UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION


WASHINGTON,
      D.C. 20549








FORM
      10-QSB








QUARTERLY
      REPORT UNDER SECTION 13 OR 15 (d)


OF
      THE
      SECURITIES EXCHANGE ACT OF 1934








For
      the
      quarterly period ended June 30, 2006





Commission
      file number: 000-51765











**Bay
      National Corporation**


(Exact
      name of small business issuer as specified in its charter)





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





2328
      West Joppa Road, Lutherville, MD 21093


Address
      of principal executive offices





(410)
      494-2580


Issuer’s
      telephone number





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





Indicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act).
            Yes
                ____   NoX





State
      the
      number of shares outstanding of each of the issuer’s classes of common equity,
      as of the latest practicable date:





At
      August
      10, 2006, the issuer had 1,933,894 shares of Common Stock
      outstanding.





Transitional
                Small Business Disclosure Format (Check One):
            Yes
                ____    No X








**PART
      I -**  **FINANCIAL
      INFORMATION**





**Item
      1.****Financial
      Statements**





**BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      BALANCE SHEETS


As
      of
      June 30, 2006 and December 31, 2005





June
                30, 2006
            
            
            December
                31, 2005ASSETS
            
            
            
            
            (Unaudited)Cash
                and due from banks
            
            
            
            $
            4,061,111
            
            $
            1,460,669Federal
                funds sold and other overnight investments
            
            
            
            
            4,759,993
            
            
            6,032,952Investment
                securities available for sale (AFS) - at fair value
            
            
            
            
            698,412
            
            
            1,540,386Other
                equity securities
            
            
            
            
            1,075,840
            
            
            794,440Loans
                held for sale
            
            
            
            
            6,517,855
            
            
            17,509,064Loans,
                net of unearned fees
            
            
            
            
            211,873,449
            
            
            182,080,897Total
                loans
            
            
            
            
            218,391,304
            
            
            199,589,961Less:
                Allowance for credit losses
            
            
            
            
            (3,000,000
            )
            
            (3,000,000
            )Loans,
                net
            
            
            
            
            215,391,304
            
            
            196,589,961Premises
                and equipment, net
            
            
            
            
            1,026,092
            
            
            746,826Accrued
                interest receivable and other assets
            
            
            
            
            3,051,901
            
            
            2,801,101Total
                Assets
            
            
            
            $
            230,064,653
            
            $
            209,966,335LIABILITIESNon-interest-bearing
                deposits
            
            
            
            $
            30,350,943
            
            $
            27,468,757Interest-bearing
                deposits
            
            
            
            
            168,554,655
            
            
            155,104,329Total
                deposits
            
            
            
            
            198,905,598
            
            
            182,573,086Short-term
                borrowings
            
            
            
            
            3,975,000
            
            
            1,444,158Subordinated
                debt
            
            
            
            
            8,000,000
            
            
            8,000,000Accrued
                expenses and other liabilities
            
            
            
            
            1,588,592
            
            
            1,735,013Total
                Liabilities
            
            
            
            
            212,469,190
            
            
            193,752,257STOCKHOLDERS'
                EQUITYCommon
                stock - $.01 par value, authorized:9,000,000
                shares authorized, 1,930,894 and 1,924,436 issuedand
                outstanding as of June 30, 2006 and December 31, 2005,
                respectively
            
            
            
            
            19,309
            
            
            19,244Additional
                paid in capital
            
            
            
            
            17,557,620
            
            
            17,451,201Retained
                earnings (accumulated deficit)
            
            
            
            
            18,534
            
            
            (1,256,367
            )Total
                Stockholders' Equity
            
            
            
            
            17,595,463
            
            
            16,214,078Total
                Liabilities and Stockholders' Equity
            
            
            
            $
            230,064,653
            
            $
            209,966,335


See
      accompanying notes to consolidated financial statements.





2


**BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      STATEMENTS OF OPERATIONS


For
      the
      three and six-month periods ended June 30, 2006 and 2005


(Unaudited)





Three
                Months Ending
              June
                30
            
            
            Six
                Months Ending
              June
                302006
            
            
            2005
            
            
            2006
            
            
            2005INTEREST
                INCOME:Interest
                and fees on loans
            $
            4,738,860
            
            $
            2,776,966
            
            $
            8,962,274
            
            $
            5,240,226Interest
                on federal funds sold and other overnight investments
            
            88,074
            
            
            45,306
            
            
            150,463
            
            
            111,784Taxable
                interest and dividends on investmentsecurities
            
            39,688
            
            
            25,762
            
            
            61,130
            
            
            37,368Total
                interest income
            
            4,866,622
            
            
            2,848,034
            
            
            9,173,867
            
            
            5,389,378INTEREST
                EXPENSE:Interest
                on deposits
            
            1,705,133
            
            
            873,777
            
            
            3,139,995
            
            
            1,664,246Interest
                on short-term borrowings
            
            35,216
            
            
            37,434
            
            
            52,936
            
            
            45,550Interest
                on note payable
            
            -
            
            
            18,527
            
            
            -
            
            
            35,523Interest
                on subordinated debt
            
            150,088
            
            
            -
            
            
            300,077
            
            
            -Total
                interest expense
            
            1,890,437
            
            
            929,738
            
            
            3,493,008
            
            
            1,745,319Net
                interest income
            
            2,976,185
            
            
            1,918,296
            
            
            5,680,859
            
            
            3,644,059Provision
                for credit losses
            
            -
            
            
            203,500
            
            
            -
            
            
            235,500Net
                interest income after provision forcredit
                losses
            
            2,976,185
            
            
            1,714,796
            
            
            5,680,859
            
            
            3,408,559NON-INTEREST
                INCOME:Service
                charges on deposit accounts
            
            42,022
            
            
            44,703
            
            
            82,761
            
            
            93,942Gain
                on sale of mortgage loans
            
            191,603
            
            
            104,147
            
            
            274,859
            
            
            145,751Other
                income
            
            20,590
            
            
            11,551
            
            
            36,875
            
            
            22,937Total
                non-interest income
            
            254,215
            
            
            160,401
            
            
            394,495
            
            
            262,630NON-INTEREST
                EXPENSES:Salaries
                and employee benefits
            
            1,347,869
            
            
            832,896
            
            
            2,578,011
            
            
            1,581,491Occupancy
                expenses
            
            121,534
            
            
            100,709
            
            
            243,942
            
            
            194,883Furniture
                and equipment expenses
            
            80,162
            
            
            74,791
            
            
            163,836
            
            
            151,882Legal
                and professional fees
            
            56,506
            
            
            32,712
            
            
            92,089
            
            
            72,712Data
                processing and other outside services
            
            183,756
            
            
            143,010
            
            
            345,920
            
            
            351,835Advertising
                and marketing related expenses
            
            167,723
            
            
            90,850
            
            
            236,357
            
            
            152,635Other
                expenses
            
            155,448
            
            
            162,107
            
            
            298,365
            
            
            298,139Total
                non-interest expenses
            
            2,112,998
            
            
            1,437,075
            
            
            3,958,520
            
            
            2,803,577Income
                before income taxes
            
            1,117,402
            
            
            438,122
            
            
            2,116,834
            
            
            867,612Income
                tax expense
            
            444,576
            
            
            -
            
            
            841,933
            
            
            -NET
                INCOME
            $
            672,826
            
            $
            438,122
            
            $
            1,274,901
            
            $
            867,612Per
                Share Data:Cash
                Dividends Paid
            $
            -
            
            
            -
            
            $
            -
            
            
            -Net
                Income (basic)
            $
            .35
            
            
            .23
            
            $
            .66
            
            
            .45Net
                Income (diluted)
            $
            .33
            
            
            .22
            
            $
            .63
            
            
            .44Weighted
                Average shares outstanding (basic)
            
            1,929,674
            
            
            1,921,649
            
            
            1,927,866
            
            
            1,920,693Effect
                of Dilution - Stock options and Warrants
            
            79,831
            
            
            76,269
            
            
            82,309
            
            
            72,020Weighted
                Average shares outstanding (diluted)
            
            2,009,505
            
            
            1,997,918
            
            
            2,010,175
            
            
            1,992,713





See
      accompanying notes to consolidated financial statements.





3


**BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY


For
      the
      six-months ended June 30, 2006 and 2005


(Unaudited)











Common
                Stock
            
            
            Additional
                Paid in Capital
            
            
            Retained
                Earnings
              (Accumulated
              Deficit)
            
            
            Total
                Stockholders’ EquityBalances
                at December 31, 2005
            $
            19,244
            
            $
            17,451,201
            
            $
            (1,256,367
            )
            $
            16,214,078Issuance
                of Common Stock
            
            65
            
            
            48,887
            
            
            -
            
            
            48,952Stock
                based compensation expense
            
            -
            
            
            57,532
            
            
            -
            
            
            57,532Net
                Income
            
            -
            
            
            -
            
            
            1,274,901
            
            
            1,274,901Balances
                at June 30, 2006
            $
            19,309
            
            $
            17,557,620
            
            $
            18,534
            
            $
            17,595,463Common
                Stock
            
            
            Additional
                Paid in Capital
            
            
            Accumulated
              Deficit
            
            
            Total
                Stockholders’ EquityBalances
                at December 31, 2004
            $
            19,177
            
            $
            17,400,284
            
            $
            (4,000,697
            )
            $
            13,418,764Issuance
                of Common Stock
            
            67
            
            
            50,917
            
            
            -
            
            
            50,984Net
                Income
            
            -
            
            
            -
            
            
            867,612
            
            
            867,612Balances
                at June 30, 2005
            $
            19,244
            
            $
            17,451,201
            
            $
            (3,133,085
            )
            $
            14,337,360













See
      accompanying notes to consolidated financial statements.





4


**BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      STATEMENTS OF CASH FLOWS


For
      the
      six-months ended June 30, 2006 and 2005


(Unaudited)





2006
            
            
            2005Cash
                Flows From Operating ActivitiesNet
                income
            $
            1,274,901
            
            $
            867,612Adjustments
                to reconcile net income to net cash provided (used)by
                operating activities:Depreciation
            
            110,055
            
            
            86,509Accretion
                of investment discounts
            
            (33,302
            )
            
            (19,872
            )Provision
                for credit losses
            
            -
            
            
            235,500Stock-based
                compensation expense
            
            57,532
            
            
            -Gain
                on sale of loans held for sale
            
            (274,859
            )
            
            (145,751
            )Origination
                of loans held for sale
            
            (57,926,124
            )
            
            (77,927,607
            )Proceeds
                from sale of loans
            
            69,192,192
            
            
            70,824,346Net
                increase in accrued interest receivable and other assets
            
            (250,800
            )
            
            (289,739
            )Net
                increase (decrease) in accrued expenses and other
                liabilities
            
            (146,421
            )
            
            40,142Net
                cash provided (used) by operating activities
            
            12,003,174
            
            
            (6,328,860
            )Cash
                Flows From Investing ActivitiesPurchases
                of investment securities - AFS
            
            (2,824,724
            )
            
            (3,078,068
            )Maturities
                of investment securities - AFS
            
            3,700,000
            
            
            3,100,000Purchase
                of Federal Reserve Bank stock
            
            (113,700
            )
            
            (139,650
            )Purchase
                of Federal Home Loan Bank of Atlanta stock
            
            (167,700
            )
            
            (98,700
            )Loan
                disbursements in excess of principal payments
            
            (29,792,552
            )
            
            (16,001,773
            )Capital
                expenditures
            
            (389,321
            )
            
            (292,435
            )Net
                cash used in investing activities
            
            (29,587,997
            )
            
            (16,510,626
            )Cash
                Flows From Financing ActivitiesNet
                increase in deposits
            
            16,332,512
            
            
            14,541,189Net
                increase in short-term borrowings
            
            2,530,842
            
            
            117,000Proceeds
                from Notes Payable
            
            -
            
            
            250,000Net
                proceeds from stock issuance
            
            48,952
            
            
            50,984Net
                cash provided by financing activities
            
            18,912,306
            
            
            14,959,173Net
                increase (decrease) in cash and cash equivalents
            
            1,327,483
            
            
            (7,880,313
            )Cash
                and cash equivalents at beginning of period
            
            7,493,621
            
            
            18,111,952Cash
                and cash equivalents at end of period
            $
            8,821,104
            
            $
            10,231,639Cash
                paid for:Interest
            $
            3,342,323
            
            $
            1,705,524Income
                taxes
            $
            910,392
            
            $
            -




See
      accompanying notes to consolidated financial statements.




5


**BAY
      NATIONAL CORPORATION**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


For
      the
      Three and Six Months Ended June 30, 2006 and 2005


(Unaudited)





**1.**  **GENERAL**





*Organization*





Bay
      National Corporation (the “Company”) was incorporated on June 3, 1999 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 “Bank”). On May 12, 2000, the Company
      purchased all the shares of common stock issued by the Bank. The Bank commenced
      operations on May 12, 2000 after successfully meeting the conditions of the
      Office of the Comptroller of the Currency (the “OCC”) to receive its charter
      authorizing it to commence operations as a national bank, and obtaining the
      approval of the Federal Deposit Insurance Corporation to insure its deposit
      accounts, and meeting certain other regulatory requirements.





*Basis
      of Presentation*





The
      accompanying consolidated financial statements include the activity of Bay
      National Corporation and its wholly owned subsidiary, Bay National Bank. All
      significant intercompany transactions and balances have been eliminated in
      consolidation.





The
      foregoing consolidated financial statements are unaudited; however, in the
      opinion of management, all adjustments (comprising only normal recurring
      accruals) necessary for a fair presentation of the results of the interim
      periods have been included. The balances as of December 31, 2005 have been
      derived from audited financial statements. These consolidated financial
      statements should be read in conjunction with the financial statements and
      accompanying notes included in Bay National Corporation’s 2005 Annual Report on
      Form 10-KSB. There have been no significant changes to the Company’s Accounting
      Policies as disclosed in the 2005 Annual Report. The results shown in this
      interim report are not necessarily indicative of results to be expected for
      the
      full year 2006 or any other interim period.





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.





*Reclassifications*





Certain
      reclassifications have been made to amounts previously reported to conform
      to
      the current presentation. These reclassifications had no effect on previously
      reported results of operations or accumulated deficit.





**2.**  **REGULATORY
      MATTERS**





The
      Bank
      is subject to various regulatory capital requirements administered by the
      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 financial statements. Under capital 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 weighting and other factors.





6


Quantitative
      measures established by regulation to ensure capital adequacy require the Bank
      to maintain minimum amounts and ratios. Management believes, as of June 30,
      2006, that the Bank meets all capital adequacy requirements to which it is
      subject.





As
      of
      June 30, 2006, 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.





**3.**  **INCOME
      TAXES**





The
      Company uses the liability method of accounting for income taxes as required
      by
      SFAS No. 109, “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 that will be in effect when these differences reverse. Deferred income
      taxes were not recognized until the fourth quarter of 2005 when it was deemed
      more likely than not that the benefits of such deferred income taxes would
      be
      realized; accordingly, no deferred income taxes or income tax benefits were
      recorded by the Company for the six months ended June 30, 2005.





**4.**  **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 earnings 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.




**5.
      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 three and six-month periods ended June 30, 2006. Prior periods have not
      been
      restated. ** Amounts
      recognized in the financial statements with respect to stock-based compensation
      are as follows:





Three
                Months Ending
              June
                30
            
            
            Six
                Months Ending
              June
                302006
            
            
            2005
            
            
            2006
            
            
            2005Amounts
                charged against income, before tax benefit
            $
            39,638
            
            $
            -
            
            $
            57,532
            
            $
            -Amount
                of related income tax benefit recognized in income
            $
            883
            
            $
            -
            
            $
            1,766
            
            $
            -





7


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
      and SFAS No. 148 to stock-based employee compensation for the three-month and
      six-month periods ended June 30, 2005:








Three
                Months
              Ending
              June
                30, 2005
            
            
            Six
                Months
              Ending
              June
                30, 2005Net
                income, as reported
            $
            438,122
            
            $
            867,612Less
                pro forma stock-based compensation expense determined under the fair
                value
                method, net of applicable tax effects
            
            (57,467
            )
            
            (74,478
            )Pro
                forma net income
            $
            380,655
            
            $
            793,134Net
                income per share:Basic
                - as reported
            $
            0.23
            
            $
            0.45Diluted
                - as reported
            $
            0.22
            
            $
            0.44Basic
                - pro forma
            $
            0.20
            
            $
            0.41Diluted
                - pro forma
            $
            0.19
            
            $
            0.40





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





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, equal to 100% of the fair market
      value of the common stock on the date of the grant, must be exercised within
      eight years of the date of grant and vest over a period of six
      years.





8


The
      following is a summary of changes in outstanding options for the six-month
      periods ended June 30, 2006 and 2005:





**Number
                of Shares**
            
            **Weighted
                Average Exercise Price**Balance,
                December 31, 2004
            
            
            147,492
            
            $
            7.67Granted
            
            
            -
            
            
            -Cancelled
            
            
            -
            
            
            -Exercised
            
            
            (4,242
            )
            $
            7.67Balance,
                June 30, 2005
            
            
            143,250
            
            $
            7.67Balance,
                December 31, 2005
            
            
            140,766
            
            $
            7.67Granted
            
            
            -
            
            
            -Cancelled
            
            
            (1,242
            )
            $
            7.58Exercised
            
            
            (6,458
            )
            $
            7.68Balance,
                June 30, 2006
            
            
            133,066
            
            $
            7.68Weighted
                average fair value of options granted during 2002
            
            $
            3.05





The
      following table summarizes information about options outstanding at June 30,
      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
            
            116,251
            
            3
            
            $7.58
            
            
            108,359
            
            $7.58$8.37
            
            16,815
            
            4
            
            $8.37
            
            
            6,079
            
            $8.37133,066
            
            
            
            $7.68
            
            
            114,438
            
            $7.62





The
      aggregate intrinsic value of options outstanding and exercisable as of June
      30,
      2006 was $1,493,000 and $1,290,634, respectively, based upon a closing price
      of
      $18.90 per share.





9


**Item
      2.**  **Management's
      Discussion and Analysis**





This
      discussion and analysis provides an overview of the financial condition and
      results of operations of Bay National Corporation (the “Parent”) and its
      national bank subsidiary, Bay National Bank (the “Bank”), collectively (the
“Company”), as of June 30, 2006 and December 31, 2005 and for the three-month
      and six-month periods ended June 30, 2006 and 2005.





**Overview**





On
      May
      12, 2000, the Parent became a bank holding company by purchasing all of the
      common stock of the Bank. The Bank opened its first office on May 12, 2000
      and
      its second office on May 26, 2000.





The
      Bank
      serves the business communities of North Baltimore and Salisbury,
      Maryland.





Asset
      growth continued for the six-month period ended June 30, 2006, while operating
      results continued to improve significantly over prior year results. Key
      measurements for the three-month and six-month periods ended June 30, 2006
      include the following:





·
            Total
                assets at June 30, 2006 increased to $230 million from $210 million
                as of
                December 31, 2005.





·
            Net
                loans outstanding increased from $196.6 million as of December 31,
                2005 to
                $215.4 million as of June 30, 2006.





·
            There
                was approximately $142,000 of nonperforming loans at June 30, 2006.
                The
                Company continues to maintain appropriate reserves for credit
                losses.





·
            Deposits
                at June 30, 2006 increased to $198.9 million from $182.6 million
                as of
                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 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 June
                30, 2006, the Company had approximately $6.6 million of CDARS deposits
                outstanding.





·
            Net
                income before income taxes was $1.1 million and $2.1 million for
                the
                three-month and six-month periods ended June 30, 2006, respectively,
                compared to $438,122 and $867,612 for the same periods in 2005. This
                represents an increase of 155.0% and 144.0% over net income before
                income
                taxes for the three-month and six-month periods ended June 30,
                2005.





·
            The
                Company realized net income of $672,826 and $1,274,901 for the three-month
                and six-month periods ended June 30, 2006, respectively. This represents
                an increase of 53.6% and 46.9% over net income of $438,122 and $867,612
                for the same periods ended June 30,
                2005.





10


·
            Net
                interest income, the Company’s main source of income, was $3.0 million and
                $5.7 million during the three-month and six-month periods ended June
                30,
                2006, respectively, compared to $1.9 million and $3.6 million for
                the same
                periods in 2005. This represents an increase of 55.1% and 55.9% for
                the
                three-month and six-month periods,
                respectively.





·
            There
                were no charge-offs for the six-month period ended June 30, 2006.
                There
                were recoveries on prior charge-offs of $7,500 for the six-month
                period
                ended June 30, 2005.





·
            Non-interest
                income increased by $93,814 and $131,865, or 58.5% and 50.2%, for
                the
                three-month and six-month periods ended June 30, 2006, respectively,
                as
                compared to the same periods in 2005.





·
            Non-interest
                expenses increased by $675,923 and $1,154,943, or 47.0% and 41.2%,
                for the
                three-month and six-month periods ended June 30, 2006, respectively,
                as
                compared to the same periods in 2005.





·
            The
                market price of the Company’s common stock increased 9.6% to a closing
                price of $18.90 at June 30, 2006 from the closing price of $17.25
                on June
                30, 2005.





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





**Results
      of Operations**





*General*





The
      Company recorded net income of $672,826 and $1,274,901 for the three-month
      and
      six-month periods ended June 30, 2006, respectively. This compares to net income
      of $438,122 and $867,612 for the same periods in 2005. This is an improvement
      of
      $234,704, or 53.6%, for the three-month period and $407,289, or 46.9%, for
      the
      six-month period. This significant improvement occurred even though the Company
      recorded $444,576 and $841,933 of income tax expense for the three-month and
      six-month periods ended June 30, 2006, respectively, and no income tax expense
      for the same periods in 2005. The year-over-year improvement in results is
      due
      to the continued year-over-year growth of the loan portfolio, resulting in
      increased interest and fees on loans, improvement in net interest margins and
      prudent management of operating expenses.





The
      Bank’s mortgage origination operations, located in Lutherville and Salisbury,
      Maryland, originate conventional first and second lien residential mortgage
      loans. The Bank sells most of its first and second lien 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 three-month periods ended
      June 30, 2006 and 2005, gains on the sale of mortgage loans totaled $191,603
      and
      $104,147, respectively. For the six-month periods ended June 30, 2006 and 2005,
      gains on the sale of mortgage loans totaled $274,859 and $145,751,
      respectively.





11


Gains
      on
      the sale of mortgage loans have increased from 2005 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. Management believes that this type of residential lending is less
      sensitive to the fluctuation of interest rates than conventional mortgage
      loans.





During
      the second quarter of 2004, the Company began purchasing 100% participations
      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.





As
      of
      June 30, 2006, the Company held $2.8 million of these loans which were
      classified as held for sale. The Company earned $148,420 of interest on this
      program for the six-month period ended June 30, 2006. This compares to $233,383
      for the same period in 2005. The activity in this program declined significantly
      during the first half of 2006 as the originating mortgage company utilized
      other
      available funding sources. As a result, management expects income from this
      program to decline over the remainder of the year. Total interest income for
      this program was $751,803 for the year ended December 31, 2005.





Management
      expects continued strength in operating results over the remainder of 2006;
      however, actual results will be subject to the volatility of the provision
      for
      credit losses, which is related to loan growth, the continued success of the
      Lutherville mortgage lending operation, the impact of declining volume in the
      mortgage participations purchasing program and the volatility of existing
      mortgage loan production, which is sensitive to economic and interest rate
      fluctuations.





*Net
      Interest Income*





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, other
      short-term borrowings and subordinated debt 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.





As
      previously stated, net interest income was $3.0 million and $5.7 million during
      the three-month and six-month periods ended June 30, 2006, respectively, as
      compared to $1.9 million and $3.6 million for the same periods in 2005. This
      represents an increase of 55.1% and 55.9% for the three-months and six-months
      ended June 30, 2006, respectively, as compared to the same periods in 2005.





Interest
      income from loans and investments for the three-month and six-month periods
      ended June 30, 2006 was $4.9 million and $9.2 million, compared to $2.8 million
      and $5.4 million for the three-month and six-month periods ended June 30, 2005,
      respectively. The 70.9% and 70.2% increases for the three-month and six-month
      periods, respectively, over the same periods in 2005 were directly related
      to
      the 27.7% increase in average interest-earning assets for the six-months ended
      June 30, 2006 as compared to the same period in 2005. The increase in interest
      income was also aided by a significant increase in average yields due to nine
      .25% increases in the target federal funds rate since June 30, 2005. The yields
      on interest earning assets increased from 6.36% for the six-months ended June
      30, 2005 to 8.54% for the six-months ended June 30, 2006.





12


The
      percentage of average interest-earning assets represented by loans was 93.9%
      and
      91.2% for the six-month periods ended June 30, 2006 and 2005, respectively.
      The
      increase was related to management’s decision to increase net interest income by
      maintaining a higher concentration of loans, which typically earn higher yields
      than investment securities. For the six-month period ended June 30, 2006, the
      average yield on the loan portfolio increased to 8.89% from 6.78% for the
      six-month period ended June 30, 2005. This increase is primarily due to the
      Federal Reserve increasing its target for the federal funds rate from 3.25%
      as
      of June 30, 2005 to 5.25% as of June 30, 2006. As can be seen by the yields
      discussed above, these increases had a significant effect on the Company’s
      operating results. Management believes that any future increases in the target
      federal funds rate will similarly improve yields on earning assets in future
      periods.





The
      average yield on the investment portfolio and other earning assets, such as
      federal funds sold, was 3.23% for the six-month period ended June 30, 2006
      as
      compared to 2.00% for the same period in 2005. This improvement in the average
      yield was a direct result of the Federal Reserve actions discussed above, as
      well as an increase in the Company’s holdings of Federal Reserve and Federal
      Home Loan Bank stocks, which pay dividend yields greater than those earned
      by
      the Company’s cash and cash equivalents. The percentage of average
      interest-earning assets represented by investments was 6.1% and 8.8% for the
      six-month periods ended June 30, 2006 and 2005, respectively.





Interest
      expense from deposits and borrowings for the three-month and six-month periods
      ended June 30, 2006 was $1,890,437 and $3,493,008, respectively, compared to
      $929,738 and $1,745,319 for the comparable periods in 2005. This 103.3% and
      100.1% increase for the three-month and six-month periods, respectively, is
      the
      result of a 30.0% increase  in
      average interest-bearing liabilities for the six-month period ended June 30,
      2006 as compared to the same period in 2005 as well as an increase in average
      rates paid. Average rates paid on these liabilities increased from 2.62% for
      the
      six-month period ended June 30, 2005 to 4.06% for the six-month period ended
      June 30, 2006. The increase in rates paid is directly attributable to the
      Federal Reserve actions discussed above as well as the issuance of $8 million
      of
      subordinated debt in December 2005. This subordinated debt bears interest at
      7.2% plus the amortization of debt issuance costs, which brings the effective
      cost to 7.56%.





As
      a
      result of the factors discussed above, net interest margins increased to 5.29%
      for the six-month period ended June 30, 2006. This is a 23.0% improvement over
      net interest margin of 4.30% for the same period in 2005. Although market rates
      of interest have increased significantly since June 30, 2005, management has
      been able to carefully implement deposit rate increases, which has allowed
      for
      significantly improved margins. Management expects that pressure to increase
      rates paid on deposits will increase if the target for the federal funds rate
      continues to rise.





13


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.





**Six
                Months Ended June 30, 2006****Average**
              **Balance**
            
            
            **Interest****and fees**
            
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            203,344,870
            
            $
            8,962,274
            
            
            8.89
            %Investment
                securities
            
            
            2,503,112
            
            
            61,130
            
            
            4.93Federal
                funds sold and other overnight investments
            
            
            10,717,297
            
            
            150,463
            
            
            2.83Total
                earning assets
            
            
            216,565,279
            
            
            9,173,867
            
            
            8.54
            %Less:
                Allowance for credit losses
            
            
            (3,000,000
            )Cash
                and due from banks
            
            
            2,024,387Premises
                and equipment, net
            
            
            884,100Accrued
                interest receivable and other assets
            
            
            2,705,908Total
                assets
            
            $
            219,179,674LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            56,737,445
            
            
            959,429
            
            
            3.41
            %Regular
                savings deposits
            
            
            7,602,962
            
            
            30,550
            
            
            .81Time
                deposits
            
            
            98,780,977
            
            
            2,150,016
            
            
            4.39Short-term
                borrowings
            
            
            2,401,785
            
            
            52,936
            
            
            4.45Subordinated
                debt
            
            
            8,000,000
            
            
            300,077
            
            
            7.56Total
                interest-bearing liabilities
            
            
            173,523,169
            
            
            3,493,008
            
            
            4.06
            %Net
                interest income and spread
            
            
            
            
            $
            5,680,859
            
            
            4.48
            %Non-interest-bearing
                demand deposits
            
            
            27,438,611Accrued
                expenses and other liabilities
            
            
            1,465,004Stockholders’
                equity
            
            
            16,752,890Total
                liabilities and stockholders’ equity
            
            $
            219,179,674Interest
                income/earning assets
            
            
            8.54
            %Interest
                expense/earning assets
            
            
            3.25Net
                interest margin
            
            
            5.29
            %Return
                on Average Assets (Annualized)
            
            
            1.17
            %Return
                on Average Equity (Annualized)
            
            
            15.35
            %Average
                Equity to Average Assets
            
            
            7.64
            %





14





**Six
                Months Ended June 30, 2005****Average**
              **Balance**
            
            
            **Interest****and fees**
            
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            154,633,131
            
            $
            5,240,226
            
            
            6.78
            %Investment
                securities
            
            
            2,234,294
            
            
            37,368
            
            
            3.34Federal
                funds sold and other overnight investments
            
            
            12,705,699
            
            
            111,784
            
            
            1.76Total
                earning assets
            
            
            169,573,124
            
            
            5,389,378
            
            
            6.36
            %Less:
                Allowance for credit losses
            
            
            (1,855,576
            )Cash
                and due from banks
            
            
            1,224,630Premises
                and equipment, net
            
            
            632,884Accrued
                interest receivable and other assets
            
            
            822,330Total
                assets
            
            $
            170,397,392LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            54,599,691
            
            
            423,803
            
            
            1.55
            %Regular
                savings deposits
            
            
            5,472,360
            
            
            17,600
            
            
            .64Time
                deposits
            
            
            68,808,025
            
            
            1,222,843
            
            
            3.55Short-term
                borrowings
            
            
            3,312,326
            
            
            45,550
            
            
            2.75Note
                payable
            
            
            1,251,381
            
            
            35,523
            
            
            5.68Total
                interest-bearing liabilities
            
            
            133,443,783
            
            
            1,745,319
            
            
            2.62
            %Net
                interest income and spread
            
            
            
            
            $
            3,644,059
            
            
            3.74
            %Non-interest-bearing
                demand deposits
            
            
            22,486,472Accrued
                expenses and other liabilities
            
            
            667,377Stockholders’
                equity
            
            
            13,799,760Total
                liabilities and stockholders’ equity
            
            $
            170,397,392Interest
                income/earning assets
            
            
            6.36
            %Interest
                expense/earning assets
            
            
            2.06Net
                interest margin
            
            
            4.30
            %Return
                on Average Assets (Annualized)
            
            
            1.02
            %Return
                on Average Equity (Annualized)
            
            
            12.57
            %Average
                Equity to Average Assets
            
            
            8.10
            %





*Provision
      for Credit Losses*





There
      were no provisions ****** for
      credit losses for the three-month and six-month periods ended June 30, 2006,
      as
      compared to a $203,500 and $235,500 provision for the three-month and six-month
      periods ended June 30, 2005, respectively. The provision for credit losses
      is
      normally reflective of the growth in loan balances outstanding in all segments
      of the portfolio as well as changes in the relative level of risk in the
      portfolio. The provisions for the three-month and six-month periods ended June
      30, 2006 were lower than the same periods in the prior year due to the fact
      that
      the relative risk mix of the portfolio declined for the six-month period ended
      June 30, 2006 as the Company successfully eliminated some riskier loans from
      the
      portfolio. 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.”





*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 three-month period
      ended June 30, 2006, the Company realized non-interest income of $254,215 as
      compared to $160,401 for the three-month period ended June 30, 2005. Gains
      on
      the sale of mortgage loans of $191,603 comprised 75.4% of the total for the
      three-month period ended June 30, 2006. This compares to gains on the sale
      of
      mortgage loans of $104,147, or 64.9% of total non-interest income, for the
      three-month period ended June 30, 2005.





15


For
      the
      six-month period ended June 30, 2006, the Company realized non-interest income
      in the amount of $394,495. Gains on the sale of mortgage loans of $274,859
      comprised 69.7% of the total for the six-month period ended June 30, 2006.
      This
      compares to gains on the sale of mortgage loans of $145,751, or 55.5% of total
      non-interest income for the six-month period ended June 30, 2005.





The
      level
      of gains on the sale of mortgage loans increased in the three-month and
      six-month periods ended June 30, 2006 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. Although these additional capabilities have increased the level of gains
      on the sale of mortgage loans, while also providing interest income on
      construction loans, it should be noted that 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 $42,022 and $82,761 for the three-month
      and
      six-month periods ended June 30, 2006, as compared to $44,703 and $93,942 for
      the three-month and six-month periods ended June 30, 2005. The decreases of
      6.0%
      and 11.9% are directly attributable to a decline in analysis fees charged on
      commercial deposit accounts. This decline occurred as the rate used for the
      calculation of analysis credits increased in conjunction with the increase
      in
      the target federal funds rate discussed earlier. Analysis credits are fee
      reductions based upon the analysis credit rate and the average balance of the
      account subject to analysis fees.





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*





Non-interest
      expense for the three-month and six-month periods ended June 30, 2006 totaled
      $2,112,998 and $3,958,520, respectively. This compares to non-interest expense
      for the comparable periods in 2005 of $1,437,075 and $2,803,577. The increases
      of $675,923 and $1,154,943, or 47.0% and 41.2%, resulted from an increase in
      salaries and benefits of $514,973 and $996,520, or 61.8% and 63.0%, for the
      same
      periods. The increases in salaries and benefits related to staffing growth,
      including the addition of two new executives in charge of business development
      and credit administration, as well as staffing growth in residential real estate
      lending, 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 $20,825 and $49,059 for the three and six-months ended
      June 30, 2006, respectively, as compared to the same periods in 2005. The 20.7%
      and 25.2% increases for the three and six-month periods, as compared to the
      same
      periods in 2005, were due in part to scheduled rent increases as well as the
      acquisition of new space obtained to facilitate the expansion of the Company’s
      Lutherville banking office and to accommodate the Lutherville mortgage lending
      group.





16


Data
      processing and other outside services expense increased $40,746, or 28.5%,
      for
      the three-months ended June 30, 2006 as compared to the same period in 2005.
      This increase was due to the fact that the three months ended June 30, 2006
      included $9,000 of fees paid for recruiting services, approximately $9,000
      of
      fees paid for human resource consulting, and higher printing expenses related
      to
      increased regulatory filings. The increased regulatory filings were required
      when the Company, pursuant to listing its common stock on the NASDAQ Capital
      Market, registered its securities under Section 12(g) of the Securities Exchange
      Act of 1934 on January 27, 2006. The remaining increase is due to the fact
      that
      systems and item processing costs are volume driven based upon the number of
      customer accounts and related transaction volume.





The
      $5,915, or 1.7%, decline in data processing and other outside services expense
      for the six-months ended June 30, 2006, as compared to the same period in 2005
      is the result of decreased data and item processing costs and other costs paid
      to external service providers. The 2005 costs include one-time expenses of
      approximately $45,000 incurred in conjunction with the Bank’s change of core
      processor in May 2005 and approximately $8,000 of systems support costs incurred
      to facilitate network infrastructure changes required for a bank processing
      system upgrade.





Advertising
      and marketing-related expenses increased $76,873, or 84.6%, for the three-months
      ended June 30, 2006, and $83,722, or 54.8%, for the six-months ended June 30,
      2006, as compared to the same periods in 2005. The increases for the three-month
      and six-month periods were related to the number of business development
      professionals on staff, an enhanced effort to increase the Company’s name
      recognition in order to continue the growth of the customer base and an increase
      of $30,000 in funds set aside for charitable contributions to The Baltimore
      Community Foundation account established by the Bank.




The
      $22,506, or 8.3%, and $31,557, or 6.0%, increases in all other non-interest
      expense items for the three and six-month periods ended June 30, 2006,
      respectively, relate to various costs associated with the increased size and
      complexity of the Company.





The
      banking industry utilizes an “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 65.4% and
      65.2% for the three-month and six-month periods ended June 30, 2006,
      respectively. This compares to 69.1% and 71.8% for the same periods in 2005.
      The
      improved ratios from the prior year were driven by strong revenue growth and
      prudent management of the Company’s cost structure.





As
      previously discussed, non-interest expense for the three-month and six-month
      periods ended June 30, 2006 increased by 47.0% and 41.2% from the comparable
      2005 periods, respectively. The rate of increase in non-interest expenses,
      including non-recurring expenses, is substantially less than the 73.6% and
      55.9%
      increase in net interest income for the three-month and six-month periods ended
      June 30, 2006 as compared to the same periods in 2005. Management believes
      this
      indicates that the Company is continuing to effectively leverage its cost
      structure to generate profitable growth. Management further believes that,
      while
      continued growth of the Company’s customer base will require additional staffing
      and space in order to appropriately service customers and effectively manage
      the
      business, this additional growth can continue without proportionate increases
      in
      these costs.





17


*Income
      Taxes*





For
      the
      three-month and six-month periods ended June
      30 , 2006,
      the Company recorded income tax expense of $444,576 and $841,933, respectively.
      For financial reporting purposes, taxable income for the three-month and
      six-month periods ended June 30, 2005 was offset by the Company’s net operating
      loss carryforward available in that period.





The
      use
      of the net operating loss carryforward had a positive effect on 2005 earnings
      because no income tax expense was recorded. In future periods, the Company
      will
      continue to record income tax expense at the statutory rate. Recognizing income
      tax expense in future periods will have a detrimental effect on the
      year-over-year earnings growth for 2006.





**Financial
      Condition**





*Composition
      of the Balance Sheet*





As
      of
      June 30, 2006, total assets were $230,064,653. This represents growth of
      $20,098,318, or 9.6%, since December 31, 2005. The growth in total assets
      includes increases of $2,600,442 in cash and due from banks, $281,400 in other
      equity securities, $18,801,343 in loans net of the allowance for credit losses
      and $530,066 in other non-earning assets. These increases were offset by
      declines of $1,272,959 in Federal funds sold and other overnight investments
      and
      $841,974 in investment securities available for sale.





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 that 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, during which time the secondary
      market investor reviews the files for completeness and accuracy. The Company
      earns interest on these loans at a rate indexed to the prime rate. The primary
      risk of 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
      June 30, 2006, the Company held $2.8 million of these loans which were
      classified as held for sale, a significant decrease from the $15.5 million
      held
      as of December 31, 2005. This $12.7 million decrease was a result of the
      mortgage company’s decision to use other funding sources for loans originated in
      the three months ended June 30, 2006. The decrease was slightly offset by an
      increase of approximately $1.7 million in loans held for sale originated by
      the
      Company’s Lutherville and Salisbury mortgage operations.





As
      of
      June 30, 2006, loans, excluding
      loans held for sale, totaled $211,873,449. This represents an increase of
      $29,792,552, or 16.4%, from a balance of $182,080,897 as of 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 essentially flat due to significant pay downs and payoffs. A total of approximately $23.2 million in
      loans that were outstanding as of December 31, 2005 were paid off during the
      first six months of 2006. This activity, combined with normal fluctuations
      in
      revolving credit balances and installment payments on amortizing loans, offset
      most of the approximately $25.4 million in new loans funded during that same
      period. The Company continues to seek prudent growth through the identification
      of new market segments, 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.





18


The
      composition of the loan portfolio as of June 30, 2006 was approximately $75.7
      million of commercial loans, $3.6 million of consumer loans, and $132.6 million
      of real estate loans (excluding mortgage loans held for sale). The composition
      of the loan portfolio as of December 31, 2005 was approximately $75.6 million
      of
      commercial loans, $2.9 million of consumer loans, and $103.6 million of real
      estate loans (excluding mortgage loans held for sale). Mortgage loans held
      for
      sale were $6.5 million and $17.5 million as of June 30, 2006 and December 31,
      2005, respectively.





Funds
      not
      extended in loans are invested in cash and due from banks and various
      investments including federal funds sold and other overnight investments, U.S.
      Treasury securities, Federal Reserve Bank stock and Federal Home Loan Bank
      stock. These investments totaled approximately $10.6 million as of June 30,
      2006
      compared to approximately $9.8 million as of December 31, 2005.





At
      June
      30, 2006, the Company had federal funds sold and other overnight investments
      totaling $4,759,993 as compared to $6,032,952 as of December 31, 2005. The
      Company held $566,040 of Federal Reserve Bank stock as of June 30, 2006 and
      $452,340 as of December 31, 2005. The Company also held Federal Home Loan Bank
      of Atlanta stock of $509,800 and $342,100 as of June 30, 2006 and December
      31,
      2005, respectively, and United States Treasury bills with a maturity value
      of
      $700,000 and $1,550,000 as of June 30, 2006 and December 31, 2005, respectively.
      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 June 30, 2006 and December 31, 2005, respectively. As of
      June
      30, 2006, approximately $334,000 of Treasury securities were pledged to
      collateralize uninsured deposits held for a municipal government. Management
      has
      made a decision to maintain an appropriate level of liquidity in the investment
      portfolio in order to ensure that funds are readily available to fund the growth
      of the loan portfolio and to meet the needs of deposit customers.





The
      increase in total assets was funded with operating earnings and an increase
      in
      deposits of $16,332,512, or 8.9%, since December 31, 2005. Short-term borrowings
      increased by $2,530,842, primarily driven by increased borrowings under
      unsecured Federal funds lines of credit.





Deposits
      at June 30, 2006 were $198,905,598, of which approximately $9.2 million, or
      4.6%, were related to two customers. Deposits at December 31, 2005 were
      $182,573,086, of which deposits for these same two customers and a third stood
      at approximately $12.0 million, or 6.6%, of total deposits. The deposits for
      these customers tend 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. Management was able to manage
      the
      rate of deposit growth to closely match loan growth by actively managing the
      level of certificates of deposit obtained by listing rates on the
      internet.




The
      market in which the Company operates is very competitive; therefore, 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 June 30, 2006, the Company had
      outstanding certificates of deposit of approximately $36 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 4.75% and an average term of 29 months. Included in the $36 million
      are
      national market certificates of deposit totaling $1.7 million that have been
      classified as “Brokered Deposits” for bank regulatory purposes. These “Brokered
      Deposits” were issued with an average yield of 5.29% and an average term of 15
      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.





19


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
      obtained 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 June 30, 2006, the Company had
      approximately $6.6 million of CDARS deposits outstanding of which $4.7 million
      was placed on behalf of customers and $1.9 million was raised by the
      Company.





Core
      deposits, which management categorizes as all deposits other than national
      market certificates of deposit, CDARS deposits and all but $5 million of
      deposits from the two large customers described above (which management
      considers to be a stable deposit amount from these customers based upon
      historical trends), stood at $158,707,500 as of June 30, 2006, up 11.9% from
      $141,825,926 as of December 31, 2005. 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.





Short-term
      borrowings 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 its short-term borrowings. The outstanding
      balance of repurchase agreements decreased from $916,158 at December 31, 2005
      to
      $300,000 at June 30, 2006 due to one customer’s decision to transfer
      approximately $1.2 million of funds from this program to the CDARS program
      and
      to invest available overnight funds in the Bank’s newly created Commercial Paper
      program . This
      decision is advantageous for the Bank and its customer because it provides
      FDIC
      insurance on the customer’s balances in the CDARS program and eliminates the
      Bank’s need to tie up securities as collateral for deposits.





Included
      in short-term borrowings as of June 30, 2006 is $432,000 of borrowings under
      the
      previously mentioned Overnight Commercial Paper program and $3,243,000 borrowed
      under unsecured Federal funds lines of credit. These borrowing 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 through a Delaware trust subsidiary,
      Bay National Capital Trust I (the “Trust”). The Company formed the Trust on
      December 12, 2005, and the Trust issued $8 million of trust preferred securities
      to investors at a fixed interest rate of 7.20%. The preferred securities bear
      a
      maturity date of February 23, 2036, but may be redeemed at the Company’s option
      on any February 23, May 23, August 23 or November 23 on or after February 23,
      2011, and require quarterly distributions by the trust to the holder of the
      trust preferred securities. The securities are subordinated to the prior payment
      of any other indebtedness of the Company that, by its terms, is not similarly
      subordinated securities. 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.





20


*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 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.





The
      allowance for credit losses as of June 30, 2006 and December 31, 2005 was
      $3,000,000. The amount equates to 1.37% and 1.50% of outstanding loans,
      including loans held for sale, as of June 30, 2006 and December 31, 2005,
      respectively. The decreased percentage as of June 30, 2006 was due to the fact
      that the level of risk in the loan portfolio decreased during the six-month
      period ended June 30, 2006. Bay National Corporation has no exposure to foreign
      countries or foreign borrowers. Management believes that the allowance for
      credit losses is adequate for each period presented.





21


As
      of
      June 30, 2006, the Company had two non accrual loans, one with an unpaid
      principal balance and fees of approximately $104,000 and the other with an
      unpaid principal balance and fees of approximately $38,000. Both of these loans
      are classified as impaired. Management has established specific credit loss
      allowances for these loans totaling approximately $142,000. In July 2006, the
      Company charged-off the one loan totaling approximately $38,000 and the
      remaining loan is still being pursued. Any losses on these loans will be charged
      off as soon as the amount of loss is determinable. Management believes that the allowances are adequate to provide for any such
      losses.





The
      Company had no charge-offs during the three-month and six-month periods ended
      June 30, 2006 and 2005, respectively.





Management
      believes that the overall allowance for credit losses is adequate.





*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, borrowings under 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 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
      June
      30, 2006, the Company had $4,061,111 in cash and due from banks, $4,759,993
      in
      federal funds sold and other overnight investments, $698,412 in three-month
      U.S.
      Treasury Securities, and $6,517,855 in loans expected to be sold within 60
      days.
      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, $1,540,386
      in
      three-month U.S. Treasury Securities, and $17,509,064 in loans expected to
      be
      sold within 60 days. The decline in loans expected to be sold within 60 days
      is
      related to the previously discussed decline in volume of the mortgage
      participations purchasing program.





The
      stability in the overall level of liquid assets, other than loans expected
      to be
      sold within 60 days, is the result of an ongoing effort by management to
      maintain adequate liquidity to fund loan growth and declines in deposit levels.
      The decline in loans expected to be sold within 60 days is not expected to
      impact future liquidity since any such decline also reduces funding needs.
      Growth in the Company’s loan portfolio, without corresponding growth in
      deposits, would reduce liquidity, as would reductions in the level of customer
      deposits.





The
      Company has commitments for a total of $7.0 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 June 30, 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.




22


The
      Company has sufficient liquidity to meet its loan commitments as well as
      fluctuations in deposits. The Company will choose 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 liquidity, capital or operations,
      nor is management aware of any current recommendation by regulatory authorities,
      which if implemented, would have a material effect on liquidity, capital or
      operations.





*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 subject to interest
      rate pricing within a given time period, including both floating rate or
      adjustable rate instruments and instruments which are approaching
      maturity.




The
      following table sets forth the amount of the Company's interest-earning assets
      and interest-bearing liabilities as of June 30, 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
            $
            4,759,993
            
            2.11%
            
            $
            4,759,993
            $
            -
            
            $
            -
            $
            -Loans
                held for sale
            
            6,517,855
            
            2.90%
            
            
            6,517,855
            
            -
            
            
            -
            
            -Loans
                - Variable rate
            
            113,265,524
            
            50.36%
            
            
            113,265,524
            
            -
            
            
            -
            
            -Loans
                - Fixed rate
            
            98,607,925
            
            43.84%
            
            
            2,305,217
            
            43,575,136
            
            
            51,065,473
            
            1,662,099Other
                earning assets
            
            1,774,252
            
            0.79%
            
            
            698,412
            
            -
            
            
            -
            
            1,075,840Total
                interest-earning assets
            $
            224,925,549
            
            100.00%
            
            
            127,547,001
            
            43,575,136
            
            
            51,065,473
            
            2,737,939Interest-bearing
                liabilitiesDeposits
                - Variable rate
            $
            63,991,973
            
            35.45%
            
            
            63,991,973
            
            -
            
            
            -
            
            -Deposits
                - Fixed rate
            
            104,562,682
            
            57.92%
            
            
            22,750,052
            
            38,922,851
            
            
            42,889,779
            
            -Short-term
                borrowings - Variable rate
            
            3,975,000
            
            2.20%
            
            
            3,975,000
            
            -
            
            
            -
            
            -Subordinated
                debt
            
            8,000,000
            
            4.43%
            
            
            -
            
            -
            
            
            -
            
            8,000,000Total
                interest-bearing liabilities
            $
            180,529,655
            
            100.00%
            
            
            90,717,025
            
            38,922,851
            
            
            42,889,779
            
            8,000,000Periodic
                repricing differencesPeriodic
                gap
            
            
            
            
            
            $
            36,829,976
            $
            4,652,285
            
            $
            8,175,694
            $
            (5,262,061
            )Cumulative
                gap
            
            
            
            
            
            $
            36,829,976
            $
            41,482,261
            
            $
            49,657,955
            $
            44,395,894Ratio
                of rate sensitive assets to rate sensitive liabilities
            
            
            
            
            
            
            140.60%
            
            111.95%
            
            
            119.06%
            
            34.22%




23


The
      Company has 55.4% of its interest-earning assets and 37.6% of its
      interest-bearing liabilities in variable rate balances. Interest-earning assets
      exceed interest-bearing liabilities by $44,395,894. The majority of this gap
      is
      concentrated in items maturing or repricing within one year. This gap is
      generally reflective of the Company’s emphasis on originating variable rate
      loans and short-term fixed rate loans and the demand in the market for higher
      yielding fixed rate deposits. This analysis indicates that the Company generally
      will benefit from increasing 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 evaluates 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 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.





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.





*Off-Balance
      Sheet Arrangements*





In
      the
      normal course of business, the Company is a party to financial instruments
      with
      off-balance sheet risk. 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.





Outstanding
      loan commitments and lines and letters of credit as of June 30, 2006 and
      December 31, 2005 are as follows:





**June
                30,**
              **2006**
            
            **December
                31,**
              **2005**Loan
                commitments
            $
            35,077,779
            $
            21,577,585Unused
                lines of credit
            
            47,742,471
            
            41,317,927Letters
                of credit
            
            2,807,304
            
            2,754,383





24


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 collateral requirement is evaluated on a
      case-by-case basis.





The
      increase in the overall level of loan commitments and unused lines of credit
      as
      of June 30, 2006 as compared to loan commitments and unused lines of credit
      as
      of December 31, 2005, is consistent with the overall increase in outstanding
      loans.








*Capital
      Resources*





The
      Company had stockholders’ equity at June 30, 2006 of $17,595,463 as compared to
      $16,214,078 at December 31, 2005. The increase in capital is
      a
      result of the positive operating results for the six-months ended June 30,
      2006
      plus an additional $48,952
      received upon the issuance of shares of common stock upon the exercise of
      options. Management
      believes that the Company has adequate capital to support projected asset growth
      over the next 12 months.





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 to the Company without approval from bank regulatory agencies at
      June
      30, 2006; however, such payments are not currently planned.





25


**Reconciliation
      of Non-GAAP Measures**





Below
      is
      a reconciliation of total deposits to core deposits as of June 30, 2006 and
      December 31, 2005, respectively:





**June
                30,**
              **2006**
            
            
            **December
                31,**
              **2005**Total
                deposits
            
            
            $
            198,905,598
            
            $
            182,573,086National
                market certificates of deposit (includes CDARS deposits)
            
            
            
            (35,999,798
            )
            
            (33,765,135
            )Variable
                balance accounts (2 customers at June 30, 2006 and 3 customers at
                December
                31, 2005)
            
            
            
            (9,198,300
            )
            
            (11,982,025
            )Portion
                of variable balance accounts considered to be core
            
            
            
            5,000,000
            
            
            5,000,000Core
                deposits
            
            
            $
            158,707,500
            
            $
            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 consolidated 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.





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.





Management
      has significant discretion in making the judgments inherent in the determination
      of the provision and allowance for credit losses. 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
      “Allowance for Credit Losses and Credit Risk Management.”





26


**Item
      3.**  **Controls
      and Procedures**





As
      of the
      end of the period covered by this quarterly report on Form 10-QSB, Bay National
      Corporation’s Chief Executive Officer and Chief Financial Officer evaluated the
      effectiveness of Bay National Corporation’s disclosure controls and
      procedures , as
      defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended
      (the “Exchange Act”) .
      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 June 30, 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 June 30, 2006, that have materially affected, or are
      reasonably likely to materially affect, Bay National Corporation’s internal
      control over financial reporting.





*Information
      Regarding Forward-Looking Statements*





This
      report contains certain forward-looking statements within the meaning of
      Section 27A of the Securities Exchange Act of 1933, as amended and
      Section 21E of the Exchange Act. Forward-looking statements also may be
      included in other statements that we make. All statements that are not
      descriptions of historical facts are forward-looking statements. 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.





The
      statements presented herein with respect to, among other things, the Company’s
      plans, objectives, expectations and intentions, including statements regarding
      profitability, liquidity, allowance for loan losses, interest rate sensitivity,
      market risk and financial and other goals are forward looking. These statements
      are based on the Company’s beliefs and assumptions, and on information available
      to it as of the date of this filing, and involve risks and uncertainties. These
      risks and uncertainties include, among others, those discussed in this report
      on
      Form 10-QSB; the Company’s limited operating history; dependence on key
      personnel; risks related to the Bank’s choice of loan portfolio; risks related
      to the Bank’s lending limit; risks of a competitive market; the impact of any
      new or amended government regulations on operating results; and the effects
      of
      developments in technology. For a more complete discussion of these risks and
      uncertainties, see the discussion under the caption “Factors Affecting Future
      Results” in Bay National Corporation’s Form 10-KSB for the year ended December
      31, 2005. The Company’s actual results and the actual outcome of our
      expectations and strategies could differ materially from those anticipated
      or
      estimated 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 the Company undertakes no obligation
      to
      update the forward-looking statements to reflect factual assumptions,
      circumstances or events that have changed after the forward-looking statements
      are made.


27


**PART
      II - OTHER INFORMATION**





Item
      1.Legal
      Proceedings.





None





Item
      2.Unregistered
      Sales of Equity Securities and Use of Proceeds.





None





Item
      3.Defaults
      Upon Senior Securities.





Not
      applicable.





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





At
      the
      Company’s Annual Meeting of Stockholders held May 23, 2006, the following
      directors were elected to serve a three-year term expiring upon the date of
      the
      Company’s 2009 Annual Meeting or until their respective successors are duly
      elected and qualified.





Votes
                CastFor
            Withheld
            TotalHugh
                W. Mohler
            1,379,999
            0
            1,379,999R.
                Michael Gill
            1,376,999
            3,000
            1,379,999Donald
                G. McClure, Jr.
            1,377,499
            2,500
            1,379,999Robert
                L. Moore
            1,374,499
            5,500
            1,379,999H.
                Victor Rieger, Jr.
            1,377,499
            2,500
            1,379,999





Names
      of
      other directors continuing in office:





William
                B. RinnierEdwin
                A. Rommel IIIHenry
                H. StansburyKenneth
                H. TroutEugene
                M. Waldron, Jr.Charles
                E. BoundsGary
                T. GillJohn
                R. LerchJames
                P. O’ConorCarl
                A.J. Wright




At
      the
      Company’s Annual Meeting of Stockholders held May 23, 2006, the selection of
      Stegman & Company to serve as independent registered public accountants to
      audit the Company’s financial statements for the 2006 fiscal year was ratified
      by the following vote:





Votes
                CastFor
            Against
            Abstain
            Total1,379,999
            0
            0
            1,379,999





There
      were no broker nonvotes on these matters.




28





Item
      5.  Other
      Information.





None





Item
      6.Exhibits.




(a)
              Exhibits.




10.15
              Lease
                  Agreement dated July 19, 2006 between Bay
                  National Bank and Riderwood Associates Limited Partnership, acting
                  through
                  its agent, The Greenland Corporation.
  31.1
              Rule
                  13a-14(a)Certification
                  of Chief Executive Officer
  31.2
              Rule
                  13a-14(a)Certification
                  of Chief Financial Officer
  32
              Rule
                  13a-14(b)Certification
                  of Chief Executive Officer and Chief Financial
                  Officer




29


**SIGNATURES**





In
      accordance with the requirements of the Exchange Act, the registrant caused
      this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.








Bay
                National CorporationDate:
                August 11, 2006
            
            By:
            /s/
                Hugh W. MohlerHugh
                W. Mohler, President(Principal
                Executive Officer)Date:
                August 11, 2006
            
            By:
            /s/
                Mark A. SemanieMark
                A. Semanie, Treasurer(Principal
                Accounting and Financial Officer)





30