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 September 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
      ____  No X





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





At
      November 13, 2006, the issuer had 1,935,369 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
      September 30, 2006 and December 31, 2005





September
                30, 2006
            
            
            December
                31, 2005ASSETS
            
            
            
            
            (Unaudited)Cash
                and due from banks
            
            
            
            $
            2,129,564
            
            $
            1,460,669Federal
                funds sold and other overnight investments
            
            
            
            
            15,140,288
            
            
            6,032,952Investment
                securities available for sale (AFS) - at fair value
            
            
            
            
            698,637
            
            
            1,540,386Other
                equity securities
            
            
            
            
            1,117,100
            
            
            794,440Loans
                held for sale
            
            
            
            
            6,369,946
            
            
            17,509,064Loans,
                net of unearned fees
            
            
            
            
            209,983,329
            
            
            182,080,897Total
                loans
            
            
            
            
            216,353,275
            
            
            199,589,961Less:
                Allowance for credit losses
            
            
            
            
            (3,090,000
            )
            
            (3,000,000
            )Loans,
                net
            
            
            
            
            213,263,275
            
            
            196,589,961Premises
                and equipment, net
            
            
            
            
            1,022,140
            
            
            746,826Accrued
                interest receivable and other assets
            
            
            
            
            3,249,814
            
            
            2,801,101Total
                Assets
            
            
            
            $
            236,620,818
            
            $
            209,966,335LIABILITIESNon-interest-bearing
                deposits
            
            
            
            $
            31,210,567
            
            $
            27,468,757Interest-bearing
                deposits
            
            
            
            
            175,581,720
            
            
            155,104,329Total
                deposits
            
            
            
            
            206,792,287
            
            
            182,573,086Short-term
                borrowings
            
            
            
            
            1,550,000
            
            
            1,444,158Subordinated
                debt
            
            
            
            
            8,000,000
            
            
            8,000,000Accrued
                expenses and other liabilities
            
            
            
            
            1,978,169
            
            
            1,735,013Total
                Liabilities
            
            
            
            
            218,320,456
            
            
            193,752,257STOCKHOLDERS'
                EQUITYCommon
                stock - $.01 par value, authorized:9,000,000
                shares authorized, 1,934,694 and 1,924,436 issuedand
                outstanding as of September 30, 2006 and December 31, 2005,
                respectively
            
            
            
            
            19,347
            
            
            19,244Additional
                paid in capital
            
            
            
            
            17,586,386
            
            
            17,451,201Retained
                earnings (accumulated deficit)
            
            
            
            
            694,629
            
            
            (1,256,367
            )Total
                Stockholders' Equity
            
            
            
            
            18,300,362
            
            
            16,214,078Total
                Liabilities and Stockholders' Equity
            
            
            
            $
            236,620,818
            
            $
            209,966,335




See
      accompanying notes to consolidated financial statements.





2


**BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      STATEMENTS OF OPERATIONS


For
      the
      three and nine-month periods ended September 30, 2006 and 2005


(Unaudited)





Three
                Months Ending
              September
                30
            
            
            Nine
                Months Ending
              September
                302006
            
            
            2005
            
            
            2006
            
            
            2005INTEREST
                INCOME:Interest
                and fees on loans
            $
            5,090,710
            
            $
            3,532,663
            
            $
            14,052,984
            
            $
            8,772,889Interest
                on federal funds sold and other overnight investments
            
            108,350
            
            
            48,617
            
            
            258,813
            
            
            160,401Taxable
                interest and dividends on investmentsecurities
            
            9,990
            
            
            16,555
            
            
            71,120
            
            
            53,923Total
                interest income
            
            5,209,050
            
            
            3,597,835
            
            
            14,382,917
            
            
            8,987,213INTEREST
                EXPENSE:Interest
                on deposits
            
            1,935,216
            
            
            1,110,071
            
            
            5,075,211
            
            
            2,774,317Interest
                on short-term borrowings
            
            16,298
            
            
            45,309
            
            
            69,234
            
            
            90,859Interest
                on note payable
            
            -
            
            
            26,278
            
            
            -
            
            
            61,801Interest
                on subordinated debt
            
            151,742
            
            
            -
            
            
            451,819
            
            
            -Total
                interest expense
            
            2,103,256
            
            
            1,181,658
            
            
            5,596,264
            
            
            2,926,977Net
                interest income
            
            3,105,794
            
            
            2,416,177
            
            
            8,786,653
            
            
            6,060,236Provision
                for credit losses
            
            127,931
            
            
            297,000
            
            
            127,931
            
            
            532,500Net
                interest income after provision forcredit
                losses
            
            2,977,863
            
            
            2,119,177
            
            
            8,658,722
            
            
            5,527,736NON-INTEREST
                INCOME:Service
                charges on deposit accounts
            
            41,597
            
            
            58,267
            
            
            124,358
            
            
            152,209Gain
                on sale of mortgage loans
            
            146,664
            
            
            160,592
            
            
            421,523
            
            
            352,745Other
                income
            
            18,104
            
            
            12,158
            
            
            54,979
            
            
            35,095Total
                non-interest income
            
            206,365
            
            
            231,017
            
            
            600,860
            
            
            540,049NON-INTEREST
                EXPENSES:Salaries
                and employee benefits
            
            1,328,702
            
            
            1,002,607
            
            
            3,906,713
            
            
            2,630,500Occupancy
                expenses
            
            126,428
            
            
            102,119
            
            
            370,370
            
            
            297,002Furniture
                and equipment expenses
            
            88,211
            
            
            69,782
            
            
            252,047
            
            
            221,664Legal
                and professional fees
            
            91,823
            
            
            30,000
            
            
            183,912
            
            
            102,712Data
                processing and other outside services
            
            167,383
            
            
            165,953
            
            
            513,303
            
            
            517,788Advertising
                and marketing related expenses
            
            126,693
            
            
            102,340
            
            
            363,050
            
            
            254,975Other
                expenses
            
            135,826
            
            
            126,748
            
            
            434,191
            
            
            424,887Total
                non-interest expenses
            
            2,065,066
            
            
            1,599,549
            
            
            6,023,586
            
            
            4,449,528Income
                before income taxes
            
            1,119,162
            
            
            750,645
            
            
            3,235,996
            
            
            1,618,257Income
                tax expense
            
            443,067
            
            
            -
            
            
            1,285,000
            
            
            -NET
                INCOME
            $
            676,095
            
            $
            750,645
            
            $
            1,950,996
            
            $
            1,618,257Per
                Share Data:Cash
                Dividends Paid
            $
            -
            
            
            -
            
            $
            -
            
            
            -Net
                Income (basic)
            $
            .35
            
            
            .39
            
            $
            1.01
            
            
            .84Net
                Income (diluted)
            $
            .34
            
            
            .37
            
            $
            .97
            
            
            .81Weighted
                Average shares outstanding (basic)
            
            1,933,385
            
            
            1,924,436
            
            
            1,929,726
            
            
            1,921,954Effect
                of Dilution - Stock options and Warrants
            
            77,687
            
            
            80,192
            
            
            80,736
            
            
            75,231Weighted
                Average shares outstanding (diluted)
            
            2,011,072
            
            
            2,004,628
            
            
            2,010,462
            
            
            1,997,185





See
      accompanying notes to consolidated financial statements.  3


**BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY


For
      the
      nine-months ended September 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
            
            103
            
            
            77,653
            
            
            -
            
            
            77,756Stock-based
                compensation expense
            
            -
            
            
            57,532
            
            
            -
            
            
            57,532Net
                Income
            
            -
            
            
            -
            
            
            1,950,996
            
            
            1,950,996Balances
                at September 30, 2006
            $
            19,347
            
            $
            17,586,386
            
            $
            694,629
            
            $
            18,300,362Common
                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
            
            -
            
            
            -
            
            
            1,618,257
            
            
            1,618,257Balances
                at September 30, 2005
            $
            19,244
            
            $
            17,451,201
            
            $
            (2,382,440
            )
            $
            15,088,005




See
      accompanying notes to consolidated financial statements.  4
 **BAY
      NATIONAL CORPORATION**





CONSOLIDATED
      STATEMENTS OF CASH FLOWS


For
      the
      nine-months ended September 30, 2006 and 2005


(Unaudited)





2006
            
            
            2005Cash
                Flows From Operating ActivitiesNet
                income
            $
            1,950,996
            
            $
            1,618,257Adjustments
                to reconcile net income to net cash provided by (used in)operating
                activities:Depreciation
            
            180,061
            
            
            137,119Accretion
                of investment discounts
            
            (41,850
            )
            
            (32,237
            )Provision
                for credit losses
            
            127,931
            
            
            532,500Stock-based
                compensation expense
            
            57,532
            
            
            -Gain
                on sale of loans held for sale
            
            (421,523
            )
            
            (352,745
            )Origination
                of loans held for sale
            
            (99,249,953
            )
            
            (144,459,618
            )Proceeds
                from sale of loans
            
            110,810,594
            
            
            135,329,248Net
                increase in accrued interest receivable and other assets
            
            (448,713
            )
            
            (570,231
            )Net
                increase in accrued expenses and other liabilities
            
            243,156
            
            
            395,513Net
                cash provided by (used in) operating activities
            
            13,208,231
            
            
            (7,402,194
            )Cash
                Flows From Investing ActivitiesPurchases
                of investment securities - AFS
            
            (4,116,401
            )
            
            (4,614,498
            )Maturities
                of investment securities - AFS
            
            5,000,000
            
            
            4,650,000Purchase
                of Federal Reserve Bank stock
            
            (154,960
            )
            
            (139,650
            )Purchase
                of Federal Home Loan Bank of Atlanta stock
            
            (167,700
            )
            
            (211,200
            )Loan
                disbursements in excess of principal payments
            
            (27,940,363
            )
            
            (26,236,067
            )Capital
                expenditures
            
            (455,375
            )
            
            (303,322
            )Net
                cash used in investing activities
            
            (27,834,799
            )
            
            (26,854,737
            )Cash
                Flows From Financing ActivitiesNet
                increase in deposits
            
            24,219,201
            
            
            26,425,928Net
                increase in short-term borrowings
            
            105,842
            
            
            2,329,000Proceeds
                from notes payable
            
            -
            
            
            850,000Net
                proceeds from stock issuance
            
            77,756
            
            
            50,984Net
                cash provided by financing activities
            
            24,402,799
            
            
            29,655,912Net
                increase (decrease) in cash and cash equivalents
            
            9,776,231
            
            
            (4,601,019
            )Cash
                and cash equivalents at beginning of period
            
            7,493,621
            
            
            18,111,952Cash
                and cash equivalents at end of period
            $
            17,269,852
            
            $
            13,510,933Cash
                paid for:Interest
            $
            5,367,026
            
            $
            2,777,209Income
                taxes
            $
            1,361,466
            
            $
            -




See
      accompanying notes to consolidated financial statements.  5
 **BAY
      NATIONAL CORPORATION**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


For
      the
      Three and Nine Months Ended September 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, 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 retained earnings (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 September
      30,
      2006, that the Bank meets all capital adequacy requirements to which it is
      subject.





As
      of
      September 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 nine months ended September 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 nine-month periods ended September 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
              September
                30
            
            
            Nine
                Months Ending
              September
                302006
            
            
            2005
            
            
            2006
            
            
            2005Amounts
                charged against income, before tax benefit
            $
            -
            
            $
            -
            
            $
            57,532
            
            $
            -Amount
                of related income tax benefit recognized in income
            $
            -
            
            $
            -
            
            $
            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(R)
      and SFAS No. 148 to stock-based employee compensation for the three-month and
      nine-month periods ended September 30, 2005:





Three
                Months Ending
              September
                30, 2005
            
            
            Nine
                Months Ending
              September
                30, 2005Net
                income, as reported
            $
            750,645
            
            $
            1,618,257Less
                pro forma stock-based compensation expense determined under the fair
                value
                method, net of applicable tax effects
            
            (1,404
            )
            
            (75,882
            )Pro
                forma net income
            $
            749,241
            
            $
            1,542,375Net
                income per share:Basic
                - as reported
            $
            .39
            
            $
            .84Diluted
                - as reported
            $
            .37
            
            $
            .81Basic
                - pro forma
            $
            .39
            
            $
            .80Diluted
                - pro forma
            $
            .37
            
            $
            .77





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 nine-month
      periods ended September 30, 2006 and 2005:





**Number
                of Shares**
            
            **Weighted
                Average Exercise Price**Balance,
                December 31, 2004
            
            147,492
            
            $
                7.67Granted
            
            -
            
            -Cancelled
            
            -
            
            -Exercised
            
            (6,726
            )
            $
                7.58Balance,
                September 30, 2005
            
            140,766
            
            $
                7.67Balance,
                December 31, 2005
            
            140,766
            
            $
                7.67Granted
            
            -
            
            -Cancelled
            
            (1,242
            )
            $
                7.58Exercised
            
            (10,258
            )
            $
                7.58Balance,
                September 30, 2006
            
            129,266
            
            $
                7.68Weighted
                average fair value of options granted during 2002
            $
            3.05





The
      following table summarizes information about options outstanding at September
      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
            
            112,451
            
            3
            
            $7.58
            
            
            104,559
            
            $7.58$8.37
            
            16,815
            
            4
            
            $8.37
            
            
            6,079
            
            $8.37129,266
            
            
            
            $7.68
            
            
            110,638
            
            $7.62





The
      aggregate intrinsic value of options outstanding and exercisable as of September
      30, 2006 was $1,476,234 and $1,258,684, respectively, based upon a closing
      price
      of $19.00 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 September 30, 2006 and December 31, 2005 and for the
      three-month and nine-month periods ended September 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 nine-month period ended September 30, 2006, while
      operating results continued to improve significantly over prior year results.
      Key measurements for the three-month and nine-month periods ended September
      30,
      2006 include the following:





·
            Total
                assets at September 30, 2006 increased to $236.6 million from $210
                million
                as of December 31, 2005.





·
            Net
                loans outstanding increased from $196.6 million as of December 31,
                2005 to
                $213.3 million as of September 30,
                2006.





·
            There
                was one loan, of approximately $70,000, that was considered a
                nonperforming loan as of September 30, 2006. The Company continues
                to
                maintain appropriate reserves for credit
                losses.





·
            Deposits
                at September 30, 2006 increased to $206.8 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 the certificate of deposit
                account
                registry service (CDARS) on behalf of a customer, it receives matching
                deposits through the network. The Company also has the ability to
                raise
                deposits directly through the network. These deposits are considered
                “Brokered Deposits” for bank regulatory purposes. As of September 30,
                2006, the Company had approximately $3.3 million of CDARS deposits
                outstanding.





·
            Net
                income before income taxes was $1.1 million and $3.2 million for
                the
                three-month and nine-month periods ended September 30, 2006, respectively,
                compared to $750,645 and $1.6 million for the same periods in 2005.
                This
                represents an increase of 49.1% and 100.0%, respectively, over net
                income
                before income taxes for the three-month and nine-month periods ended
                September 30, 2005.





·
            The
                Company realized net income of $676,095 and $1,950,996 for the three-month
                and nine-month periods ended September 30, 2006, respectively. This
                represents a decrease of 9.9% and an increase of 20.6% over net income
                of
                $750,645 and $1,618,257 for the same periods ended September 30,
                2005.





10


·
            Net
                interest income, the Company’s main source of income, was $3.1 million and
                $8.8 million during the three-month and nine-month periods ended
                September
                30, 2006, respectively, compared to $2.4 million and $6.1 million
                for the
                same periods in 2005. This represents an increase of 28.5% and 45.0%
                for
                the three-month and nine-month periods,
                respectively.





·
            There
                was one charge-off of $37,931 for the three-month and nine-month
                periods
                ended September 30, 2006. There were recoveries on prior charge-offs
                of
                $7,500 for the nine-month period ended September 30,
                2005.





·
            Non-interest
                income decreased by $24,652, or 10.7%, and increased by $60,811,
                or
                11.26%, for the three-month and nine-month periods ended September
                30,
                2006, respectively, as compared to the same periods in 2005.





·
            Non-interest
                expenses increased by $465,517 and $1,574,058, or 29.1% and 35.4%,
                for the
                three-month and nine-month periods ended September 30, 2006, respectively,
                as compared to the same periods in 2005.





·
            The
                Company’s common stock closed at $19.00 on September 29, 2006, which was
                the same as the closing price at September 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 $676,095 and $1,950,996 for the three-month
      and
      nine-month periods ended September 30, 2006, respectively. This compares to
      net
      income of $750,645 and $1,618,257 for the same periods in 2005. This is a
      decline of $74,550, or 9.9%, for the three-month period and an improvement
      of
      $332,739, or 20.6%, for the nine-month period. The quarterly decline is the
      direct result of quarterly income tax expense of $443,067 during the three-month
      period ended September 30, 2006 and no income tax expense for the same period
      in
      2005. This significant improvement in year-to-date results occurred even though
      the Company recognized $1,285,000 of income tax expense for the nine-month
      period ended September 30, 2006 and no income tax expense for the same period
      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
      impact of income taxes will be greater in the final quarter of 2006 since the
      Company recorded an income tax benefit of $655,000 in the three-month period
      ended December 31, 2005. Management expects that net income for the three-month
      period ended December 31, 2006 will reflect additional income tax expense
      instead of a tax benefit.





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
      September 30, 2006 and 2005, net gains on the sale of mortgage loans totaled
      $146,664 and $160,592, respectively. For the nine-month periods ended September
      30, 2006 and 2005, net gains on the sale of mortgage loans totaled $421,523
      and
      $352,745, respectively.





11


Gains
      on
      the sale of mortgage loans have increased for the nine-month period ended
      September 30, 2006 as compared to the same period in 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.





Gains
      on
      the sale of mortgage loans have decreased for the three-month period ended
      September 30, 2006 as compared to the same period in 2005 due to a slowdown
      in
      the real estate markets in both of the Company’s territories.





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
      September 30, 2006, the Company held $3.5 million of these loans which were
      classified as held for sale. The Company earned $258,683 of interest on this
      program for the nine-month period ended September 30, 2006. This compares to
      $496,004 for the same period in 2005. The activity in this program declined
      significantly during the first nine months 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 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 $3.1 million and $8.8 million during
      the three-month and nine-month periods ended September 30, 2006, respectively,
      as compared to $2.4 million and $6.1 million for the same periods in 2005.
      This
      represents an increase of 28.5% and 45.0% for the three-months and nine-months
      ended September 30, 2006, respectively, as compared to the same periods in
      2005.





12


Interest
      income from loans and investments for the three-month and nine-month periods
      ended September 30, 2006 was $5.2 million and $14.4 million, compared to $3.6
      million and $9.0 million for the three-month and nine-month periods ended
      September 30, 2005, respectively. The 44.8% and 60.0% increases for the
      three-month and nine-month periods, respectively, over the same periods in
      2005
      were directly related to the 25.5% increase in average interest-earning assets
      for the nine-months ended September 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 six 0.25% increases in the target federal funds rate
      since September 30, 2005. The yields on interest earning assets increased from
      6.78% for the nine-months ended September 30, 2005 to 8.67% for the nine-months
      ended September 30, 2006.





The
      percentage of average interest-earning assets represented by loans was 93.8%
      and
      92.1% for the nine-month periods ended September 30, 2006 and 2005,
      respectively. The high percentage of loans to earning assets is consistent
      with
      management’s strategy to maximize net interest income by maintaining a higher
      concentration of loans, which typically earn higher yields than investment
      securities. For the nine-month period ended September 30, 2006, the average
      yield on the loan portfolio increased to 9.02% from 7.18% for the nine-month
      period ended September 30, 2005. This increase is primarily due to the Federal
      Reserve increasing its target for the federal funds rate from 3.75% as of
      September 30, 2005 to 5.25% as of September 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
      subsequent periods.





The
      average yield on the investment portfolio and other earning assets, such as
      federal funds sold, was 3.23% for the nine-month period ended September 30,
      2006
      as compared to 2.05% 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 6.2% and 7.9% for the
      nine-month periods ended September 30, 2006 and 2005, respectively.





Interest
      expense from deposits and borrowings for the three-month and nine-month periods
      ended September 30, 2006 was $2.1 million and $5.6 million, respectively,
      compared to $1.2 million and $2.9 million for the comparable periods in 2005.
      This 78.0% and 91.2% increase for the three-month and nine-month periods,
      respectively, is the result of a 27.0% increase  in
      average interest-bearing liabilities for the nine-month period ended September
      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
      2.79%
      for the nine-month period ended September 30, 2005 to 4.21% for the nine-month
      period ended September 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 7.55%.





As
      a
      result of the factors discussed above, net interest margins increased to 5.30%
      for the nine-month period ended September 30, 2006. This is a 16.0% improvement
      over net interest margin of 4.57% for the same period in 2005. Although market
      rates of interest have increased significantly since September 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.





**Nine
                Months Ended September 30, 2006****Average**
              **Balance**
            
            
            **Interest**
              **and
                fees**
            
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            208,210,918
            
            $
            14,052,984
            
            
            9.02
            %Investment
                securities
            
            
            2,265,407
            
            
            71,120
            
            
            4.02Federal
                funds sold and other overnight investments
            
            
            11,405,557
            
            
            258,813
            
            
            3.03Total
                earning assets
            
            
            221,881,882
            
            
            14,382,917
            
            
            8.67
            %Less:
                Allowance for credit losses
            
            
            (3,005,441
            )Cash
                and due from banks
            
            
            2,050,263Premises
                and equipment, net
            
            
            926,898Accrued
                interest receivable and other assets
            
            
            2,731,175Total
                assets
            
            $
            224,584,777LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            60,199,478
            
            
            1,602,848
            
            
            3.56
            %Regular
                savings deposits
            
            
            6,721,544
            
            
            48,063
            
            
            .96Time
                deposits
            
            
            100,788,864
            
            
            3,424,300
            
            
            4.54Short-term
                borrowings
            
            
            2,055,513
            
            
            69,234
            
            
            4.50Subordinated
                debt
            
            
            8,000,000
            
            
            451,819
            
            
            7.55Total
                interest-bearing liabilities
            
            
            177,765,399
            
            
            5,596,264
            
            
            4.21
            %Net
                interest income and spread
            
            
            
            
            $
            8,786,653
            
            
            4.46
            %Non-interest-bearing
                demand deposits
            
            
            28,095,382Accrued
                expenses and other liabilities
            
            
            1,571,903Stockholders’
                equity
            
            
            17,152,093Total
                liabilities and stockholders’ equity
            
            $
            224,584,777Interest
                income/earning assets
            
            
            8.67
            %Interest
                expense/earning assets
            
            
            3.37Net
                interest margin
            
            
            5.30
            %Return
                on Average Assets (Annualized)
            
            
            1.16
            %Return
                on Average Equity (Annualized)
            
            
            15.21
            %Average
                Equity to Average Assets
            
            
            7.64
            %


14


**Nine****Months Ended September 30, 2005****Average**
              **Balance**
            
            
            **Interest**
              **and
                fees**
            
            
            **Yield/**
              **Rate**ASSETSLoans
                and loans held for sale
            
            $
            162,883,257
            
            $
            8,772,889
            
            
            7.18
            %Investment
                securities
            
            
            2,325,834
            
            
            53,923
            
            
            3.09Federal
                funds sold and other overnight investments
            
            
            11,643,564
            
            
            160,401
            
            
            1.84Total
                earning assets
            
            
            176,852,655
            
            
            8,987,213
            
            
            6.78
            %Less:
                Allowance for credit losses
            
            
            (1,959,675
            )Cash
                and due from banks
            
            
            1,316,501Premises
                and equipment, net
            
            
            683,184Accrued
                interest receivable and other assets
            
            
            793,880Total
                assets
            
            $
            177,686,545LIABILITIES
                AND STOCKHOLDERS’ EQUITYInterest-bearing
                demand deposits
            
            $
            55,137,766
            
            
            695,691
            
            
            1.68
            %Regular
                savings deposits
            
            
            5,460,498
            
            
            26,457
            
            
            .65Time
                deposits
            
            
            74,127,589
            
            
            2,052,169
            
            
            3.69Short-term
                borrowings
            
            
            3,960,879
            
            
            90,859
            
            
            3.06Note
                payable
            
            
            1,337,363
            
            
            61,801
            
            
            6.16Total
                interest-bearing liabilities
            
            
            140,024,095
            
            
            2,926,977
            
            
            2.79
            %Net
                interest income and spread
            
            
            
            
            $
            6,060,236
            
            
            3.99
            %Non-interest-bearing
                demand deposits
            
            
            22,888,519Accrued
                expenses and other liabilities
            
            
            767,178Stockholders’
                equity
            
            
            14,006,753Total
                liabilities and stockholders’ equity
            
            $
            177,686,545Interest
                income/earning assets
            
            
            6.78
            %Interest
                expense/earning assets
            
            
            2.21Net
                interest margin
            
            
            4.57
            %Return
                on Average Assets (Annualized)
            
            
            1.21
            %Return
                on Average Equity (Annualized)
            
            
            15.40
            %Average
                Equity to Average Assets
            
            
            7.88
            %




*Provision
      for Credit Losses*





The
      provision ****** for
      credit losses for both the three-month and nine-month periods ended September
      30, 2006 was $127,931, as compared to a $297.000 and $532,500 provision for
      the
      three-month and nine-month periods ended September 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
      nine-month periods ended September 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 nine-month period ended September 30, 2006 as the Company
      successfully eliminated some riskier loans. 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.”





15




*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 September 30, 2006, the Company realized non-interest income of $206,365
      as compared to $231,017 for the three-month period ended September 30, 2005.
      Gains on the sale of mortgage loans of $146,664 comprised 71.1% of the total
      for
      the three-month period ended September 30, 2006. This compares to gains on
      the
      sale of mortgage loans of $160,592, or 69.5% of total non-interest income,
      for
      the three-month period ended September 30, 2005.





For
      the
      nine-month period ended September 30, 2006, the Company realized non-interest
      income in the amount of $600,860. Gains on the sale of mortgage loans of
      $421,523 comprised 70.2% of the total for the nine-month period ended September
      30, 2006. This compares to gains on the sale of mortgage loans of $352,745,
      or
      65.3% of total non-interest income for the nine-month period ended September
      30,
      2005.





The
      level
      of gains on the sale of mortgage loans declined in the three-month period ended
      September 30, 2006 due to a general decrease in home purchase and refinance
      activity in the Company’s markets. The level of gains on the sale of mortgage
      loans increased in the nine-month period ended September 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 an extended slowdown in the housing
      market, could impact the Company’s ability to generate consistent non-interest
      income associated with mortgage loan production.





Service
      charges on deposit accounts totaled $41,597 and $124,358 for the three-month
      and
      nine-month periods ended September 30, 2006, as compared to $58,267 and $152,209
      for the three-month and nine-month periods ended September 30, 2005. The
      decreases of 28.6% and 18.3% are primarily attributable to a decline in the
      level of overdraft fees charged on transaction accounts. This decline occurred
      as the average level of overdrawn balances declined by approximately 56% for
      the
      nine-month period ended September 30, 2006 as compared to the same period in
      2005. The decline is a result of the Company’s ongoing emphasis of attracting
      relationships that tend to maintain higher account balances.





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





*Non-Interest
      Expense*





Non-interest
      expense for the three-month and nine-month periods ended September 30, 2006
      totaled $2,065,066 and $6,023,586, respectively. This compares to non-interest
      expense for the comparable periods in 2005 of $1,599,549 and $4,449,528. The
      increases of $465,517 and $1,574,058, or 29.1% and 35.4%, resulted primarily
      from an increase in salaries and benefits of $326,095 and $1,276,213, or 32.5%
      and 48.5%, for the same periods. The increases in salaries and benefits related
      to staffing growth, including the addition of a Senior Credit Officer in January
      2006 and a Senior Business Development Officer in June, 2006, as well as
      staffing growth in residential real estate lending, 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.





16


Occupancy
      expenses increased by $24,309 and $73,368 for the three and nine-months ended
      September 30, 2006, respectively, as compared to the same periods in 2005.
      The
      23.8% and 24.7% increases for the three and nine-month periods were due
      primarily to scheduled rent increases and the acquisition of new space obtained
      to facilitate the expansion of the Company’s Lutherville banking office during
      the fourth quarter of 2005.





Legal
      and
      professional fees increased $61,823, or 206.1%, for the three-months ended
      September 30, 2006, and $81,200, or 79.1%, for the nine-months ended September
      30, 2006, as compared to the same periods in 2005. The increases for the
      three-month and nine-month periods were related to legal fees incurred in
      connection with the drafting of executive employment agreements and legal
      assistance with the development of a commercial paper program, as well as an
      increase in internal and external audit fees related to Company growth and
      management’s desire to more frequently assess more complex functions such as
      Information Technology controls and residential lending compliance. Management
      expects that professional fees will continue to rise in 2006 and 2007 due to
      the
      costs associated with using outside consultants to facilitate the review and
      documentation of internal control over financial reporting pursuant to Section
      404 of the Sarbanes-Oxley Act of 2002.





Data
      processing and other outside services expense increased $1,430, or 0.9%, for
      the
      three-months ended September 30, 2006 as compared to the same period in 2005.
      The small increase for the three-month period as well as a $4,485, or 0.9%,
      decline in data processing and other outside services expense for the
      nine-months ended September 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.




The
      savings in data and item processing was significant enough to offset increases
      in costs paid during 2006 for enhancements to the Company’s information
      technology maintenance and security infrastructure, human resource consulting,
      and higher printing expenses related to increased regulatory filings. The
      increased regulatory filings were required when the Company registered its
      securities under Section 12 of the Securities Exchange Act of 1934, as amended
      (the “Exchange Act”) in connection with listing its common stock on the NASDAQ
      Capital Market during the first quarter of 2006.





Advertising
      and marketing-related expenses increased $24,353, or 23.8%, for the three-months
      ended September 30, 2006, and $108,075, or 42.4%, for the nine-months ended
      September 30, 2006, as compared to the same periods in 2005. The increases
      for
      the three-month and nine-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 $42,000 in charitable contributions.




The
      $27,507, or 14.0%, and $39,687, or 6.1%, increases in all other non-interest
      expense items for the three and nine-month periods ended September 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 62.3% and
      64.2% for the three-month and nine-month periods ended September 30, 2006,
      respectively. This compares to 60.4% and 67.4% for the same periods in 2005.
      The
      improvement in the efficiency ratio for the nine-month period from the prior
      year was driven by strong revenue growth and prudent management of the Company’s
      cost structure. Fluctuations in the three-month period are a result of increased
      expenses not always matching up to revenue growth.





17


Management
      will continue to focus on leveraging its cost structure to generate profitable
      growth. Management 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 impairing efficiency.





*Income
      Taxes*





For
      the
      three-month and nine-month periods ended September
      30, 2006,
      the Company recorded income tax expense of $443,067 and $1,285,000,
      respectively. For financial reporting purposes, taxable income for the
      three-month and nine-month periods ended September 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 for the three-month and nine-month
      periods ended September 30, 2005. In the fourth quarter of 2005, the Company
      determined that it would be required to pay income taxes for the first time
      in
      its brief history. As a result, the Company incurred a current income tax
      liability of $428,000 for the year ended December 31, 2005. The 2005 liability
      was offset by the recognition of a deferred tax asset of $1,083,000, resulting
      in a net tax benefit of $655,000 for the three-month period and year ended
      December 31, 2005.





The
      use
      of the net operating loss carryforward and the recognition of net deferred
      income tax assets had a positive effect on 2005 earnings. The $655,000 net
      tax
      benefit, in combination with income tax expenses recorded in 2006, will have
      a
      detrimental effect on earnings growth for the year ended December 31, 2006
      as
      compared to the year ended December 31, 2005.





**Financial
      Condition**





*Composition
      of the Balance Sheet*





As
      of
      September 30, 2006, total assets were $236,620,818. This represents growth
      of
      $26,654,483, or 12.7%, since December 31, 2005. The growth in total assets
      includes increases of $668,895 in cash and due from banks, $9,107,336 in Federal
      funds sold and other overnight investments, $322,660 in other equity securities,
      $16,673,314 in loans net of the allowance for credit losses and $724,027 in
      other non-earning assets. These increases were offset by a decline of $841,749
      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.





18


As
      of
      September 30, 2006, the Company held $3.5 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 $12.0 million decrease was a result of the
      mortgage company’s decision to use other funding sources for loans originated in
      the nine months ended September 30, 2006. The decrease was slightly offset
      by an
      increase of approximately $767,000 in loans held for sale originated by the
      Company’s Lutherville and Salisbury mortgage operations.





As
      of
      September 30, 2006, loans, excluding
      loans held for sale, totaled $209,983,329. This represents an increase of
      $27,902,432, or 15.3%, 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 flat due to significant pay downs and payoffs. A total of approximately $28.8 million in
      loans, that were outstanding as of December 31, 2005, were paid off during
      the
      first nine months of 2006. This activity, combined with normal fluctuations
      in
      revolving credit balances and installment payments on amortizing loans, offset
      most of the approximately $36.0 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.





The
      composition of the loan portfolio as of September 30, 2006 was approximately
      $73.6 million of commercial loans, $4.0 million of consumer loans, and $132.4
      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 $6.4 million and $17.5 million as of September 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 $19.1 million as of September
      30,
      2006 compared to approximately $9.8 million as of December 31, 2005.





At
      September 30, 2006, the Company had federal funds sold and other overnight
      investments totaling $15,140,288 as compared to $6,032,952 as of December 31,
      2005. This increase is a result of increased deposits resulting from a
      strengthened focus on local deposit gathering. The Company held $607,300 of
      Federal Reserve Bank stock as of September 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 September 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 September 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 September 30, 2006 and December 31, 2005, respectively. As of
      September 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.





19


The
      increase in total assets was funded with operating earnings and an increase
      in
      deposits of $24,219,201, or 13.3%, since December 31, 2005. Short-term
      borrowings were flat from December 31, 2005 because deposit growth was
      sufficient to support asset growth.





Deposits
      at September 30, 2006 were $206,792,287, of which approximately $6.5 million,
      or
      3.1%, was related to one customer. Deposits at December 31, 2005 were
      $182,573,086, of which deposits for this same customer and two others 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.





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 September 30, 2006, the Company had
      outstanding certificates of deposit of approximately $32.2 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 4.95% and an average term of 31 months. Included in the $32.2 million
      are national market certificates of deposit totaling $1.1 million that have
      been
      classified as “Brokered Deposits” for bank regulatory purposes. These “Brokered
      Deposits” were issued with an average yield of 4.59% and an average term of 20
      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.





In
      the
      first quarter of 2006, the Company began using brokered certificates of deposit
      through the Promontory Financial Network. Through this deposit matching network
      and its certificate of deposit account registry service (CDARS), the Company
      has
      the ability to offer its customers access to FDIC-insured deposit products
      in
      aggregate amounts exceeding current insurance limits. When the Company places
      funds through CDARS on behalf of a customer, it receives matching deposits
      through the network. The Company also has the ability to raise deposits directly
      through the network. These deposits are also considered “Brokered Deposits” for
      bank regulatory purposes. As of September 30, 2006, the Company had
      approximately $3.3 million of CDARS deposits outstanding of which $400,000
      was
      placed on behalf of customers and $2.9 million was raised by the
      Company.





Core
      deposits, which management categorizes as all deposits other than national
      market certificates of deposit, CDARS deposits and $3.5 million of the $6.5
      million deposits from the large customer described above, stood at $171,181,151
      as of September 30, 2006, up 20.7% from $141,825,926 as of December 31, 2005.
      Deposit balances relating to accounts from two customers, previously labeled
      as
      highly variable balance accounts, are no longer excluded from core deposits
      since their balances are no longer significant as of September 30, 2006. The
      increase in core deposits was due to an investment made in the addition of
      personnel specifically tasked with growing the core deposit base. Core deposits
      are closely monitored by management because they consider such deposits not
      only
      a relatively stable source of funding but also reflective of the growth of
      commercial and consumer depository relationships.





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 September 30, 2006 due to one customer’s decision to invest
      available overnight funds in the Bank’s newly created Overnight Commercial Paper
      program . This
      decision is advantageous for the Bank because it eliminates the Bank’s need to
      tie up securities as collateral for deposits.





20


Included
      in short-term borrowings as of September 30, 2006 is $1,250,000 of borrowings
      under the previously-mentioned Overnight Commercial Paper program. These
      borrowings are unsecured and are subordinated to all deposits. Short-term
      borrowings as of December 31, 2005 included $528,000 borrowed under unsecured
      Federal funds lines of credit.




Subordinated
      debt consists of $8 million of fixed interest rate trust preferred securities
      (the “Trust Preferred Securities”), issued 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.





*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 those values are
      adjusted 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.





21


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 September 30, 2006 and December 31, 2005
      was
      $3,090,000 and $3,000,000, respectively. The amount equates to 1.43% and 1.50%
      of outstanding loans, including loans held for sale, as of September 30, 2006
      and December 31, 2005, respectively. The decreased percentage as of September
      30, 2006 was due to the decreased level of risk in the loan portfolio during
      the
      nine-month period ended September 30, 2006. Bay National Corporation has no
      exposure to foreign countries or foreign borrowers.





As
      of
      September 30, 2006, the Company had one non-accrual loan with an unpaid
      principal balance and fees of approximately $70,000. This loan is classified
      as
      impaired. Management has established a specific credit loss allowance for this
      loan totaling approximately $70,000. Any losses on this loan will be charged
      off
      as soon as the amount of loss is determinable.





The
      Company had charge-offs totaling $37,931 during the three-month and nine-month
      periods ended September 30, 2006 and no charge-offs during the similar periods
      in 2005.





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





*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
      September 30, 2006, the Company had $2,129,564 in cash and due from banks,
      $15,140,288 in federal funds sold and other overnight investments, $698,637
      in
      three-month U.S. Treasury Securities, and $6,369,946 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.





22


The
      increase in the overall level of liquid assets, other than loans expected to
      be
      sold within 60 days, is the result of a strengthened focus on local deposit
      gathering. 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 $23 million of borrowing
      capacity with the Federal Home Loan Bank of Atlanta as of September 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.





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.




23


The
      following table sets forth the amount of the Company's interest-earning assets
      and interest-bearing liabilities as of September 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
            $
            15,140,288
            
            6.49%
            
            $
            15,140,288
            $
            -
            
            $
            -
            
            $
            -Loans
                held for sale
            
            6,369,946
            
            2.73%
            
            
            6,369,946
            
            -
            
            
            -
            
            
            -Loans
                - Variable rate
            
            112,110,487
            
            48.05%
            
            
            112,110,487
            
            -
            
            
            -
            
            
            -Loans
                - Fixed rate
            
            97,872,842
            
            41.95%
            
            
            19,268,666
            
            40,626,660
            
            
            36,756,660
            
            
            1,220,856Other
                earning assets
            
            1,815,737
            
            0.78%
            
            
            698,637
            
            -
            
            
            -
            
            
            1,117,100Total
                interest-earning assets
            $
            233,309,300
            
            100.00%
            
            $
            153,588,024
            $
            40,626,660
            
            $
            36,756,660
            
            $
            2,337,956Interest-bearing
                liabilitiesDeposits
                - Variable rate
            $
            70,326,611
            
            37.99%
            
            $
            70,326,611
            $
            -
            
            $
            -
            
            $
            -Deposits
                - Fixed rate
            
            105,255,109
            
            56.85%
            
            
            18,711,362
            
            48,247,054
            
            
            38,296,693
            
            
            -Short-term
                borrowings - Variable rate
            
            1,550,000
            
            0.84%
            
            
            1,550,000
            
            -
            
            
            -
            
            
            -Subordinated
                debt
            
            8,000,000
            
            4.32%
            
            
            -
            
            -
            
            
            -
            
            
            8,000,000Total
                interest-bearing liabilities
            $
            185,131,720
            
            100.00%
            
            $
            90,587,973
            $
            48,247,054
            
            $
            38,296,693
            
            $
            8,000,000Periodic
                repricing differencesPeriodic
                gap
            
            
            
            
            
            $
            63,000,051
            $
            (7,620,394
            )
            $
            (1,540,033
            )
            $
            (5,662,044
            )Cumulative
                gap
            
            
            
            
            
            $
            63,000,051
            $
            55,379,657
            
            $
            53,839,624
            
            $
            48,177,580Ratio
                of rate sensitive assets to rate sensitive liabilities
            
            
            
            
            
            
            169.95%
            
            84.20%
            
            
            95.98%
            
            
            29.22%




The
      Company has 57.3% of its interest-earning assets and 38.8% of its
      interest-bearing liabilities in variable rate balances. Interest-earning assets
      exceed interest-bearing liabilities by $48,177,580. 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.





24


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 September 30, 2006 and
      December 31, 2005 are as follows:





**September
                30,**
              **2006**
            
            **December
                31,**
              **2005**Loan
                commitments
            $
            39,057,588
            $
            21,577,585Unused
                lines of credit
            
            61,855,842
            
            41,317,927Letters
                of credit
            
            2,888,659
            
            2,754,383





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





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





In
      general, loan commitments, lines of credit and letters of credit are made on
      the
      same terms, including with respect to collateral, as outstanding loans. Each
      customer’s credit-worthiness and 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 September 30, 2006 as compared to loan commitments and unused lines of credit
      as of December 31, 2005, is reflective of the level of business development
      activity undertaken during the year.





25


*Capital
      Resources*





The
      Company had stockholders’ equity at September 30, 2006 of $18,300,362 as
      compared to $16,214,078 at December 31, 2005. The increase in capital is
      a
      result of the positive operating results for the nine-months ended September
      30,
      2006 plus an additional $77,756
      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
      September 30, 2006; however, such payments are not currently
      planned.





26


**Reconciliation
      of Non-GAAP Measures**





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





**September
                30,**
              **2006**
            
            
            **December
                31, 2005**Total
                deposits
            
            
            $
            206,792,287
            
            $
            182,573,086National
                market certificates of deposit (includes CDARS deposits)
            
            
            
            (32,159,329
            )
            
            (33,765,135
            )Variable
                balance accounts (1 customer at September 30, 2006 and 3 customers
                at
                December 31, 2005)
            
            
            
            (6,451,807
            )
            
            (11,982,025
            )Portion
                of variable balance accounts considered to be core
            
            
            
            3,000,000
            
            
            5,000,000Core
                deposits
            
            
            $
            171,181,151
            
            $
            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.”





27


**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 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 September 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 September 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.


28


**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.





None





Item
      5.  Other
      Information.





None





Item
      6.Exhibits.





(a)
            Exhibits.




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:
                November 13, 2006
            
            By:
            /s/
                Hugh W. MohlerHugh
                W. Mohler, President(Principal
                Executive Officer)Date:
                November 13, 2006
            
            By:
            /s/
                Mark A. SemanieMark
                A. Semanie, Treasurer(Principal
                Accounting and Financial Officer)





30