,683
              
              $
              59,500,959
              
              $
              30,053,686
              
              $
              8,000,000Periodic
                  repricing differencesPeriodic
                  gap
              
              
              
              
              
              
              
              $
              64,067,163
              
              $
              (19,857,214
              )
              $
              12,143,095
              
              $
              (3,858,168
              )Cumulative
                  gap
              
              
              
              
              
              
              
              $
              64,067,163
              
              $
              44,209,949
              
              $
              56,353,044
              
              $
              52,494,876Ratio
                  of rate sensitive assets to rate
                sensitive
                  liabilities
              
              
              
              
              
              
              
              
              163.23
              %
              
              66.63
              %
              
              140.40
              %
              
              51.77
              %




The
      Company has 58.13% of its interest-earning assets and 38.08% of its
      interest-bearing liabilities in variable rate balances. The excess of
      interest-earning assets over interest-bearing liabilities of $44,209,949 in
      the
      categories of items maturing or repricing within 12 months comprises the
      majority of the overall gap. This gap is generally reflective of the Company’s
      emphasis on investing in short-term investments and originating variable rate
      loans and the demand in the market for higher yielding fixed rate deposits.
      This
      analysis indicates that the Company generally will benefit from rising market
      rates of interest. However, since all interest rates and yields do not adjust
      at
      the same pace, the gap is only a general indicator of interest rate sensitivity.
      The analysis of the Company's interest-earning assets and interest-bearing
      liabilities presents only a static view of the timing of maturities and
      repricing opportunities, without taking into consideration the fact that changes
      in interest rates do not affect all assets and liabilities equally. Net interest
      income may be affected by other significant factors in a given interest rate
      environment, including changes in the volume and mix of interest-earning assets
      and interest-bearing liabilities.





Management
      constantly monitors and manages the structure of the Company's balance sheet,
      seeks to control interest rate exposure and evaluate pricing strategies.
      Strategies to better match maturities of interest-earning assets and
      interest-bearing liabilities include structuring loans with rate floors and
      ceilings on variable rate notes and by providing for repricing opportunities
      on
      fixed rate notes. Management believes that a lending strategy focusing on
      variable rate loans and short-term fixed rate loans will best facilitate the
      goal of minimizing interest rate risk. However, management will
      opportunistically enter into longer term fixed rate loans and/or investments
      when, in management’s judgment, rates adequately compensate the Company for the
      interest rate risk. The Company's current investment concentration in federal
      funds sold and other overnight investments provides the most flexibility and
      control over rate sensitivity since it generally can be restructured more
      quickly than the loan portfolio. On the liability side, deposit products can
      be
      restructured so as to offer incentives to attain the maturity distribution
      desired; although, competitive factors sometimes make control over deposit
      maturity difficult.






43





In
      theory, maintaining a nominal level of interest rate sensitivity can diminish
      interest rate risk. In practice, this is made difficult by a number of factors,
      including cyclical variation in loan demand, different impacts on interest
      sensitive assets and liabilities when interest rates change and the availability
      of funding sources. Management generally attempts to maintain a balance between
      rate-sensitive assets and liabilities as the exposure period is lengthened
      to
      minimize the overall interest rate risk to the Company.





LIQUIDITY





The
      Company’s overall asset/liability strategy takes into account the need to
      maintain adequate liquidity to fund asset growth and deposit runoff. Management
      monitors the liquidity position daily.





The
      Company’s primary sources of funds are deposits, short-term borrowings in the
      form of repurchase agreements, commercial paper, borrowings under the Federal
      funds and Federal Home Loan Bank credit facilities, scheduled amortization
      and
      prepayment of loans, funds provided by operations and capital. While scheduled
      principal repayments on loans are a relatively predictable source of funds,
      deposit flows and loan prepayments are greatly influenced by market interest
      rates, economic conditions, and rates offered by our competition.





The
      Company's most liquid assets are cash and assets that can be readily converted
      into cash, including investment securities maturing within one year. As of
      December 31, 2006, the Company had $2,348,304 in cash and due from banks,
      $31,549,900 in federal funds sold and other overnight investments and $697,526
      in three-month U.S. Treasury Securities. As of December 31, 2005, the Company
      had $1,460,669 in cash and due from banks, $6,032,952 in federal funds sold
      and
      other overnight investments and $1,540,386 in three-month U.S. Treasury
      Securities.





The
      increase in the overall level of liquid assets, other than loans expected to
      be
      sold within 60 days, is the result of a strengthened focus on local deposit
      gathering. Growth in the Company’s loan portfolio, without corresponding growth
      in deposits, would reduce liquidity, as would reductions in the level of
      customer deposits.





During
      2006, the Company maintained commitments for a total of $9.0 million of
      borrowing availability under unsecured Federal Funds lines of credit with three
      separate financial institutions. The Company also has approximately $21 million
      of borrowing capacity with the Federal Home Loan Bank of Atlanta as of December
      31, 2006. These credit facilities can be used in conjunction with the normal
      deposit strategies, which include pricing changes to increase deposits as
      necessary. From time to time, the Company may sell or participate out loans
      to
      create additional liquidity as required.





The
      Company has sufficient liquidity to meet its loan commitments as well as
      fluctuations in deposits. The Company will seek to retain maturing certificates
      of deposit, when necessary, by offering competitive rates.





Management
      is not aware of any known trends, events or uncertainties that will have or
      are
      reasonably likely to have a material effect on our liquidity, capital or
      operations, nor are we aware of any current recommendation by regulatory
      authorities, which if implemented, would have a material effect on liquidity,
      capital or operations.






44





CONTRACTUAL
      OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES, AND OFF-BALANCE SHEET
      ARRANGEMENTS





The
      Company is a party to financial instruments with off-balance sheet risk in
      the
      normal course of business. These financial instruments primarily include
      commitments to extend credit, lines of credit and standby letters of credit.
      The
      Company uses these financial instruments to meet the financing needs of its
      customers. These financial instruments involve, to varying degrees, elements
      of
      credit, interest rate and liquidity risk. In addition, the Company also has
      operating lease obligations and purchase commitments.





Outstanding
      loan commitments and lines and letters of credit at December 31, 2006 and 2005
      are as follows:


**2006**
            
            **2005**Loan
                commitments
            
            $
            33,782,891
            
            $
            21,577,585Unused
                lines of credit
            
            
            66,660,250
            
            
            41,317,927Letters
                of credit
            
            
            2,188,659
            
            
            2,754,383




Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of any condition established in the contract. Commitments generally
      have interest rates fixed at current market amounts, fixed expiration dates
      or
      other termination clauses and may require payment of a fee. Unused lines of
      credit represent the unused portion of lines of credit previously extended
      and
      available to the customer as long as there is no violation of any contractual
      condition. These lines generally have variable interest rates. Since many of
      the
      commitments are expected to expire without being drawn upon, and since it is
      unlikely that customers will draw upon their line of credit in full at any
      time,
      the total commitment amount or line of credit amount does not necessarily
      represent future cash requirements. The Company is not aware of any loss it
      would incur by funding its commitments or lines of credit.





Standby
      letters of credit are conditional commitments issued to guarantee the
      performance of a customer to a third party. The Company’s exposure to credit
      loss in the event of nonperformance by the customer is the contract amount
      of
      the commitment.





In
      general, loan commitments, lines of credit and letters of credit are made on
      the
      same terms, including with respect to collateral, as outstanding loans. Each
      customer’s credit-worthiness and the collateral required are evaluated on a
      case-by-case basis.





The
      increase in the overall level of loan commitments and unused lines of credit
      as
      of December 31, 2006 as compared to loan commitments and unused lines of credit
      as of December 31, 2005, is reflective
      of the level of business development activity undertaken during the
      year.





The
      Company has various financial obligations, including contractual obligations
      and
      commitments that may require future cash payments.





45


The
      following table presents, as of December 31, 2006, significant fixed and
      determinable contractual obligations to third parties by payment
      date.





**Within
                one**
              **year**
            
            **One
                to**
              **three
                years**
            
            **Three
                to**
              **five
                years**
            
            **Over
                five**
              **years**
            
            **Total**Deposits
                without a
              stated
                maturity(a)
            
            $
            109,017,952
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            109,017,952Certificates
                of deposit(a)
            
            
            85,830,285
            
            
            21,044,460
            
            
            9,009,226
            
            
            -
            
            
            115,883,971Other
                borrowings(a)
            
            
            1,603,784
            
            
            -
            
            
            -
            
            
            8,000,000
            
            
            9,603,784Operating
                leases
            
            
            487,203
            
            
            1,007,027
            
            
            279,410
            
            
            -
            
            
            1,773,640Purchase
                obligations
            
            
            364,277
            
            
            425,839
            
            
            141,946
            
            
            -
            
            
            932,062Total
            
            $
            197,303,501
            
            $
            22,477,326
            
            $
            9,430,582
            
            $
            8,000,000
            
            $
            237,211,409





(a)
            Includes
                accrued interest payable.





The
      Company's operating lease obligations represent short and long-term lease and
      rental payments for facilities. Purchase obligations represent estimated
      obligations under agreements to purchase goods or services that are enforceable
      and legally binding on the Company. The purchase obligation amounts presented
      above primarily relate to estimated obligations under data and item processing
      contracts and accounts payable for goods and services received through December
      31, 2006.





CAPITAL
      RESOURCES





The
      Company had stockholders’ equity at December 31, 2006 of $18,842,493 as compared
      to $16,214,078 at December 31, 2005. The
      increase in capital is the result of positive operating results. The Company
      has
      declared no cash dividends since its inception.





Banking
      regulatory authorities have implemented strict capital guidelines directly
      related to the credit risk associated with an institution’s assets. Banks and
      bank holding companies are required to maintain capital levels based on their
      "risk adjusted” assets so that categories of assets with higher "defined” credit
      risks will require more capital support than assets with lower risks. The Bank
      has exceeded its capital adequacy requirements to date.





Banking
      regulations also limit the amount of dividends that may be paid without prior
      approval of the Bank's regulatory agencies. Regulatory approval is required
      to
      pay dividends that exceed the Bank’s net profits for the current year plus its
      retained net profits for the preceding two years. The Bank could have paid
      dividends of approximately $2.6 million to the Company at December 31,
      2006.








46


The
      tables below present the Bank's capital position relative to its various minimum
      regulatory capital requirements as of December 31, 2006 and 2005. For a
      discussion of these capital requirements, see "Item 1. Description of Business
      -
      Supervision and Regulation - Bay National Bank - Capital Adequacy
      Guidelines."





**December
                31, 2006****Actual**
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            
            $
            25,951,690
            
            
            10.34
            %
            $
            20,074,000
            
            
            8.00
            %
            $
            25,093,000
            
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            
            22,814,690
            
            
            9.09
            %
            
            10,037,000
            
            
            4.00
            %
            
            15,056,000
            
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            
            22,814,690
            
            
            9.29
            %
            
            7,370,000
            
            
            3.00
            %
            
            12,284,000
            
            
            5.00
            %








**December
                31, 2005****Actual**
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            
            $
            21,668,568
            
            
            10.21
            %
            $
            16,675,000
            
            
            8.00
            %
            $
            20,843,000
            
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            
            18,668,568
            
            
            8.96
            %
            
            8,337,000
            
            
            4.00
            %
            
            12,506,000
            
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            
            18,668,568
            
            
            9.15
            %
            
            6,124,000
            
            
            3.00
            %
            
            10,206,000
            
            
            5.00
            %





The
      tables below present Bay
      National Corporation’s capital position relative to its various minimum
      regulatory capital requirements as of December 31, 2006 and 2005.





**December
                31, 2006****Actual**
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            
            $
            29,979,493
            
            
            11.94
            %
            $
            20,084,000
            
            
            8.00
            %
            $
            25,104,000
            
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            
            26,337,366
            
            
            10.49
            %
            
            10,042,000
            
            
            4.00
            %
            
            15,063,000
            
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            
            26,337,366
            
            
            10.72
            %
            
            7,370,000
            
            
            3.00
            %
            
            12,284,000
            
            
            5.00
            %








**December
                31, 2005****Actual**
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            
            $
            26,826,078
            
            
            12.86
            %
            $
            16,686,000
            
            
            8.00
            %
            $
            20,857,000
            
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            
            22,920,597
            
            
            10.99
            %
            
            8,343,000
            
            
            4.00
            %
            
            12,514,000
            
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            
            22,920,597
            
            
            11.23
            %
            
            6,124,000
            
            
            3.00
            %
            
            10,206,000
            
            
            5.00
            %





47


**Impact
      of Inflation and Changing Prices**





The
      consolidated financial statements and notes thereto presented herein have been
      prepared in accordance with accounting principles generally
      accepted in the United States of America ,
      which
      require the measurement of financial position and operating results in terms
      of
      historical dollars without considering the change in the relative purchasing
      power of money over time and due to inflation. The impact of inflation is
      reflected in the increased cost of the Company's operations. Unlike most
      industrial companies, nearly all the assets of the Company are monetary in
      nature. As a result, interest rates have a greater impact on the Company's
      performance than do the effects of general levels of inflation. Interest rates
      do not necessarily move in the same direction or to the same extent as the
      price
      of goods and services.





**Reconciliation
      of Non-GAAP Measures**





Below
      is
      a reconciliation of total deposits to core deposits as of December 31, 2006
      and
      December 31, 2005, respectively:





**December
                31,**
              **2006**
            
            **December
                31,**
              **2005**Total
                deposits
            
            $
            224,148,952
            
            $
            182,573,086National
                market certificates of deposit
            
            
            (29,586,997
            )
            
            (33,765,135
            )Variable
                balance accounts (1 customer in 2006 and 3 customers in
                2005)
            
            
            (8,197,951
            )
            
            (11,982,025
            )Portion
                of variable balance accounts considered to be core
            
            
            3,000,000
            
            
            5,000,000Core
                deposits
            
            $
            189,364,004
            
            $
            141,825,926





**Application
      of Critical Accounting Policies**





The
      Company’s consolidated financial statements are prepared in accordance with
      accounting principles generally accepted in the United States of America and
      follow general practices within the industries in which it operates. Application
      of these principles requires management to make estimates, assumptions and
      judgments that affect the amounts reported in the financial statements and
      accompanying notes. These estimates, assumptions and judgments are based on
      information available as of the date of the financial statements; accordingly,
      as this information changes, the financial statements could reflect different
      estimates, assumptions and judgments. Certain policies inherently have a greater
      reliance on the use of estimates, assumptions and judgments and as such, have
      a
      greater possibility of producing results that could be materially different
      than
      originally reported. Estimates, assumptions and judgments are necessary when
      assets and liabilities are required to be recorded at fair value, when a decline
      in the value of an asset not carried on the financial statements at fair value
      warrants an impairment write-down or valuation reserve to be established or
      when
      an asset or liability must be recorded contingent upon a future event. Carrying
      assets and liabilities at fair value inherently results in more financial
      statement volatility. The fair values and the information used to record
      valuation adjustments for certain assets and liabilities are based either on
      quoted market prices or are provided by other third-party sources, when
      available.





The
      most
      significant accounting policies followed by the Company are presented in Note
      1
      to the consolidated financial statements. These policies, along with the
      disclosures presented in the other financial statement notes and in this
      financial review, provide information on how significant assets and liabilities
      are valued in the financial statements and how those values are determined.
      Based on the valuation techniques used and the sensitivity of financial
      statement amounts to the methods, assumptions and estimates underlying those
      amounts, management has identified the determination of the allowance for credit
      losses as the accounting area that requires the most subjective or complex
      judgments, and, as such, could be most subject to revision as new information
      becomes available.






48





The
      allowance for credit losses represents management's best estimate of losses
      known and inherent in the loan portfolio that are both probable and reasonable
      to estimate, based on, among other factors: prior loss experience of the Company
      and peer institutions; current economic conditions; review of the ongoing
      financial conditions of borrowers; and the views of the Company’s regulators and
      the firm that conducts an annual independent loan review. Determining the amount
      of the allowance for credit losses is considered a critical accounting estimate
      because it requires significant estimates, assumptions and judgments. The loan
      portfolio also represents the largest asset type on the consolidated balance
      sheets.





The
      Company uses a loan grading system where loans are graded based on management's
      evaluation of the risk associated with each loan. A factor, based on the loan
      grading, is applied to the loan balance to reserve for losses. In addition,
      management judgmentally establishes an additional nonspecific reserve. The
      nonspecific portion of the allowance reflects management's estimate of probable
      inherent but undetected losses within the portfolio due to uncertainties in
      economic conditions, delays in obtaining information, including unfavorable
      information about a borrower's financial condition, the difficulty in
      identifying triggering events that correlate perfectly to subsequent loss rates
      and risk factors that have not yet manifested themselves in loss allocation
      factors.





Management
      has significant discretion in making the judgments inherent in the determination
      of the provision and allowance for credit losses, including the valuation of
      collateral and the financial condition of the borrower, and in establishing
      allowance percentages and risk ratings. The establishment of allowance factors
      is a continuing exercise and allowance factors may change over time, resulting
      in an increase or decrease in the amount of the provision or allowance based
      upon the same volume and classification of loans.





Changes
      in allowance factors or in management’s interpretation of those factors will
      have a direct impact on the amount of the provision and a corresponding effect
      on income and assets. Also, errors in management’s perception and assessment of
      the allowance factors could result in the allowance not being adequate to cover
      losses in the portfolio and may result in additional provisions or charge-offs,
      which would adversely affect income and capital. For additional information
      regarding the allowance for loan and lease losses, see the “Provision for Credit
      Losses and Credit Risk Management” section of this financial
      review.





**Recent
      Accounting Pronouncements And Developments**




In
      December 2004, the Financial Accounting Standards Board (“FASB”) adopted
      Statement of Financial Accounting Standards No. 123 (revised), “Share Based
      Payment” (SFAS 123R”), which revised SFAS 123, “Accounting for Stock-Based
      Compensation.” SFAS 123R establishes accounting requirements for share-based
      compensation to employees and carries forward prior guidance on accounting
      for
      awards to non-employees. The provisions of this statement became effective
      for
      us on January 1, 2006 for all equity awards vesting after the effective date.
      SFAS 123R requires an entity to recognize compensation expense based on an
      estimate of the number of awards expected to actually vest, exclusive of awards
      expected to be forfeited. At December 31, 2006, the Company recognized $115,714
      in stock based compensation expense.





Note
      1 to
      the consolidated financial statements discusses SFAS 123R and other new
      accounting policies adopted by the Company during 2006 and the expected impact
      of accounting policies, recently issued or proposed, but not yet required to
      be
      adopted. To the extent the adoption of new accounting standards materially
      affects the Company's financial condition, results of operations or liquidity,
      the impacts are discussed in the applicable section(s) of this financial review
      and notes to the consolidated financial statements.






49





**Risk
      Management**





The
      Board
      of Directors is the foundation for effective corporate governance and risk
      management. The Board demands accountability of management, keeps stockholders'
      and other constituencies' interests in focus and fosters a strong internal
      control environment. Through its Executive, Asset/Liability and Audit
      Committees, the Board actively reviews critical risk positions, including
      market, credit, liquidity and operational risk. The Company's goal in managing
      risk is to reduce earnings volatility, control exposure to unnecessary risk
      and
      ensure appropriate returns for risk assumed. Senior management actively manages
      risk at the line of business level, supplemented with corporate-level oversight
      through the Asset/Liability Committee, the internal audit process and quality
      control functions and other risk management groups within the Company. This
      risk
      management structure is designed to uncover risk issues through a systematic
      process, enabling timely and appropriate action to avoid and mitigate risk.
      The
      risk management process establishes risk limits and other measurement systems,
      with a focus on risk reduction strategies and capital allocation practices.


50


Item
      7.  Financial Statements





The
      following consolidated financial statements are filed with this
      report:





Report
      of
      Independent Registered Public Accounting Firm





Consolidated
      Balance Sheets - December 31, 2006 and 2005





Consolidated
                Statements of Operations - For the years ended December 31, 2006,
                2005 and
                2004





Consolidated
      Statements of Changes in Stockholders’ Equity - For the years ended December 31,
      2006, 2005 and 2004





Consolidated
                Statements of Cash Flows - For the years ended December 31, 2006,
                2005 and
                2004




Notes
      to
      Consolidated Financial Statements








51


**Report
      of Independent Registered Public Accounting Firm**








Board
      of
      Directors and Stockholders


Bay
      National Corporation





We
      have
      audited the accompanying consolidated balance sheets of Bay National Corporation
      and subsidiary (the “Company”) as of December 31, 2006 and 2005, and the related
      consolidated statements of operations, changes in stockholders’ equity, and cash
      flows for each of the three years in the period ended December 31, 2006. These
      financial statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States) .
      Those standards require that we plan and perform the audit to obtain reasonable
      assurance about whether the financial statements are free of material
      misstatement. The Company is not required to have, nor are we engaged to
      perform, an audit of its internal control over financial reporting. Our audits
      included consideration of internal control over financial reporting as a basis
      for designing audit procedures that are appropriate in the circumstances, but
      not for the purpose of expressing an opinion on the effectiveness of the
      Company’s internal control over financial reporting. Accordingly, we express no
      such opinion. An audit also 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 by management,
      as
      well as evaluating the overall financial statement presentation. We believe
      that
      our audits provide a reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Bay National Corporation
      and
      subsidiary as of December 31, 2006 and 2005, and the results of their operations
      and their cash flows for each of the three years in the period ended December
      31, 2006, in conformity with accounting principles generally accepted in the
      United States of
      America.





/s/
      Stegman & Company


Baltimore,
      Maryland


March
      14,
      2007





52


CONSOLIDATED
      BALANCE SHEETS


December
      31, 2006 and 2005





2006
            
            2005ASSETSCash
                and due from banks
            
            $
            2,348,304
            
            $
            1,460,669Federal
                funds sold and other overnight investments
            
            
            31,549,900
            
            
            6,032,952Investment
                securities available for sale (AFS) - at fair value
            
            
            697,526
            
            
            1,540,386Other
                equity securities
            
            
            1,117,100
            
            
            794,440Loans
                held for sale
            
            
            1,444,303
            
            
            17,509,064Loans,
                net of unearned fees
            
            
            216,571,375
            
            
            182,080,897Total
                Loans
            
            
            218,015,678
            
            
            199,589,961Less:
                Allowance for credit losses
            
            
            (3,175,000
            )
            
            (3,000,000
            )Loans,
                net
            
            
            214,840,678
            
            
            196,589,961Premises
                and equipment, net
            
            
            1,100,220
            
            
            746,826Accrued
                interest receivable and other assets
            
            
            3,151,119
            
            
            2,801,101Total
                Assets
            
            $
            254,804,847
            
            $
            209,966,335LIABILITIESNon-interest-bearing
                deposits
            
            $
            34,808,624
            
            $
            27,468,757Interest-bearing
                deposits
            
            
            189,340,328
            
            
            155,104,329Total
                deposits
            
            
            224,148,952
            
            
            182,573,086Short-term
                borrowings
            
            
            1,545,000
            
            
            1,444,158Subordinated
                debt
            
            
            8,000,000
            
            
            8,000,000Accrued
                expenses and other liabilities
            
            
            2,268,402
            
            
            1,735,013Total
                Liabilities
            
            
            235,962,354
            
            
            193,752,257STOCKHOLDERS'
                EQUITYCommon
                stock - $.01 par value, authorized:9,000,000
                shares authorized, 1,935,369 and 1,924,436 issued
              and
                outstanding as of December 31, 2006 and 2005,
                respectively:
            
            
            19,354
            
            
            19,244Additional
                paid in capital
            
            
            17,649,678
            
            
            17,451,201Retained
                earnings (accumulated deficit)
            
            
            1,173,461
            
            
            (1,256,367
            )Total
                Stockholders' Equity
            
            
            18,842,493
            
            
            16,214,078Total
                Liabilities and Stockholders' Equity
            
            $
            254,804,847
            
            $
            209,966,335




See
      accompanying notes to consolidated financial statements.


53




CONSOLIDATED
      STATEMENTS OF OPERATIONS


For
      the
      years ended December 31, 2006, 2005 and 200 4





2006
            
            2005
            
            2004INTEREST
                INCOME:Interest
                and fees on loans
            
            $
            19,117,244
            
            $
            12,671,707
            
            $
            7,431,368Interest
                on federal funds sold and other overnightinvestments
            
            
            557,970
            
            
            224,732
            
            
            147,023Taxable
                interest and dividends on investment securities
            
            
            105,625
            
            
            86,267
            
            
            45,173Total
                interest income
            
            
            19,780,839
            
            
            12,982,706
            
            
            7,623,564INTEREST
                EXPENSE:Interest
                on deposits
            
            
            7,132,611
            
            
            4,058,519
            
            
            2,438,887Interest
                on short-term borrowings
            
            
            86,522
            
            
            115,810
            
            
            19,020Interest
                on note payable
            
            
            -
            
            
            91,709
            
            
            6,302Interest
                on subordinated debt
            
            
            603,567
            
            
            28,108
            
            
            -Total
                interest expense
            
            
            7,822,700
            
            
            4,294,146
            
            
            2,464,209Net
                interest income
            
            
            11,958,139
            
            
            8,688,560
            
            
            5,159,355Provision
                for credit losses
            
            
            202,931
            
            
            1,178,866
            
            
            559,596Net
                interest income after provision for credit losses
            
            
            11,755,208
            
            
            7,509,694
            
            
            4,599,759NON-INTEREST
                INCOME:Service
                charges on deposit accounts
            
            
            148,042
            
            
            188,276
            
            
            237,980Gain
                on sale of mortgage loans
            
            
            573,387
            
            
            512,047
            
            
            244,716Other
                income
            
            
            55,904
            
            
            50,270
            
            
            56,151Total
                non-interest income
            
            
            777,333
            
            
            750,593
            
            
            538,847NON-INTEREST
                EXPENSE:Salaries
                and employee benefits
            
            
            5,431,989
            
            
            3,627,630
            
            
            2,442,774Occupancy
                expenses
            
            
            506,323
            
            
            420,866
            
            
            312,550Furniture
                and equipment expenses
            
            
            342,261
            
            
            304,132
            
            
            255,547Legal
                and professional fees
            
            
            245,412
            
            
            154,476
            
            
            175,757Data
                processing and other outside services
            
            
            701,422
            
            
            655,726
            
            
            582,396Advertising
                and marketing related expenses
            
            
            512,709
            
            
            445,482
            
            
            212,237Other
                expenses
            
            
            684,239
            
            
            562,645
            
            
            355,081Total
                non-interest expenses
            
            
            8,424,355
            
            
            6,170,957
            
            
            4,336,342Income
                before income taxes
            
            
            4,108,186
            
            
            2,089,330
            
            
            802,264Income
                tax expense (benefit)
            
            
            1,678,358
            
            
            (655,000
            )
            
            -Net
                Income
            
            $
            2,429,828
            
            $
            2,744,330
            
            $
            802,264Per
                Share Data:Net
                Income (Basic)
            
            $
            1.25
            
            $
            1.43
            
            $
            .43Net
                Income (Diluted)
            
            $
            1.20
            
            $
            1.37
            
            $
            .41Average
                Shares Outstanding (Basic)
            
            
            1,938,110
            
            
            1,922,580
            
            
            1,877,929Effect
                of dilution - Stock options and Warrants
            
            
            80,099
            
            
            79,645
            
            
            58,764Average
                Shares Outstanding (Diluted)
            
            
            2,018,209
            
            
            2,002,225
            
            
            1,936,693





See
      accompanying notes to consolidated financial statements.


54


CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY


For
      the
      years ended December 31, 2006, 2005 and 2004




Common
              Stock
            
            Additional
              Paid
                in
              Capital
            
            Retained
              Earnings
              (Accumulated
              Deficit)
            
            TotalBalances
                at January 1, 2004
            
            $
            18,627
            
            $
            16,850,834
            
            $
            (4,802,961
            )
            $
            12,066,500Issuance
                of Common Stock
            
            
            550
            
            
            549,450
            
            
            -
            
            
            550,000Net
                Income
            
            
            -
            
            
            -
            
            
            802,264
            
            
            802,264Balances
                at December 31, 2004
            
            
            19,177
            
            
            17,400,284
            
            
            (4,000,697
            )
            
            13,418,764Issuance
                of Common Stock
            
            
            67
            
            
            50,917
            
            
            -
            
            
            50,984Net
                Income
            
            
            -
            
            
            -
            
            
            2,744,330
            
            
            2,744,330Balances
                at December 31, 2005
            
            
            19,244
            
            
            17,451,201
            
            
            (1,256,367
            )
            
            16,214,078Issuance
                of Common Stock
            
            
            110
            
            
            82,763
            
            
            -
            
            
            82,873Stock-based
                compensation expense
            
            
            -
            
            
            115,714
            
            
            -
            
            
            115,714Net
                Income
            
            
            -
            
            
            -
            
            
            2,429,828
            
            
            2,429,828Balances
                at December 31, 2006
            
            $
            19,354
            
            $
            17,649,678
            
            $
            1,173,461
            
            $
            18,842,493










See
      accompanying notes to consolidated financial statements. ****






55




CONSOLIDATED
      STATEMENTS OF CASH FLOWS


For
      the
      years ended December 31, 2006, 2005 and 2004





2006
            
            2005
            
            2004Cash
                Flows From Operating Activities:Net
                Income
            
            $
            2,429,828
            
            $
            2,744,330
            
            $
            802,264Adjustments
                to reconcile net income to net cash provided
              (used)
                by operating activities:Depreciation
            
            
            250,494
            
            
            193,196
            
            
            204,204Loss
                on disposal of equipment
            
            
            19,798
            
            
            203
            
            
            17,018Accretion
                of investment discounts
            
            
            (50,556
            )
            
            (46,539
            )
            
            (19,251
            )Provision
                for credit losses
            
            
            202,931
            
            
            1,178,866
            
            
            559,596Stock-based
                compensation
            
            
            115,714
            
            
            -
            
            
            -Deferred
                income taxes
            
            
            (55,000
            )
            
            (1,083,000
            )
            
            -Gain
                on sale of loans held for sale
            
            
            (573,387
            )
            
            (512,047
            )
            
            (244,716
            )Origination
                of loans held for sale
            
            
            (110,309,174
            )
            
            (217,744,320
            )
            
            (108,988,138
            )Proceeds
                from sale of loans
            
            
            126,947,322
            
            
            210,360,465
            
            
            100,543,517Net
                increase in accrued interest receivable and other assets
            
            
            (295,018
            )
            
            (977,347
            )
            
            (188,403
            )Net
                increase in accrued expenses and other liabilities
            
            
            533,389
            
            
            948,345
            
            
            277,813Net
                cash provided by (used in) operating activities
            
            
            19,216,341
            
            
            (4,937,848
            )
            
            (7,036,096
            )Cash
                Flows From Investing Activities:Purchases
                of investment securities available for sale
            
            
            (5,106,584
            )
            
            (6,149,351
            )
            
            (6,177,447
            )Maturities
                of investment securities available for sale
            
            
            6,000,000
            
            
            6,200,000
            
            
            6,200,000Purchase
                of Federal Reserve Bank stock
            
            
            (154,960
            )
            
            (139,650
            )
            
            -Purchase
                of Federal Home Loan Bank of Atlantastock
            
            
            (167,700
            )
            
            (98,700
            )
            
            (75,000
            )Loan
                disbursements in excess of principal payments
            
            
            (34,518,409
            )
            
            (40,656,326
            )
            
            (40,037,558
            )Expenditures
                for premises and equipment
            
            
            (623,686
            )
            
            (346,642
            )
            
            (177,193
            )Net
                cash used by investing activities
            
            
            (34,571,339
            )
            
            (41,190,669
            )
            
            (40,267,198
            )Cash
                Flows From Financing Activities:Net
                increase in deposits
            
            
            41,575,866
            
            
            28,646,044
            
            
            45,396,141Net
                increase in short-term borrowings
            
            
            100,842
            
            
            63,158
            
            
            159,000Net
                payoff (proceeds) from notes payable
            
            
            -
            
            
            (1,250,000
            )
            
            1,250,000Proceeds
                from subordinated debt
            
            
            -
            
            
            8,000,000
            
            
            -Net
                proceeds from issuance of common stock
            
            
            82,873
            
            
            50,984
            
            
            550,000Net
                cash provided by financing activities
            
            
            41,759,581
            
            
            35,510,186
            
            
            47,355,141Net
                increase (decrease) in cash and cash equivalents
            
            
            26,404,583
            
            
            (10,618,331
            )
            
            51,847Cash
                and cash equivalents at beginning of year
            
            
            7,493,621
            
            
            18,111,952
            
            
            18,060,105Cash
                and cash equivalents at end of year
            
            $
            33,898,204
            
            $
            7,493,621
            
            $
            18,111,952Cash
                paid for:Interest
            
            $
            7,399,278
            
            $
            4,128,414
            
            $
            2,366,155Income
                taxes
            
            $
            2,002,466
            
            $
            -
            
            $
            -





See
      accompanying notes to consolidated financial statements.





56




**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


**1.**
            **SUMMARY
                OF SIGNIFICANT ACCOUNTING
                POLICIES**





The
      consolidated financial statements include the accounts of Bay National
      Corporation and its subsidiary, Bay National Bank (the “Bank”), collectively
      (the “Company”). All significant intercompany balances and transactions have been eliminated in
      consolidation. The investment in subsidiary is recorded on the parent's books
      on
      the basis of its equity in the net assets. The accounting and reporting policies
      of the Company conform to accounting principles generally accepted in the United
      States of
      America and to
      general practices in the banking industry.





Certain
      reclassifications have been made to amounts previously reported to conform
      to
      the classifications made in 2006.





**Nature
      of Business**





Bay
      National Corporation is incorporated under the laws of the State of Maryland
      to
      operate as a bank holding company of a national bank with the name Bay National
      Bank. The Company owns all the shares of common stock issued by the Bank. The
      Bank is chartered by the Office of the Comptroller of the Currency (the "OCC")
      to operate as a national bank. The Bank’s deposit accounts are eligible to be
      insured by the Federal Deposit Insurance Corporation.





The
      principal business of the Company is to make loans and other investments and
      to
      accept time and demand deposits. The Company’s primary market areas are
      Baltimore and Salisbury, Maryland, although the Company’s business development
      efforts generate business outside of these areas. The Company offers a broad
      range of banking products, including a full line of business and personal
      savings and checking accounts, money market demand accounts, certificates of
      deposit and other banking services. The Company funds a variety of loan types
      including commercial and residential real estate loans, commercial term loans
      and lines of credit, consumer loans and letters of credit. The Company’s
      customers are primarily individuals and small businesses.





**Use
      of Estimates**





The
      preparation of financial statements in conformity with accounting principles generally
      accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts
      of
      assets and liabilities and disclosure of contingent assets and liabilities
      at
      the date of the financial statements and the reported amounts of revenues and
      expenses during the reporting period. Actual results could differ from those
      estimates.





**Cash
      and Cash Equivalents**





The
      Company has included cash and due from banks, and federal funds sold and other
      overnight investments as cash and cash equivalents for the purpose of reporting
      cash flows.








57


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





**Investments
      Available-for-Sale and Other Equity Securities** ****





Marketable
      equity securities and debt securities, not classified as held-to-maturity or
      trading, are classified as available-for-sale. Securities available-for-sale
      are
      acquired as part of the Company's asset/liability management strategy and may
      be
      sold in response to changes in interest rates, loan demand, changes in
      prepayment risk and other factors. Securities available-for-sale are carried
      at
      fair value, with unrealized gains or losses based on the difference between
      amortized cost and fair value reported as accumulated other comprehensive
      income, a separate component of stockholders' equity, net of deferred tax.
      Realized gains and losses, using the specific identification method, are
      included as a separate component of non-interest income. Related interest and
      dividends are included in interest income. Declines in the fair value of
      individual available-for-sale securities below their cost, that are other than
      temporary, result in write-downs of the individual securities to their fair
      value. Factors affecting the determination of whether an other-than-temporary
      impairment has occurred include a downgrading of the security by a rating
      agency, a significant deterioration in the financial condition of the issuer,
      or
      the fact that management would not have the intent and ability to hold a
      security for a period of time sufficient to allow for any anticipated recovery
      in fair value.





Other
      equity securities represented by Federal Reserve Bank and Federal Home Loan
      Bank
      of Atlanta stock are considered restricted as to marketability. The Bank’s
      investment in these securities is carried at cost.





**Loans
      Held for Sale**





The
      Company engages in sales of residential mortgage loans originated by the Bank
      and by a third party. Loans held for sale are carried at the lower of aggregate
      cost or fair value. Fair value is derived from secondary market quotations
      for
      similar instruments. Gains and losses on the sale of loans originated by the
      Bank are recorded as a component of non-interest income in the accompanying
      consolidated statements of operations. No gains or losses are realized on the
      sale of loans originated by third parties. The
      Company's current practice is to sell loans on a servicing released basis,
      and,
      therefore, it has no intangible asset recorded for the value of such servicing
      at either December 31, 2006 or December 31, 2005. The Company earns interest
      on
      the outstanding balances of all loans that are held for sale.





**Loans**





Loans
      are
      stated at the principal amount outstanding net
      of
      any deferred fees and costs. Interest
      income on loans is accrued at the contractual rate on the principal amount
      outstanding. It is the Company's policy to discontinue the accrual of interest
      when circumstances indicate that collection is doubtful. Fees charged and costs
      capitalized for originating certain loans are amortized on the interest method
      over the term of the loan.





Loans
      are
      considered impaired when, based on current information, it is improbable that
      the Company will collect all principal and interest payments according to
      contractual terms. Generally, loans are considered impaired once principal
      and
      interest payments are 90 days past due and they are placed on non-accrual.
      Management also considers the financial condition of the borrower, cash flows
      of
      the loan and the value of the related collateral. Impaired loans do not include
      large groups of smaller balance homogeneous credits such as residential real
      estate, consumer installment loans and commercial leases, which are evaluated
      collectively for impairment. Loans specifically reviewed for impairment are
      not
      considered impaired during periods of "minimal delay" in payment (usually ninety
      days or less) provided eventual collection of all amounts due is expected.
      Impaired loans are measured based on the present value of expected future cash
      flows discounted at the loan’s effective interest rate, except that as a
      practical expedient, the Company may measure impairment based on a loan’s
      observable market price or the fair value of the collateral, if the loan is
      collateral dependent. The Company recognizes interest income on impaired loans
      on a cash basis if the borrower demonstrates the ability to meet the contractual
      obligation and collateral is sufficient. If there is doubt regarding the
      borrower’s ability to make payments, or if the collateral is not sufficient,
      payments received are accounted for as a reduction in principal.






58


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


**Allowance
      for Credit Losses**





The
      allowance for credit losses is established through a provision for credit losses
      charged to expense. Loans are charged against the allowance for credit losses
      when management believes that the collectibility of the principal is unlikely.
      The allowance, based on evaluations of the collectibility of loans, is an amount
      that management believes will be adequate to absorb possible losses on existing
      loans that may become uncollectible. The evaluations take into consideration
      such factors as changes in the nature and volume of the loan portfolio, overall
      portfolio quality, review of specific problem loans and current economic
      conditions and trends that may affect the borrowers' ability to
      pay.





The
      allowance for credit losses represents an estimation done pursuant to Statement
      of Financial Accounting Standards (“SFAS”) No. 5 “Accounting for Contingencies”
and SFAS No. 114 “Accounting by Creditors for Impairment of a Loan.” The Company
      uses a loan grading system where loans are graded based on management's
      evaluation of the risk associated with each loan. A factor, based on the loan
      grading, is applied to the loan balance to reserve for losses. In addition,
      management judgmentally establishes an additional nonspecific reserve. The
      nonspecific portion of the allowance reflects management's estimate of probable
      inherent, but undetected, losses within the portfolio due to uncertainties
      in
      economic conditions, delays in obtaining information, including unfavorable
      information about a borrower's financial condition, the difficulty in
      identifying triggering events that correlate perfectly to subsequent loss rates
      and risk factors that have not yet manifested themselves in loss allocation
      factors. The
      adequacy of the allowance is determined through careful and continuous
      evaluation of the credit portfolio and involves consideration of a number of
      factors to establish a prudent level. Determination of the allowance is
      inherently subjective and requires significant estimates, including estimated
      losses on pools of homogeneous loans based on historical loss experience and
      consideration of current economic trends, which may be susceptible to
      significant change.





While
      management believes it has established the allowance for credit losses in
      accordance with generally accepted accounting principles and has taken into
      account the views of its regulators and the current economic environment, there
      can be no assurance that in the future the Company's regulators or the economic
      environment will not require further increases in the allowance.





**Rate
      Lock Commitments**





The
      Company enters into commitments to originate residential mortgage loans with
      interest rates determined prior to funding. Such rate lock commitments on
      mortgage loans to be sold in the secondary market are considered to be
      derivatives. The period of time between issuance of a loan commitment and
      closing and sale of the loan generally range from 15 to 90 days. The Company
      protects itself from changes in interest rates through the use of best efforts
      forward delivery commitments, whereby the Company commits to sell a loan at
      the
      time the borrower commits to an interest rate with the intent that the buyer
      has
      assumed interest rate risk on the loan. As a result, the Company is not exposed
      to losses nor will it realize gains related to its rate lock commitments due
      to
      changes in interest rates.






59


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


**Premises
      and Equipment**





Premises
      and equipment are stated at cost less accumulated depreciation and amortization
      computed using the straight-line method. Premises and equipment are depreciated
      over the useful lives of the assets, except for leasehold improvements which
      are
      amortized over the terms of the respective leases or the estimated useful lives
      of the improvements, whichever is shorter. Useful lives range from: five to
      ten
      years for furniture, fixtures and equipment; and three to five years for
      software, hardware and data handling equipment. Leasehold improvements are
      amortized over the term of the respective lease plus the first optional renewal
      period, if applicable. Maintenance and repairs are charged to expense as
      incurred, while improvements, which extend the useful life, are capitalized
      and
      depreciated over the estimated remaining life of the asset.





Long-lived
      depreciable assets are evaluated periodically for impairment when events or
      changes in circumstances indicate the carrying amount may not be recoverable.
      Impairment exists when the expected undiscounted future cash flows of a
      long-lived asset are less than its carrying value. In that event, the Company
      recognizes a loss for the difference between the carrying amount and the
      estimated fair value of the asset based on a quoted market price, if applicable,
      or a discounted cash flow analysis.





**Transfers
      of Financial Assets**





Transfers
      of financial assets are accounted for as sales, when control over the assets
      has
      been surrendered. Control over transferred assets is deemed to be surrendered
      when: (1) the assets have been isolated from the Company; (2) the transferee
      obtains the right (free of conditions that constrain it from taking advantage
      of
      that right) to pledge or exchange the transferred assets; and (3) the Company
      does not maintain effective control over the transferred assets through an
      agreement to repurchase them before their maturity.





60


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





**Stock-Based
      Compensation**





Effective January
      1, 2006, the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No. 123(R), *Share-based
      Payment,* and
      has
      included the stock-based employee compensation cost in its income statements
      for
      the year ended December 31, 2006. Prior periods have not been
      restated. ** Amounts
      recognized in the financial statements with respect to stock-based compensation
      are as follows:





**200****6**Amounts
                charged against income, before tax benefit
            
            $
            115,714Amount
                of related income tax benefit recognized in income
            
            $
            12,444





The
      following table illustrates the effect on net income and earnings per share
      if
      the Company had applied the fair value recognition provisions of SFAS No. 123(R)
      and SFAS No. 148 to stock-based employee compensation for the periods ended
      December 31, 2005 and 2004:


**2005**
              
              **2004**Net
                  income as reported
              
              $
              2,744,330
              
              $
              802,264Less
                  pro forma stock-based compensation expense determined
                under
                  the fair value method, net of related tax effects
              
              
              (102,382
              )
              
              (92,474
              )Pro
                  forma net income (loss)
              
              $
              2,641,948
              
              $
              709,790Net
                  income (loss) per share:Basic
                  - as reported
              
              $
              1.43
              
              $
              .43Diluted
                  - as reported
              
              $
              1.37
              
              $
              .41Basic
                  - pro forma
              
              $
              1.37
              
              $
              .38Diluted
                  - pro forma
              
              $
              1.32
              
              $
              .37





61




**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option-pricing model with the following weighted average
      assumptions used for grants during the year ended December 31:





**2002**Dividend
                yield
            
            
            -Expected
                volatility
            
            
            20.00
            %Risk-free
                interest rate
            
            
            4.17
            %Expected
                lives (in years)
            
            
            8





**Advertising
      Costs**





Advertising
      costs are generally expensed as incurred.





**Income
      Taxes**





The
      Company uses the liability method of accounting for income taxes. Under the
      liability method, deferred-tax assets and liabilities are determined based
      on
      differences between the financial statement carrying amounts and the tax bases
      of existing assets and liabilities (i.e., temporary differences) and are
      measured at the enacted rates in effect when these differences reverse.





**Earnings
      Per Share**





Earnings
      per common share are computed by dividing net income by the weighted average
      number of common shares outstanding during the period. Diluted net income per
      common share is computed by dividing net income by the weighted average number
      of common shares outstanding during the period, including any potential dilutive
      common shares outstanding such as options and warrants.





**New
      Accounting Standards**




In
      December 2004, the FASB revised SFAS 123, “Accounting for Stock-Based
      Compensation.” SFAS 123R establishes accounting requirements for share-based
      compensation to employees and carries forward prior guidance on accounting
      for
      awards to non-employees. The provisions of this statement became effective
      January 1, 2006 for non-accelerated filers for all equity awards vesting after
      the effective date. SFAS 123R requires an entity to recognize compensation
      expense based on an estimate of the number of awards expected to actually vest,
      exclusive of awards expected to be forfeited. The impact to the Company’s
      financial statements is more fully discussed in Note 1 - Stock Based
      Compensation.





In
      May
      2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections, a
      replacement of APB Opinion No. 20 and FASB Statement No. 3.” This statement
      establishes, unless impracticable, retrospective application as the required
      method for reporting a change in accounting principle in the absence of explicit
      transition requirements specific to a newly adopted accounting principle. Previously,
      most changes in accounting principle were recognized by including the cumulative
      effect of changing to the new accounting principle in net income of the period
      of the change. Under SFAS 154, retrospective application requires
      (i) the cumulative effect of the change to the new accounting principle on
      periods prior to those presented to be reflected in the carrying amounts of
      assets and liabilities as of the beginning of the first period presented,
      (ii) an offsetting adjustment, if any, to be made to the opening balance of
      retained earnings (or other appropriate components of equity) for that period,
      and (iii) financial statements for each individual prior period presented
      to be adjusted to reflect the direct period-specific effects of applying the
      new
      accounting principle. Special retroactive application rules apply in situations
      where it is impracticable to determine either the period-specific effects or
      the
      cumulative effect of the change. Indirect effects of a change in accounting
      principle are required to be reported in the period in which the accounting
      change is made. SFAS 154 carries forward the guidance in APB Opinion 20
“Accounting Changes,” requiring justification of a change in  accounting
      principle on the basis of preferability. SFAS 154 also carries forward
      without change the guidance contained in APB Opinion 20, for reporting the
      correction of an error in previously issued financial statements and for a
      change in an accounting estimate. SFAS 154 is effective for accounting
      changes and corrections of errors made in fiscal years beginning after
      December 15, 2005. SFAS 154 did not significantly impact the Company’s
      financial statements upon its adoption on January 1, 2006.






62


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


In
      November 2005, the FASB
      issued Staff Position (FSP) No. 115-1, “The Meaning of
      Other-Than-Temporary Impairment and Its Application to Certain
      Investments.” ** FSP
      115-1
      provides guidance for determining when an investment is considered impaired,
      whether impairment is other-than-temporary, and measurement of an impairment
      loss. An investment is considered impaired if the fair value of the investment
      is less than its cost. If, after consideration of all available evidence to
      evaluate the realizable value of its investment, impairment is determined to
      be
      other-than-temporary, then an impairment loss should be recognized equal to
      the
      difference between the investment’s cost and its fair value. FSP 115-1 nullifies
      certain provisions of Emerging Issues Task Force (EITF) Issue No. 03-1,
“The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments,” while retaining the disclosure requirements of EITF 03-1
      which were adopted in 2003. FSP 115-1 is effective for reporting periods
      beginning after December 15, 2005. FSP 115-1 did not significantly impact
      the Company’s financial statements upon its adoption on January 1,
      2006.





*SFAS No. 155,
      “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB
      Statements No. 133 and 140.”* SFAS 155
      amends SFAS 133, “Accounting for Derivative Instruments and Hedging
      Activities” and SFAS 140, “Accounting for Transfers and Servicing of
      Financial Assets and Extinguishments of Liabilities.” SFAS 155
      (i) permits fair value remeasurement for any hybrid financial instrument
      that contains an embedded derivative that otherwise would require bifurcation,
      (ii) clarifies which interest-only strips and principal-only strips are not
      subject to the requirements of SFAS 133, (iii) establishes a
      requirement to evaluate interests in securitized financial assets to identify
      interests that are freestanding derivatives or that are hybrid financial
      instruments that contain an embedded derivative requiring bifurcation,
      (iv) clarifies that concentrations of credit risk in the form of
      subordination are not embedded derivatives, and (v) amends SFAS 140 to
      eliminate the prohibition on a qualifying special purpose entity from holding
      a
      derivative financial instrument that pertains to a beneficial interest other
      than another derivative financial instrument. SFAS 155 is effective for the
      Company on January 1, 2007 and is not expected to have a significant impact
      on the Company’s financial statements.




*SFAS No. 156,
      “Accounting for Servicing of Financial Assets — an amendment of FASB
      Statement No. 140.”* SFAS 156
      amends SFAS 140. “Accounting for Transfers and Servicing of Financial
      Assets and Extinguishments of Liabilities — a replacement of FASB Statement
      No. 125,” by requiring, in certain situations, an entity to recognize a
      servicing asset or servicing liability each time it undertakes an obligation
      to
      service a financial asset by entering into a servicing contract. All separately
      recognized servicing assets and servicing liabilities are required to be
      initially measured at fair value. Subsequent measurement methods include the
      amortization method, whereby servicing assets or servicing liabilities are
      amortized in proportion to and over the period of estimated net servicing income
      or net servicing loss or the fair value method, whereby servicing assets or
      servicing liabilities are measured at fair value at each reporting date and
      changes in fair value are reported in earnings in the period in which they
      occur. If the amortization method is used, an entity must assess servicing
      assets or servicing liabilities for impairment or increased obligation based
      on
      the fair value at each reporting date. SFAS 156 is effective for the
      Company on January 1, 2007 and is not expected to have a significant impact
      on the Company’s financial statements.






63


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





*SFAS No. 157,
      “Fair Value Measurements.”* SFAS 157
      defines fair value, establishes a framework for measuring fair value in
      generally accepted accounting principles, and expands disclosures about fair
      value measurements. SFAS 157 is effective for the Company on
      January 1, 2008 and is not expected to have a significant impact on the
      Company’s financial statements.





*FASB
      Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an
      interpretation of FASB Statement 109.”* Interpretation
      48 prescribes a recognition threshold and a measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. Benefits from tax positions should be
      recognized in the financial statements only when it is more likely than not
      that
      the tax position will be sustained upon examination by the appropriate taxing
      authority that would have full knowledge of all relevant information. A tax
      position that meets the more-likely-than-not recognition threshold is measured
      at the largest amount of benefit that is greater than fifty percent likely
      of
      being realized upon ultimate settlement. Tax positions that previously failed
      to
      meet the more-likely-than-not recognition threshold should be recognized in
      the
      first subsequent financial reporting period in which that threshold is met.
      Previously recognized tax positions that no longer meet the more-likely-than-not
      recognition threshold should be derecognized in the first subsequent financial
      reporting period in which that threshold is no longer met. Interpretation 48
      also provides guidance on the accounting for and disclosure of unrecognized
      tax
      benefits, interest and penalties. Interpretation 48 is effective for the Company
      on January 1, 2007 and is not expected to have a significant impact on the
      Company’s financial statements.




**2.**
            **INVESTMENT
                SECURITIES**





**Investments
      available-for-sale**





The
      amortized cost and estimated fair values of investments available-for-sale
      at
      December 31, 2006 are as follows:





**Amortized**
              **Cost**
            
            **Gross**
              **Unrealized**
              **Gains**
            
            **Gross**
              **Unrealized**
              **Losses**
            
            **Estimated**
              **Fair
                Value**U.S.
                Treasury securities
            
            $
            697,526
            
            $
            -
            
            $
            -
            
            $
            697,526Total
                investments available-for-sale
            
            $
            697,526
            
            $
            -
            
            $
            -
            
            $
            697,526









64


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


The
      amortized cost and estimated fair values of investments available-for-sale
      at
      December 31, 2006 by contractual maturity are shown below.





**Amortized**
              **Cost**
            
            **Estimated
                Fair Value**Due
                in one year or less
            
            $
            697,526
            
            $
            697,526Total
                investments available-for-sale
            
            $
            697,526
            
            $
            697,526





The
      amortized cost and estimated fair values of investments available-for-sale
      at
      December 31, 2005 were as follows:





**Amortized**
              **Cost**
            
            **Gross**
              **Unrealized**
              **Gains**
            
            **Gross**
              **Unrealized**
              **Losses**
            
            **Estimated**
              **Fair
                Value**U.S.
                Treasury securities
            
            $
            1,540,386
            
            $
            -
            
            $
            -
            
            $
            1,540,386Total
                investments available-for-sale
            
            $
            1,540,386
            
            $
            -
            
            $
            -
            
            $
            1,540,386





There
      were no sales of investments available-for-sale during 2006, 2005 or
      2004.





At
      December 31, 2006 and 2005, investments available-for-sale with a carrying
      value
      of $300,000 and $916,158, respectively, were pledged as collateral for certain
      short-term borrowings.





**Other
      equity securities**





At
      December 31, the
      Company’s investment in other equity securities consisted of :





**2006**
            
            **2005**Federal
                Reserve Bank stock
            
            $
            607,300
            
            $
            452,340Federal
                Home Loan Bank stock
            
            
            509,800
            
            
            342,100Total
                investments in other equity securities
            
            $
            1,117,100
            
            $
            794,440





**3.**  ****  **LOANS
      AND ALLOWANCE FOR CREDIT LOSSES**





Major
      loan categories at December 31 are presented below:




**2006**
            
            **2005**Real
                Estate - Home Equity Line of Credit
            
            $
            19,963,116
            
            $
            21,067,964Real
                Estate - Construction
            
            
            76,889,997
            
            
            47,933,768Real
                Estate - Mortgage
            
            
            27,903,399
            
            
            34,542,931Loans
                Held for Sale
            
            
            1,444,303
            
            
            17,509,064Commercial
            
            
            88,491,722
            
            
            75,626,825Consumer
            
            
            3,323,141
            
            
            2,909,409Total
                Loans
            
            
            218,015,678
            
            
            199,589,961Less:
                Allowance for credit losses
            
            
            (3,175,000
            )
            
            (3,000,000
            )Net
                Loans
            
            $
            214,840,678
            
            $
            196,589,961






65


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


Activity
      in the allowance for credit losses for the year ended December
      31, 2006,
      2005
      and 2004 is shown below:





**2006**
            
            **2005**
            
            **2004**Balance
                at beginning of year
            
            $
            3,000,000
            
            $
            1,810,000
            
            $
            1,266,500Provision
                for credit losses
            
            
            202,931
            
            
            1,178,866
            
            
            559,596Loan
                charge-offsCommercial
            
            
            (37,931
            )
            
            -
            
            
            (15,222
            )Consumer
            
            
            -
            
            
            -
            
            
            (2,134
            )Loan
                recoveriesCommercial
            
            
            10,000
            
            
            11,134
            
            
            1,260Net
                recoveries (charge-offs)
            
            
            (27,931
            )
            
            11,134
            
            
            (16,096
            )Balance
                at end of year
            
            $
            3,175,000
            
            $
            3,000,000
            
            $
            1,810,000





As
      of
      December 31, 2005, loans to one borrower, with a net principal balance of
      $1,708,874, were considered impaired under SFAS No. 114 for which a $500,000
      reserve was established in the fourth quarter of 2005. As of December 31, 2006,
      the principal balance had been fully paid on these loans, the Company had unpaid
      fees of $13,000 related to one loan and a specific credit reserve was
      established for $13,000.





**4.**  **PREMISES
      AND EQUIPMENT**





Premises
      and equipment at December 31 include the following:





**2006**
            
            **2005**Furniture
                and equipment
            
            $
            694,244
            
            $
            520,944Computer
                hardware and software
            
            
            472,590
            
            
            602,550Leasehold
                improvements
            
            
            721,969
            
            
            475,9431,888,803
            
            
            1,599,437Less
                accumulated depreciation
            
            
            (788,583
            )
            
            (852,611
            )Net
                premises and equipment
            
            $
            1,100,220
            
            $
            746,826





The
      Company rents office space in four locations under three non-cancelable lease
      arrangements and one monthly rental agreement accounted for as operating leases.
      The initial lease periods are from one to five years and provide for one or
      more
      one to five-year renewal options. The leases for the Baltimore locations provide
      for percentage annual rent escalations. The lease for the Salisbury location
      requires that the lessee pay certain operating expenses applicable to the leased
      space.





Rent
      expense applicable to operating leases, for the periods ended December 31,
      was
      as follows:





**2006**
            
            **2005**
            
            **2004**Minimum
                rentals
            
            $
            391,927
            
            $
            330,406
            
            $
            241,097Less:
                Sublease rentals
            
            
            (23,568
            )
            
            (23,657
            )
            
            (12,930
            )Net
                rent expense
            
            $
            368,359
            
            $
            306,749
            
            $
            228,167





66


At
      December 31, 2006, future minimum lease payments under non-cancelable operating
      leases having an initial term in excess of one year are as follows:





Years
                ending December 31:2007
            
            $
            487,2032008
            
            
            500,9942009
            
            
            506,0332010
            
            
            174,7432011
            
            
            104,667Total
                minimum lease payments
            
            $
            1,773,640







**5.**   **DEPOSITS**





The
      following table sets forth the composition of the Company's deposits as of
      December 31, 200 6
      and
      December 31, 2005:




**2006**
            
            **2005**Demand
                Deposits
            
            $
            58,118,270
            
            
            25.93
            %
            $
            61,057,678
            
            
            33.44
            %Savings
            
            
            7,456,143
            
            
            3.33
            
            
            9,215,092
            
            
            5.05Money
                Market and sweep
            
            
            43,428,638
            
            
            19.37
            
            
            19,411,421
            
            
            10.63Certificates
                of deposit
            
            
            115,145,901
            
            
            51.37
            
            
            92,888,895
            
            
            50.88Total
                deposits
            
            $
            224,148,952
            
            
            100.00
            %
            $
            182,573,086
            
            
            100.00
            %





The
      following table sets forth the maturity distribution for the Company's deposits
      at December 31, 2006. Some of the deposits may be renewed or withdrawn prior
      to
      maturity. Therefore, the following table should not be used as a forecast of
      future cash flows.





**Within
                one**
              **year**
            
            **One
                to**
              **three
                years**
            
            **Three
                to**
              **five
                years**
            
            **Over
                five**
              **years**Demand
                deposits
            
            $
            58,118,270
            
            $
            -
            
            $
            -
            
            $
            -Savings
            
            
            7,456,143
            
            
            -
            
            
            -
            
            
            -Money
                Market and sweep
            
            
            43,428,638
            
            
            -
            
            
            -
            
            
            -Certificates
                of deposit
            
            
            85,092,215
            
            
            21,044,460
            
            
            9,009,226
            
            
            -Total
            
            $
            194,095,266
            
            $
            21,044,460
            
            $
            9,009,226
            
            $
            -





Certificates
      of deposit in amounts of $100,000 or more and their remaining maturities at
      December 31 are as follows:





**2006**
            
            **2005**Three
                months or less
            
            $
            17,995,943
            
            $
            4,374,777Over
                three months through six months
            
            
            19,591,959
            
            
            11,163,966Over
                six months through twelve months
            
            
            10,346,026
            
            
            6,400,569Over
                twelve months
            
            
            12,844,155
            
            
            15,072,324Total
            
            $
            60,778,083
            
            $
            37,011,636









67





Interest
      expense on deposits, for the years ended December 31, is as
      follows:





**2006**
            
            **2005**
            
            **2004**Interest-bearing
                transaction
            
            $
            873,622
            
            $
            525,691
            
            $
            293,076Savings
                and money market
            
            
            1,402,610
            
            
            575,007
            
            
            244,628Time,
                $100,000 or more
            
            
            2,097,542
            
            
            980,590
            
            
            531,287Other
                time
            
            
            2,758,837
            
            
            1,977,231
            
            
            1,369,896Total
                interest on deposits
            
            $
            7,132,611
            
            $
            4,058,519
            
            $
            2,438,887





**6.**  **BORROWINGS**





Information
      relating to short-term borrowings, as of December 31, 2006 and 2005, is as
      follows:





**Securities
                under agreement to repurchase****2006**
            
            **2005****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**As
                of year-end
            
            $
            300,000
            
            
            4.00
            %
            $
            916,158
            
            
            3.10
            %Average
                for the year
            
            $
            494,913
            
            
            3.59
            %
            $
            1,392,674
            
            
            2.72
            %Maximum
                month-end
                balance
            
            $
            1,277,000
            
            
            
            
            $
            1,550,000





**Federal
                funds purchased****2006**
            
            **2005****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**As
                of year-end
            
            $
            -
            
            
            -
            %
            $
            528,000
            
            
            4.35
            %Average
                for the year
            
            $
            266,351
            
            
            5.11
            %
            $
            230,384
            
            
            2.61
            %Maximum
                month-end
                balance
            
            $
            3,243,000
            
            
            
            
            $
            528,000





**Commercial
                paper****2006**
            
            **2005****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**As
                of year-end
            
            $
            1,245,000
            
            
            4.50
            %
            $
            -
            
            
            -
            %Average
                for the year
            
            $
            670,370
            
            
            4.33
            %
            $
            -
            
            
            -
            %Maximum
                month-end
                balance
            
            $
            1,389,000
            
            
            
            
            $
            -








68


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





**Federal
                Home Loan Bank Borrowings****2006**
            
            **2005****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**As
                of year-end
            
            $
            -
            
            
            -
            %
            $
            -
            
            
            -
            %Average
                for the year
            
            $
            504,110
            
            
            5.17
            %
            $
            2,007,671
            
            
            3.58
            %Maximum
                month-end
                balance
            
            $
            -
            
            
            
            
            $
            6,000,000





The
      Company pledges U.S. Government Treasury Securities, based upon their market
      values, as collateral for 100% of the principal and accrued interest of its
      securities under agreement to repurchase.





The
      Company maintained commitments for a total of $9 million of borrowing
      availability under unsecured federal funds lines of credit with three separate
      financial institutions. The Company also has approximately $21 million of
      borrowing capacity with the Federal Home Loan Bank of Atlanta as of December
      31,
      2006. These borrowing facilities will be used, as necessary, to supplement
      short-term liquidity needs.





Information
      relating to note payable as of December 31, 2006 and 2005 is as
      follows:





**2006**
            
            **2005****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**As
                of year-end
            
            $
            -
            
            
            -
            %
            $
            -
            
            
            -
            %Average
                for the year
            
            $
            -
            
            
            -
            %
            $
            1,426,027
            
            
            6.43
            %Maximum
                month-end
                balance
            
            $
            -
            
            
            
            
            $
            2,100,000





During
      2005, the note
      payable consisted of maximum borrowings of $2,100,000 under a $5 million,
      three-year unsecured non-revolving credit facility executed on September 28,
      2004 with another financial institution. The loan paid interest at the prime
      rate. As of December 12, 2005, the credit facility terminated. The Company
      funded the repayment with proceeds from the issuance by its wholly owned
      subsidiary, Bay National Capital Trust I, of $8.0 million of 30-year fixed
      rate
      trust preferred securities. See discussion below.





Information
      relating to subordinated debt as of December 31, 2006 and 2005 is as
      follows:





**2006**
            
            **2005****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**As
                of year-end
            
            $
            8,000,000
            
            
            7.20
            %
            $
            8,000,000
            
            
            7.20
            %Average
                for the year
            
            $
            8,000,000
            
            
            7.54
            %
            $
            438,356
            
            
            7.20
            %Maximum
                month-end
                balance
            
            $
            8,000,000
            
            
            
            
            $
            8,000,000





On
      December 12, 2005, the Company participated in a private placement of $8 million
      of fixed interest rate trust preferred securities (the “Trust Preferred
      Securities”), through a newly formed Delaware trust subsidiary, Bay National
      Capital Trust I (the “Trust”). The Trust was formed for the purpose of issuing
      the Trust Preferred Securities and all of its common securities are owned by
      the
      Company. The Company purchased the common securities from the Trust for
      $248,000. In accordance with provisions of FIN46, the financial position and
      results of operations are not included in the Company’s consolidated financial
      position and results of operations.






69


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


The
      Trust
      used the proceeds of the sale of the Trust Preferred Securities and common
      securities to purchase from the Company the aggregate principal amount of
      $8,248,000 of the Company’s Fixed Rate Junior Subordinated Debt Securities Due
      2036 (the “Debt Securities”). Like the Trust Preferred Securities, the Debt
      Securities bear interest at the fixed annual rate of 7.20% until maturity.
      The
      interest expense on Trust Preferred Securities was $603,567 and $28,108 in
      2006
      and 2005, respectively. The Debt Securities mature on February 23, 2036, but
      may
      be redeemed at the Company’s option at any time on any February 23, May 23,
      August 23 or November 23 on or after February 23, 2011, or at any time upon
      certain events, such as a change in the regulatory capital treatment of Debt
      Securities, the Trust being deemed to be an “investment company” under the
      Investment Company Act of 1940, as amended, or the occurrence of certain adverse
      tax events. Except upon the occurrence of the events described above, which
      require a redemption premium for redemptions prior to February 23, 2011, the
      Company may redeem the Debt Securities at their aggregate principal amount,
      plus
      accrued interest, if any.





The
      parent was required to retain $1,000,000 of the proceeds from the Debt
      Securities for general corporate purposes (which may include making interest
      payments on the Debt Securities) until the earlier of (i) the date on which
      the
      retained funds are reduced to zero, or (ii) the date on which Bay National
      Bank
      (or any successor) meets the statutory requirements to pay dividends of at
      least
      $148,464 for each of two consecutive quarters with positive retained earnings
      remaining after any such dividend payment. As of December 31, 2006, the Bank
      has
      the ability to pay the required dividends.





The
      Debt
      Securities are subordinated to the prior payment of other indebtedness of the
      Company that, by its terms, is not similarly subordinated. Although the Debt
      Securities are recorded as a liability on the Company’s balance sheet, for
      regulatory purposes, the Debt Securities are being treated as Tier 1 or Tier
      2
      capital under regulatory capital guidelines issued by the Federal Reserve
      Board.





**7.**  **ISSUANCE
      OF COMMON STOCK**





On
      August
      31, 1999, the Board of Directors of the Company authorized the issuance on
      September 10, 1999, to each stockholder of record of the Company on August
      31,
      1999, a warrant to purchase one share of common stock at $10 per share for
      every
      two shares that the stockholder purchased in the organizational offering. As
      a
      result, the Company issued warrants to purchase 56,250 shares. The warrants
      were
      issued in recognition of the financial and organizational risk undertaken by
      the
      purchasers in the organizational offering. The warrants became exercisable
      on
      April 30, 2001 and were exercisable in whole or in part until November 16,
      2004.
      During the second half of 2004, 55,000 of these warrants were exercised
      resulting in the issuance of 55,000 shares of common stock and the receipt
      of
      $550,000 of additional capital.











70


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





**8.**  **STOCK-BASED
      COMPENSATION PLANS**





**Stock
      Options**





The
      Company’s 2001 Stock Option Plan (“Option Plan”) provides for the granting of
      incentive and non-qualifying stock options to the Company’s directors and to
      selected employees on a periodic basis at the discretion of the Board of
      Directors. The Option Plan authorizes the issuance of up to 200,000 shares
      of
      common stock, has a term of ten years, and is administered by the Compensation
      Committee of the Board of Directors. The Compensation Committee consists of
      at
      least three non-employee directors appointed by the Board of Directors. In
      general, the options have an exercise price, which may not be less than 100%
      of
      the fair market value on the date of the grant, must be exercised within eight
      years and vest over a period of six years.





The
      following is a summary of changes in shares under options for the years ended
      December 31, 2006, 2005 and 2004:





**Number
                of**
              **Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**Balance,
                January 1, 2004
            
            
            147,906
            
            $
            7.67Granted
            
            
            -
            
            
            -Cancelled
            
            
            (414
            )
            
            7.58Exercised
            
            
            -
            
            
            -Balance,
                December 31, 2004
            
            
            147,492
            
            
            7.67Granted
            
            
            -
            
            
            -Cancelled
            
            
            -
            
            
            -Exercised
            
            
            (6,726
            )
            
            7.58Balance,
                December 31, 2005
            
            
            140,766
            
            
            7.67Granted
            
            
            -
            
            
            -Cancelled
            
            
            (1,242
            )
            
            7.58Exercised
            
            
            (10,933
            )
            
            7.58Balance,
                December 31, 2006
            
            
            128,591
            
            $
            7.68Weighted
                average fair value of options
              granted
                during 2002
            
            $
            3.05





71


**BAY
      NATIONAL CORPORATION**


Notes
      to
      Consolidated Financial Statements


For
      the
      years ended December 31, 2006, 2005 and 2004


The
      following table summarizes information about options outstanding at December
      31,
      2006:





**Options
                Outstanding**
            
            
            **Options
                Exercisable****Range
                of Exercise Price**
            
            **Number**
            
            **Weighted
                Average Remaining Contractual Life**
              **(in
                years)**
            
            **Weighted
                Average Exercise Price**
            
            
            **Number**
            
            **Weighted
                Average Exercise Price**$7.58
            
            111,776
            
            3
            
            $7.58
            
            
            109,784
            
            $7.58$8.37
            
            16,815
            
            4
            
            $8.37
            
            
            8,407
            
            $8.37128,591
            
            
            
            $7.68
            
            
            118,191
            
            $7.64





The
      aggregate intrinsic value of options outstanding and exercisable as of December
      31, 2006 was $1,480,944 and $1,366,738, respectively, based upon a closing
      price
      of $19.20 per share. The unrecognized compensation cost related to unvested
      stock option awards was $31,718 for the year ended December 31, 2006 based
      upon
      a weighted average fair value of $3.05.





The
      following table summarizes the changes in unvested option shares during the
      year
      ended December 31, 2006:





**Number
                of**
              **Shares**
            
            **Weighted**
              **Average**
              **Grant
                Date**
              **Fair
                Value**Unvested
                options at January 1, 2006
            
            
            37,780
            
            $
            3.05Granted
            
            
            -
            
            
            -Vested
            
            
            (27,380
            )
            
            -Cancelled
            
            
            -
            
            
            -Unvested
                options at December 31, 2006
            
            
            10,400
            
            $
            3.05





**Restricted
      Stock Units**





Pursuant
      to an employment agreement (“Agreement”) dated June 1, 2006, a grant of 12,000
      shares of the Company’s common stock was awarded to a member of senior
      management. The stock grant vests as follows: 25% (3,000 shares) on the first
      anniversary of the Agreement; 25% (3,000 shares) on the second anniversary
      of
      the Agreement; 25% (3,000 shares) on the third anniversary of the Agreement;
      and
      25% (3,000 shares) on the fourth anniversary of the Agreement. The vesting
      of
      the shares is subject to the individual being employed under this Agreement
      at
      each vesting date. Additional shares may be awarded from time to time subject
      to
      approval of the Board of Directors. The Company incurred compensation expense
      associated with this restricted stock of $33,163 for the year ended December
      31,
      2006.


72


**BAY
      NATIONAL CORPORATION**


Notes
      to
      Consolidated Financial Statements


For
      the
      years ended December 31, 2006, 2005 and 2004


The
      following table summarizes the changes in outstanding shares under restricted
      stock grants for the year ended December 31, 2006.





**Number
                of**
              **Shares**
            
            **Value
                at**
              **Issuance
                Date**Unvested
                grants at January 1, 2006
            
            
            -
            
            $
            -Granted
            
            
            12,000
            
            
            18.95Vested
            
            
            -
            
            
            -Cancelled
            
            
            -
            
            
            -Unvested
                grants at December 31, 2006
            
            
            12,000
            
            $
            18.95








**9.**   **RETIREMENT
      PLAN**





The
      Company has a 401(k) profit sharing plan covering substantially all full-time
      employees. The plan requires the Company to match 25% of employee contributions
      of up to 3% of compensation as defined under the plan. The Company has also
      elected to make a safe harbor contribution to the plan on behalf of all eligible
      employees, as defined under the plan. The safe harbor contribution is equal
      to
      3% of compensation as defined under the plan. The plan permits additional
      contributions at the discretion of management. Expenses under this plan totaled
      $171,224, $120,368 and $77,180 for the years ended December 31, 2006, 2005
      and 2004, respectively.





**10.**  **INCOME
      TAXES**





Federal
      and state income tax expense (benefit) consists of the following for the periods
      ended December 31:





**2006**
            
            **2005**Current
                federal income tax
            
            $
            1,391,380
            
            $
            307,000Current
                state income tax
            
            
            341,978
            
            
            121,000Deferred
                federal income tax expense (benefit)
            
            
            (50,000
            )
            
            (887,000
            )Deferred
                state income tax expense (benefit)
            
            
            (5,000
            )
            
            (196,000
            )Total
                income tax expense (benefit)
            
            $
            1,678,358
            
            $
            (655,000
            )





73


**BAY
      NATIONAL CORPORATION**


Notes
      to
      Consolidated Financial Statements


For
      the
      years ended December 31, 2006, 2005 and 2004


The
      following table is a summary of the tax effect of temporary differences that
      give rise to a significant portion of deferred tax assets:





Deferred
                tax assets:
            
            **2006**
            
            **2005**Net
                operating loss carryforwards
            
            $
            115,000
            
            $
            62,000Contributions
            
            
            -
            
            
            47,000Deferred
                loan fees, net
            
            
            67,000
            
            
            105,000Stock
                based compensation
            
            
            27,000
            
            
            -Allowance
                for credit losses
            
            
            1,058,000
            
            
            979,000Total
                deferred tax assets
            
            
            1,267,000
            
            
            1,193,000Less
                valuation allowance
            
            
            (115,000
            )
            
            (62,000
            )Deferred
                tax assets, net of valuation allowance
            
            
            1,152,000
            
            
            1,131,000Deferred
                tax liabilities:Depreciation
                and amortization
            
            
            (14,000
            )
            
            (48,000
            )Deferred
                loan costs, net
            
            
            -
            
            
            -Netdeferred
                tax assets (liabilities)
            
            $
            1,138,000
            
            $
            1,083,000





For
      the
      year ended December 31, 2006, the Company recorded an income tax liability
      of
      $1,733,358 compared to $428,000 for the year ended December 31, 2005. Taxable
      income for the year ended December 31, 2004 was offset by the Company’s net
      operating loss carryforwards available in that year. The 2006 liability was
      offset by the recognition of a deferred tax asset of $55,000, resulting in
      a net
      tax expense of $1,678,358 for the year ended December 31, 200 6.
      The
      2005 liability was offset by the recognition of a deferred tax asset of
      $1,083,000, resulting in a net tax benefit of $655,000 for the year ended
      December 31, 2005, which had a positive effect on earnings. At December 31,
      2006, the Company had a net operating loss carryforward of approximately $1.6
      million for the unconsolidated state tax return of Bay National
      Corporation.





Reported
      income tax expense (benefit) differed from the amounts computed by applying
      the
      U.S. federal statutory income tax rate of 34% to income before income taxes
      as
      follows:





**2006**
            
            **2005**
            
            **2004**Federal
                income tax expense computed at the statutory rate
            
            $
            1,396,783
            
            $
            710,372
            
            $
            272,770State
                income tax expense (benefit), net
            
            
            222,405
            
            
            (49,500
            )
            
            -Nondeductible
                expenses
            
            
            18,281
            
            
            13,536
            
            
            9,365Other
            
            
            (12,111
            )
            
            -
            
            
            -Adjustment
                to valuation allowance
            
            
            53,000
            
            
            (1,329,408
            )
            
            (282,135
            )Federal
                income tax (benefit) expense, as reported
            
            $
            1,678,358
            
            $
            (655,000
            )
            $
            -





**11.**  **RELATED
      PARTY TRANSACTIONS**





Certain
      directors and executive officers have loan transactions with the Company. Such
      loans were made in the ordinary course of business on substantially the same
      terms, including interest rates and collateral, as those prevailing at the
      time
      for comparable transactions with outsiders. The following schedule summarizes
      changes in amounts of loans outstanding, both direct and indirect, to these
      persons during 2006  and
      2005.






74


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


**2006**
            
            **2005**Balance
                at beginning of period
            
            $
            8,059,647
            
            $
            5,828,095Additions
            
            
            16,914,183
            
            
            12,546,714Repayments
            
            
            (13,728,546
            )
            
            (10,315,162
            )Balance
                at December 31
            
            $
            11,245,284
            
            $
            8,059,647





A
      director of the Company owns an office building which is leased to the Company.
      The lease term commenced September 1, 1999 for a term of five years and contains
      renewal options for three additional five-year terms. Rent expense under this
      agreement was $27,500 for the years ended December 31, 2006 and 2005 and $25,004
      for the year ended December 31, 2004. Management believes that the terms of
      the
      foregoing lease are no more and no less favorable to the Company than those
      which could have been received from unaffiliated parties.





An
      individual, who became a director of the Company in 2003, is an executive
      officer of the company which owns an office building in which the Company had
      leased space under two separate operating leases. The leases were effectively
      combined during 2004 and extended to February 28, 2010. Bay National Corporation
      has the right to extend the leases for one additional five year term, to
      February 28, 2015. Rent expense under this lease was $347,573, $286,406, and
      $202,945 for the periods ended December 31, 2006, 2005 and 2004, respectively.
      Management believes that the terms of the foregoing leases are no more and
      no
      less favorable to the Company than those which could have been received from
      unaffiliated parties.





**12.**  **FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK**





The
      Company is a party to financial instruments with off-balance sheet risk in
      the
      normal course of business. These financial instruments may include commitments
      to extend credit, standby letters of credit and purchase commitments. The
      Company uses these financial instruments to meet the financing needs of its
      customers. Financial instruments involve, to varying degrees, elements of
      credit, interest rate and liquidity risk. These do not represent unusual risks
      and management does not anticipate any losses which would have a material effect
      on the accompanying financial statements.





Outstanding
      loan commitments and lines and letters of credit at December 31 are as
      follows:





**2006**
            
            **2005**Loan
                commitments
            
            $
            33,782,891
            
            $
            21,577,585Unused
                lines of credit
            
            
            66,660,250
            
            
            41,317,927Standby
                letters of credit
            
            
            2,188,659
            
            
            2,754,383





Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of any condition established in the contract. The Company generally
      requires collateral to support financial instruments with credit risk on the
      same basis as it does for on-balance sheet instruments. The collateral is based
      on management's credit evaluation of the counter party. Commitments generally
      have fixed expiration dates or other termination clauses and may require payment
      of a fee. Since many of the commitments are expected to expire without being
      drawn upon, the total commitment amount does not necessarily represent future
      cash requirements. Each customer's credit-worthiness is evaluated on a
      case-by-case basis.






75


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


Standby
      letters of credit are conditional commitments issued to guarantee the
      performance of a customer to a third party. The credit risk involved in issuing
      letters of credit is essentially the same as that involved in extending loan
      facilities to customers.





**13.**  **REGULATORY
      MATTERS**





As
      of
      December 31, 2006 , the
      Company was required to maintain a weekly average of $1,753,000 of
      non-interest-bearing deposits with the Federal Reserve Bank. As of December
      31,
      2005 , the
      Company was required to maintain a weekly average of $1,004,000 of
      non-interest-bearing deposits with the Federal Reserve Bank. The average weekly
      balance maintained with the Federal Reserve Bank for the weekly period including
      December 31, 2006 was $1,900,000. The average weekly balance maintained with
      the
      Federal Reserve Bank for the weekly period including December 31, 2005 was
      $1,073,000. The actual balances maintained with the Federal Reserve Bank at
      December 31, 2006 and 2005 were $1,900,000 and $1,024,914,
      respectively.





The
      Company and the Bank are subject to various regulatory capital requirements
      administered by federal banking agencies. Failure to meet minimum capital
      requirements can initiate certain mandatory and possibly additional
      discretionary actions by regulators that, if undertaken, could have a direct
      material effect on the Company’s and the Bank's financial statements. Under
      capital adequacy guidelines and the regulatory framework for prompt corrective
      action, the Bank must meet specific capital guidelines that involve quantitative
      measures of the Bank's assets, liabilities and certain off-balance sheet items
      as calculated under regulatory accounting practices. The Bank's capital amounts
      and classification are also subject to qualitative judgments by the regulators
      about components, risk weightings and other factors.





Quantitative
      measures established by regulation to ensure capital adequacy require the Bank
      to maintain amounts and ratios (set forth in the table below) of total and
      Tier
      I capital (as defined in the regulations) to risk-weighted assets (as defined)
      and Tier I capital (as defined) to average assets (as defined). Management
      believes, as of December 31, 2006, that the Bank met all capital adequacy
      requirements to which it is subject.





The
      Bank
      has been categorized as “well capitalized” by the OCC under the regulatory
      framework for prompt corrective action. To be categorized as well capitalized,
      the Bank must maintain minimum total risk-based, Tier I risk-based and Tier
      I
      leverage ratios. There are no conditions or events that management believes
      would prevent the Bank from continuing to be categorized as well
      capitalized.





76


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





The
      Bank’s actual capital amounts and ratios as of December 31, 2006 and
      2005
      are presented in the
      following tables:





**December
                31, 2006****Actual**
            
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            $
            25,951,690
            
            10.34
            %
            $
            20,074,000
            
            8.00
            %
            $
            25,093,000
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            22,814,690
            
            9.09
            %
            
            10,037,000
            
            4.00
            %
            
            15,056,000
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            22,814,690
            
            9.29
            %
            
            7,370,000
            
            3.00
            %
            
            12,284,000
            
            5.00
            %








**December
                31, 2005****Actual**
            
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            $
            21,668,568
            
            10.21
            %
            $
            16,675,000
            
            8.00
            %
            $
            20,843,000
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            18,668,568
            
            8.96
            %
            
            8,337,000
            
            4.00
            %
            
            12,506,000
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            18,668,568
            
            9.15
            %
            
            6,124,000
            
            3.00
            %
            
            10,206,000
            
            5.00
            %





Bay
      National Corporation’s actual capital amounts and ratios as of December 31, 2006 and
      2005
      are presented in the
      following tables:





**December
                31, 2006****Actual**
            
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            $
            29,979,493
            
            11.94
            %
            $
            20,084,000
            
            8.00
            %
            $
            25,104,000
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            26,337,366
            
            10.49
            %
            
            10,042,000
            
            4.00
            %
            
            15,063,000
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            26,337,366
            
            10.72
            %
            
            7,370,000
            
            3.00
            %
            
            12,284,000
            
            5.00
            %





77


**BAY
      NATIONAL CORPORATION**


Notes
      to
      Consolidated Financial Statements


For
      the
      years ended December 31, 2006, 2005 and 2004








**December
                31, 2005****Actual**
            
            
            **For
                Capital**
              **Adequacy
                Purpose**
            
            
            **To
                Be Well**
              **Capitalized
                Under**
              **Prompt
                Corrective**
              **Action
                Provisions****Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**
            
            
            **Amount**
            
            **Ratio**Total
                Capital (to Risk Weighted Assets):
            $
            26,826,078
            
            12.86
            %
            $
            16,686,000
            
            8.00
            %
            $
            20,857,000
            
            10.00
            %Tier
                I Capital (to Risk Weighted Assets):
            
            22,920,597
            
            10.99
            %
            
            8,343,000
            
            4.00
            %
            
            12,514,000
            
            6.00
            %Tier
                I Capital (to Average Assets):
            
            22,920,597
            
            11.23
            %
            
            6,124,000
            
            3.00
            %
            
            10,206,000
            
            5.00
            %





Banking
      regulations also limit the amount of dividends that may be paid without prior
      approval of the Bank's regulatory agencies. Regulatory approval is required
      to
      pay dividends which exceed the Bank’s net profits for the current year, plus its
      retained net profits for the preceding two years.





**14.**  **FAIR
      VALUE OF FINANCIAL INSTRUMENTS**





The
      Company discloses fair value information about financial instruments, for which
      it is practicable to estimate the value, whether or not such financial
      instruments are recognized on the balance sheet. Financial instruments have
      been
      defined broadly to encompass 99.0% of the Company's assets and 99.4% of its
      liabilities. Fair value is the amount at which a financial instrument could
      be
      exchanged in a current transaction between willing parties, other than in a
      forced sale or liquidation, and is best evidenced by a quoted market price,
      if
      one exists.





Quoted
      market prices, where available, are shown as estimates of fair market values.
      Because no quoted market prices are available for a significant part of the
      Company's financial instruments, the fair values of such instruments have been
      derived based on the amount and timing of future cash flows and estimated
      discount rates.





Present
      value techniques used in estimating the fair value of many of the Company's
      financial instruments are significantly affected by the assumptions used. In
      that regard, the derived fair value estimates cannot be substantiated by
      comparison to independent markets and, in many cases, could not be realized
      in
      immediate cash settlement of the instrument. Additionally, the accompanying
      estimates of fair values are only representative of the fair values of the
      individual financial assets and liabilities and should not be considered an
      indication of the fair value of the Company.





78


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004




The
      estimated fair values of the Company's financial instruments at December 31
      are
      as follows:





2006
            2005Estimated
            
            EstimatedCarrying
            Fair
            Carrying
            FairAmount
            Value
            Amount
            ValueFinancial
                AssetsCash
                and temporary investments(1)
            $
            33,898,204
            
            $
            33,898,204
            
            $
            7,493,621
            
            $
            7,493,621Investments
                available-for-sale
            697,526
            
            697,526
            
            1,540,386
            
            1,540,386Other
                equity securities
            1,117,100
            
            1,117,100
            
            794,440
            
            794,440Loans,
                net of allowances(2)
            214,840,678
            
            213,777,628
            
            196,589,961
            
            196,403,633Accrued
                interest receivable and other assets(3)
            1,654,381
            
            1,654,381
            
            1,199,924
            
            1,199,924Financial
                LiabilitiesDeposits
            $
            224,148,952
            
            $
            224,405,800
            
            $
            182,573,086
            
            $
            182,710,244Short-term
                borrowings
            1,545,000
            
            1,545,000
            
            1,444,158
            
            1,444,158Subordinated
                debt
            8,000,000
            7,993,481
            8,000,000
            
            8,090,097Accrued
                interest payable and other liabilities(3)
            811,755
            811,755
            361,506
            
            361,506




(1)
            Temporary
                investments include federal funds sold and overnight
                investments.


(2)
            Loans,
                net of allowances, include loans held for
                sale.


(3)
            Only
                financial instruments as defined in Statement of Financial Accounting
                Standards No. 107, “Disclosure about Fair Value of Financial Instruments,”
                are included in other assets and other
                liabilities.





The
      following methods and assumptions were used to estimate the fair value of each
      category of financial instruments for which it is practicable to estimate that
      value:





**Cash
      and due from banks, federal funds sold and overnight
      investments.** The
      carrying amount approximated the fair value.





**Loans
      held for sale.** The fair
      value of residential mortgage loans held for sale was derived from secondary
      market quotations for similar instruments.





**Investment
      Securities.** The fair
      value for U.S. Treasury securities was based upon quoted market
      bids.





**Other
      equity securities.** The fair
      value of Federal Reserve Bank and Federal Home Loan Bank of Atlanta stock is
      not
      readily determinable since these stocks are restricted as to
      marketability.





**Loans.** The fair
      value was estimated by computing the discounted value of estimated cash flows,
      adjusted for potential credit losses, for pools of loans having similar
      characteristics. The discount rate was based upon the current loan origination
      rate for a similar loan. Non-performing loans have an assumed interest rate
      of
      0%.





**Accrued
      interest receivable.** The
      carrying amount approximated the fair value of accrued interest, considering
      the
      short-term nature of the receivable and its expected collection.






79


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004


**Other
      assets.** The
      carrying amount approximated the fair value.





**Deposit
      liabilities.** The fair
      value of demand, money market savings and regular savings deposits, which have
      no stated maturity, were considered equal to their carrying amount, representing
      the amount payable on demand. These estimated fair values do not include the
      intangible value of core deposit relationships, which comprise a significant
      portion of the Bank’s deposit base. Management believes that the Bank’s core
      deposit relationships provide a relatively stable, low-cost funding source
      that
      has a substantial intangible value separate from the value of the deposit
      balances.





The
      fair
      value of time deposits was based upon the discounted value of contractual cash
      flows at current rates for deposits of similar remaining maturity.





**Short-term
      borrowings.** The
      carrying amount approximated the fair value of repurchase agreements due to
      their variable interest rates.





**Note
      payable.** The
      carrying amount approximated the fair value of the note payable due to their
      variable interest rates.





**Subordinated
      Debt.**  Carrying
      values were discounted using a cash flow approach based on market rates as
      of
      December 31, 2006.





**Other
      liabilities.** The
      carrying amount approximated the fair value of accrued interest payable, accrued
      dividends and premiums payable, considering their short-term nature and expected
      payment.





**Off-balance
      sheet instruments.** The
      Company charges fees for commitments to extend credit. Interest rates on loans,
      for which these commitments are extended, are normally committed for periods
      of
      less than one month. Fees charged on standby letters of credit and other
      financial guarantees are deemed to be immaterial and **** these
      guarantees are expected to be settled at face amount or expire unused. It is
      impractical to assign any fair value to these commitments.




80


**BAY
      NATIONAL CORPORATION**


Notes
      to
      Consolidated Financial Statements


For
      the
      years ended December 31, 2006, 2005 and 2004


**15.**  **PARENT
      COMPANY FINANCIAL INFORMATION**





Condensed
      financial information for Bay National Corporation (Parent Only) is as
      follows:





CONDENSED
      BALANCE SHEETS


December
      31, 2006 and 2005


2006
            
            2005ASSETSCash
                and cash equivalents
            
            $
            5,450
            
            $
            5,212Due
                from subsidiary
            
            
            4,019,503
            
            
            5,432,231Investment
                in subsidiary
            
            
            23,062,691
            
            
            18,916,568Other
                assets
            
            
            108,883
            
            
            134,894Total
                Assets
            
            $
            27,196,527
            
            $
            24,488,905LIABILITIESAccrued
                expenses and other liabilities
            
            $
            106,034
            
            $
            26,827Subordinated
                debt
            
            
            8,248,000
            
            
            8,248,000Total
                Liabilities
            
            
            8,354,034
            
            
            8,274,827STOCKHOLDERS'
                EQUITYCommon
                stock - $.01 par value, authorized:9,000,000
                shares authorized, 1,935,369 and 1,924,436 issued
              and
                outstanding as of December 31, 2006 and 2005,
                respectively:
            
            
            19,354
            
            
            19,244Additional
                paid in capital
            
            
            17,649,678
            
            
            17,451,201Retained
                earnings (accumulated deficit)
            
            
            1,173,461
            
            
            (1,256,367
            )Total
                Stockholders' Equity
            
            
            18,842,493
            
            
            16,214,078Total
                Liabilities and Stockholders' Equity
            
            $
            27,196,527
            
            $
            24,488,905










81


**BAY
        NATIONAL CORPORATION**
 Notes
        to
        Consolidated Financial Statements
 For
        the
        years ended December 31, 2006, 2005 and 2004





CONDENSED
      STATEMENTS OF OPERATIONS


For
      the
      years ended December 31, 2006, 2005 and 2004





2006
            
            2005
            
            2004Interest
                and dividends on investment securities
            
            $
            238
            
            $
            1,376
            
            $
            2,231Interest
                expense
            
            
            603,567
            
            
            119,817
            
            
            6,302Net
                interest expense
            
            
            (603,329
            )
            
            (118,441
            )
            
            (4,071
            )Non-interest
                expense
            
            
            162,966
            
            
            -
            
            
            1,335Loss
                before income taxes and equity in undistributed losses of
                subsidiary
            
            
            (766,295
            )
            
            (118,441
            )
            
            (5,406
            )Income
                tax expense (benefit)
            
            
            -
            
            
            (257,000
            )
            
            -Income
                (loss) before equity in undistributed income (losses) of
                subsidiary
            
            
            (766,295
            )
            
            138,559
            
            
            (5,406
            )Equity
                in undistributed income of subsidiary
            
            
            3,196,123
            
            
            2,605,771
            
            
            807,670Net
                Income
            
            $
            2,429,828
            
            $
            2,744,330
            
            $
            802,264





CONDENSED
      STATEMENTS OF CASH FLOWS


For
      the
      years ended December 31, 2006, 2005 and 2004





2006
            
            2005
            
            2004Cash
                Flows From Operating ActivitiesNet
                Income
            
            $
            2,429,828
            
            $
            2,744,330
            
            $
            802,264Adjustments
                to reconcile net income (loss) to net cash(used)
                provided by operating activities:Equity
                in undistributed (income) loss of subsidiary
            
            
            (3,196,123
            )
            
            (2,605,771
            )
            
            (807,670
            )Stock
                based compensation expense
            
            
            115,714
            
            
            -
            
            
            -Net
                decrease (increase) in other assets
            
            
            1,438,739
            
            
            (5,429,625
            )
            
            812,686Net
                increase in other liabilities
            
            
            79,207
            
            
            20,525
            
            
            6,302Net
                cash provided by (used in) operating activities
            
            
            867,365
            
            
            (5,270,541
            )
            
            813,582Cash
                Flows From Investing ActivitiesInvestment
                in subsidiary
            
            
            (950,000
            )
            
            (1,878,000
            )
            
            (3,162,500
            )Net
                cash used in investing activities
            
            
            (950,000
            )
            
            (1,878,000
            )
            
            (3,162,500
            )Cash
                Flows From Financing ActivitiesNet
                proceeds (payoff) from note payable
            
            
            -
            
            
            (1,250,000
            )
            
            1,250,000Proceeds
                from issuance of preferred stock
            
            
            -
            
            
            8,248,000
            
            
            -Issuance
                of common stock
            
            
            82,873
            
            
            50,984
            
            
            550,000Net
                cash provided by financing activities
            
            
            82,873
            
            
            7,048,984
            
            
            1,800,000Net
                increase (decrease) in cash and cash equivalents
            
            
            238
            
            
            (99,557
            )
            
            (548,918
            )Cash
                and cash equivalents at beginning of year
            
            
            5,212
            
            
            104,769
            
            
            653,687Cash
                and cash equivalents at end of year
            
            $
            5,450
            
            $
            5,212
            
            $
            104,769







82





Item8.
      Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure





There
      has
      been no occurrence requiring a response to this Item.





Item
      8A. Controls and Procedures





As
      of the
      end of the period covered by this annual report on Form 10-KSB, Bay National
      Corporation’s Chief Executive Officer and Chief Financial Officer evaluated the
      effectiveness of Bay National Corporation’s disclosure controls and procedures.
      Based upon that evaluation, Bay National Corporation’s Chief Executive Officer
      and Chief Financial Officer concluded that Bay National Corporation’s disclosure
      controls and procedures are effective as of December 31, 2006. Disclosure
      controls and procedures are controls and other procedures that are designed
      to
      ensure that information required to be disclosed by Bay National Corporation
      in
      the reports that it files or submits under the Exchange Act is recorded,
      processed, summarized and reported within the time periods specified in the
      Securities and Exchange Commission’s rules and forms.





In
      addition, there were no changes in Bay National Corporation’s internal control
      over financial reporting (as defined in Rule 13a-15 under the Exchange Act)
      during the quarter ended December 31, 2006, that have materially affected,
      or
      are reasonably likely to materially affect, Bay National Corporation’s internal
      control over financial reporting.





Item
      8B. Other Information





On
      December 18, 2006, the Compensation Committee of the Board of Directors of
      Bay
      National Bank increased, effective January 1, 2007, Hugh Mohler’s annual base
      compensation from $225,000 to $240,000, Richard Oppitz’s annual base
      compensation from $140,000 to $154,000, Mark Semanie’s annual base compensation
      from $180,000 to $185,000 and Richard Springer’s annual base compensation from
      $200,000 to $206,000.








83


**PART
      III**





Item
      9. Directors, Executive Officers, Promoters, Control Persons
      and Corporate Governance; Compliance with Section 16(a) of the Exchange
      Act





**Code
      of Ethics**





Bay
      National Corporation’s Board of Directors has adopted a code of conduct that
      applies to all of its directors, officers and employees, including it principal
      executive officer, principal financial officer, principal accounting officer
      or
      controller and persons performing similar functions. That Code of Conduct is
      posted on Bay National Bank’s internet website at www.baynational.com .





The
      remaining information required by this Item 9 is incorporated by reference
      to the information appearing under the captions “Proposal 1. Election of
      Director,” “Board Meetings and Committees” and “Section 16(a) Beneficial
      Ownership Reporting Compliance” in the Proxy Statement for the 2007 Annual
      Meeting of Stockholders of Bay National Corporation.





Item10.
      Executive Compensation





The
      information required by this Item 10 is incorporated by reference to the
      information appearing under the captions “Director Compensation” and “Executive
      Compensation” in the Proxy Statement for the 2007 Annual Meeting of Stockholders
      of Bay National Corporation.





84


Item
      11. Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters





**Securities
      Authorized For Issuance Under Equity Compensation Plans**





The
      following table sets forth certain information as of December 31, 2006,
      with respect to compensation plans under which equity securities of Bay National
      Corporation are authorized for issuance.





**Equity
                Compensation Plan Information**Plan
                category
            
            Number
                of securities
              to
                be issued upon
              exercise
                of
              outstanding
                options
              and
                warrants
              
              
              (a)
            
            
            Weighted-average
              exercise
                price of
              outstanding
                options
              and
                warrants
              
              
              
              (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
            
            128,591
            
            
            $
                7.68
            
            
            53,750Equity
                compensation plans not
              approved
                by security holders
            
            -
            
            
            -
            
            
            -Total
            
            128,591
            
            
            $
                7.68
            
            
            53,750





The
      remaining information required by this Item 11 is incorporated by reference
      to the information appearing under the caption “Security Ownership of Management
      and Certain Securityholders” in the Proxy Statement for the 2007 Annual Meeting
      of Stockholders of Bay National Corporation.





Item
      12. Certain Relationships and Related Transactions, and
      Director Independence





The
      information required by this Item 12 is incorporated by reference to the
      information appearing under the captions “Proposal 1. Election of Directors” and
“Certain Relationships and Related Transactions” in the Proxy Statement for the
      2007 Annual Meeting of Stockholders of Bay National Corporation.


85


Item13.
      Exhibits





The
      following exhibits are filed with or incorporated by reference into this report.


No.
              Description
                  of Exhibit3.1*
              Articles
                  of Incorporation of Bay National Corporation3.2*
              Bylaws
                  of Bay National Corporation4.1*
              Rights
                  of Holders of Common Stock (as contained in Exhibit
                  3.1)4.2*
              Form
                  of Common Stock Certificate4.3
              Indenture
                  dated as of December 12, 2005 between Bay National Corporation
                  and
                  Wilmington Trust Company, as Trustee.4.4
              Amended
                  and Restated Declaration of Trust dated as of December 12, 2005
                  between
                  Wilmington Trust Company, as the Trustees of Bay National Capital
                  Trust I,
                  Bay National Corporation, as Sponsor, and Hugh W. Mohler, Mark
                  A. Semanie
                  and Warren F. Boutilier, as the Administrators.4.5
              Guarantee
                  Agreement dated as of December 12, 2005 between Bay National Corporation
                  and Wilmington Trust Company.10.1
              Amended
                  and Restated Employment Agreement, dated as of June 1, 2006, between
                  Bay
                  National Bank and Hugh W. Mohler.10.2+
              Employment
                  Agreement, dated as of June 1, 2006, between Bay National Bank
                  and Richard
                  C. Springer.10.3+
              Terms
                  of December 2007 Amendment to Employment Agreement
                  between Bay National Bank and Hugh W. Mohler10.3.1
              Terms
                  of December 2007 Amendment to Employment
                  Agreement between Bay National Bank and Richard J.
                  Oppitz10.3.2
              Terms
                  of December 2007 Amendment to Employment
                  Agreement between Bay National Bank and Mark A.
                  Semanie10.3.3
              Terms
                  of December 2007 Amendment to Employment
                  Agreement between Bay National Bank and Richard C.
                  Springer10.4
              Terms
                  of Employment Arrangement between Bay National Bank and Mark A.
                  Semanie10.5**
              Bay
                  National Corporation Stock Option Plan10.6**
              Form
                  of Incentive Stock Option Agreement for Stock Option
                  Plan10.7#
              Bay
                  National Corporation and Bay National Bank Director Compensation
                  Policy10.8*
              Office
                  Lease Agreement dated July 16, 1999 between Bay National Corporation
                  and
                  Joppa Green II Limited Partnership10.9*
              Office
                  Lease Agreement dated July 16, 1999 between Bay National Corporation
                  and
                  Joppa Green II Limited Partnership10.10##
              Amendment
                  to Lease Agreement dated February 12, 2004 between Bay National
                  Corporation and Joppa Green II Limited Partnership10.11##
              Amendment
                  to Lease Agreement dated October 5, 2004 between Bay National Corporation
                  and Joppa Green II Limited Partnership10.12##
              Amendment
                  to Lease Agreement dated January 3, 2005 between Bay National Corporation
                  and Joppa Green II Limited Partnership10.13##
              Amendment
                  to Lease Agreement dated March 7, 2005 between Bay National Corporation
                  and Joppa Green II Limited Partnership10.14*
              Lease
                  Agreement dated September 16, 1999 between Bay National Corporation
                  and
                  John R. Lerch and Thomas C.
                  Thompson
   86
   21.1
              Subsidiaries
                  of Bay National
                  Corporation23.1
              Consent
                  of Stegman & Company31.1
              Rule
                  13a-14(a) Certification of Chief Executive Officer31.2
              Rule
                  13a-14(a) Certification of Chief Financial Officer32
              Section
                  1350 Certification of Chief Executive Officer and
                  Chief Financial Officer




The
      exhibits which are denominated with an asterisk (*) were previously filed by
      Bay
      National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Registration Statement on Form SB-2, as
      amended, under the Securities Act of 1933, Registration Number
      333-87781.





The
      exhibits which are denominated by the plus sign (+) were previously filed by
      Bay
      National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Current Report on Form 8-K filed on June 6,
      2006.





The
      exhibits which are denominated by two asterisks (**) were previously filed
      by
      Bay National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Registration Statement on Form S-8, as amended,
      under the Securities Act of 1933, Registration Number 333-69428.





The
      exhibit which is denominated by the number sign (#) was previously filed by
      Bay
      National Corporation as a part of, and is hereby incorporated by reference
      from,
      Bay National Corporation’s Current Report on Form 8-K filed on January 26,
      2005.





The
      exhibits which are denominated by two number signs (##) were previously filed
      by
      Bay National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Current Report on Form 8-K filed on March 11,
      2005.





Note:
      Exhibits 10.1 through 10.7 relate to management contracts or compensatory plans
      or arrangements.





87


Item
      14. Principal Accountant Fees and Services.





The
      information required by this Item 14 is incorporated by reference to the
      information appearing under the captions “Audit Committee Report - Audit and
      Non-Audit Fees” and “Audit Committee Report - Policy on Audit Committee
      Pre-Approval of Audit and Non-Audit Services of Independent Auditor” in the
      Proxy Statement for the 2007 Annual Meeting of Stockholders of Bay National
      Corporation.








88


**SIGNATURES**
 
 In
        accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
        this report to be signed on its behalf by the undersigned, thereunto duly
        authorized.
  BAY
        NATIONAL
        CORPORATION
 
 Date:
                  March 26, 2007
              By:/s/ Hugh W. Mohler
              Hugh
                  W. Mohler, President
 
 In
        accordance with the Exchange Act, this report has been signed below by the
        following persons on behalf of the registrant and in the capacities and on
        the
        dates indicated.
 
 
 **Name**
              **Position**
              **Date**/s/
                  Hugh W. Mohler
                Hugh
                  W. Mohler
              Director
                  and President
                (Principal
                  Executive Officer)
              March
                  26, 2007/s/
                  Mark A. Semanie.
                Mark
                  A. Semanie
              Executive
                  Vice President and CFO
                (Principal
                  Accounting and Financial Officer)
              March
                  26, 2007/s/
                  Charles E. Bounds
                Charles
                  E. Bounds
              Director
              March
                  28, 2007/s/
                  Gary T. Gill
                Gary
                  T. Gill
              Director
              March
                  30, 2007/s/
                  R. Michael Gill
                R.
                  Michael Gill
              Director
              March
                  30, 2007/s/
                  John R. Lerch
                John
                  R. Lerch
              Director
              March
                  26, 2007/s/Donald
                  G. McClure, Jr.
                Donald
                  G. McClure, Jr.
              Director
              March
                  26, 2007/s/
                  Robert L. Moore
                Robert
                  L. Moore
              Director
              March
                  28, 2007/s/
                  James P. O'Conor
                James
                  P. O’Conor
              Director
              March
                  27, 2007/s/H.
                  Victor Rieger, Jr.
                H.
                  Victor Rieger, Jr.
              Director
              March
                  27, 2007
   89
  /s/
                  William B. Rinnier
                William
                  B. Rinnier
              Director
              March
                  29, 2007/s/
                  Edwin A. Rommel
                Edwin
                  A. Rommel, III
              Director
              March
                  26, 2007/s/Henry
                  H. Stansbury
                Henry
                  H. Stansbury
              Director
              March
                  27, 2007/s/
                  Kenneth H. Trout
                Kenneth
                  H. Trout
              Director
              March
                  29, 2007/s/
                  Eugene M. Waldron, Jr.
                Eugene
                  M. Waldron, Jr.
              Director
              March
                  26, 2007/s/
                  Carl A. J. Wright
                Carl
                  A.J. Wright
              Director
              March
                  28, 2007





90





EXHIBIT
      INDEX




No.
                Description
                    of Exhibit3.1*
                Articles
                    of Incorporation of Bay National Corporation3.2*
                Bylaws
                    of Bay National Corporation4.1*
                Rights
                    of Holders of Common Stock (as contained in Exhibit
                    3.1)4.2*
                Form
                    of Common Stock Certificate4.3
                Indenture
                    dated as of December 12, 2005 between Bay National Corporation
                    and
                    Wilmington Trust Company, as Trustee.4.4
                Amended
                    and Restated Declaration of Trust dated as of December 12, 2005
                    between
                    Wilmington Trust Company, as the Trustees of Bay National Capital
                    Trust I,
                    Bay National Corporation, as Sponsor, and Hugh W. Mohler, Mark
                    A. Semanie
                    and Warren F. Boutilier, as the Administrators.4.5
                Guarantee
                    Agreement dated as of December 12, 2005 between Bay National
                    Corporation
                    and Wilmington Trust Company.10.1
                Amended
                    and Restated Employment Agreement, dated as of June 1, 2006,
                    between Bay
                    National Bank and Hugh W. Mohler.10.2+
                Employment
                    Agreement, dated as of June 1, 2006, between Bay National Bank
                    and Richard
                    C. Springer.10.3+
                Terms
                    of December 2007 Amendment to Employment Agreement
                    between Bay National Bank and Hugh W. Mohler10.3.1
                Terms
                    of December 2007 Amendment to Employment
                    Agreement between Bay National Bank and Richard J.
                    Oppitz10.3.2
                Terms
                    of December 2007 Amendment to Employment
                    Agreement between Bay National Bank and Mark A.
                    Semanie10.3.3
                Terms
                    of December 2007 Amendment to Employment
                    Agreement between Bay National Bank and Richard C.
                    Springer10.4
                Terms
                    of Employment Arrangement between Bay National Bank and Mark
                    A.
                    Semanie10.5**
                Bay
                    National Corporation Stock Option Plan10.6**
                Form
                    of Incentive Stock Option Agreement for Stock Option
                    Plan10.7#
                Bay
                    National Corporation and Bay National Bank Director Compensation
                    Policy10.8*
                Office
                    Lease Agreement dated July 16, 1999 between Bay National Corporation
                    and
                    Joppa Green II Limited Partnership10.9*
                Office
                    Lease Agreement dated July 16, 1999 between Bay National Corporation
                    and
                    Joppa Green II Limited Partnership10.10##
                Amendment
                    to Lease Agreement dated February 12, 2004 between Bay National
                    Corporation and Joppa Green II Limited Partnership10.11##
                Amendment
                    to Lease Agreement dated October 5, 2004 between Bay National
                    Corporation
                    and Joppa Green II Limited Partnership10.12##
                Amendment
                    to Lease Agreement dated January 3, 2005 between Bay National
                    Corporation
                    and Joppa Green II Limited Partnership10.13##
                Amendment
                    to Lease Agreement dated March 7, 2005 between Bay National Corporation
                    and Joppa Green II Limited Partnership10.14*
                Lease
                    Agreement dated September 16, 1999 between Bay National Corporation
                    and
                    John R. Lerch and Thomas C.
                    Thompson
 21.1
                Subsidiaries
                    of Bay National
                    Corporation23.1
                Consent
                    of Stegman & Company31.1
                Rule
                    13a-14(a) Certification of Chief Executive Officer31.2
                Rule
                    13a-14(a) Certification of Chief Financial Officer32
                Section
                    1350 Certification of Chief Executive Officer and
                    Chief Financial Officer




91




The
      exhibits which are denominated with an asterisk (*) were previously filed by
      Bay
      National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Registration Statement on Form SB-2, as
      amended, under the Securities Act of 1933, Registration Number
      333-87781.





The
      exhibits which are denominated by the plus sign (+) were previously filed by
      Bay
      National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Current Report on Form 8-K filed on June 6,
      2006.





The
      exhibits which are denominated by two asterisks (**) were previously filed
      by
      Bay National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Registration Statement on Form S-8, as amended,
      under the Securities Act of 1933, Registration Number 333-69428.





The
      exhibit which is denominated by the number sign (#) was previously filed by
      Bay
      National Corporation as a part of, and is hereby incorporated by reference
      from,
      Bay National Corporation’s Current Report on Form 8-K filed on January 26,
      2005.





The
      exhibits which are denominated by two number signs (##) were previously filed
      by
      Bay National Corporation as a part of, and are hereby incorporated by reference
      from, Bay National Corporation’s Current Report on Form 8-K filed on March 11,
      2005.





Note:
      Exhibits 10.1 through 10.7 relate to management contracts or compensatory plans
      or arrangements.







92