UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended September 30, 2006

		OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 0-5127

MERCANTILE BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

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

2 Hopkins Plaza

Baltimore, Maryland 21201

(Address of principal executive offices) (Zip Code)

(410) 237-5900

(Registrant’s telephone number, including area code)

NONE

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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 o

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

Large accelerated filer x Accelerated filer o Non-accelerated filer o

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

As of October 20, 2006, there were 125,490,121 shares of registrant’s Common Stock, $2 par value per share, outstanding.

MERCANTILE BANKSHARES CORPORATION
Quarterly Report on Form 10-Q
September 30, 2006

Table of Contents

Part I - Financial Information

	Item 1.	Financial Statements (Unaudited)

		Consolidated Balance Sheets
		Statements of Consolidated Income
		Statements of Changes in Consolidated Shareholders’ Equity
		Statements of Consolidated Cash Flows
		Notes to Consolidated Financial Statements

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk

	Item 4.	Controls and Procedures

Part II - Other Information

	Item 1.	Legal Proceedings

	Item 1A.	Risk Factors

	Item 6.	Exhibits

Signatures

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

MERCANTILE BANKSHARES CORPORATION
CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)	September 30, 2006			December 31, 2005			September 30, 2005
ASSETS
Cash and due from banks	$	318,184		$	369,536		$	328,964
Interest-bearing deposits in other banks	200			200			200
Federal funds sold	133,608			25,104			232,129
Total cash and cash equivalents	451,992			394,840			561,293
Investment securities available-for-sale (Note 4)	3,126,770			3,089,628			3,048,846
Investment securities held-to-maturity (Note 4) - fair value of $14,766 (September 2006), $17,181 (December 2005) and $17,380 (September 2005)	14,361			16,659			16,804
Total investment securities	3,141,131			3,106,287			3,065,650
Loans held-for-sale	1,930			26,263			42,307
Loans:
Commercial	2,925,300			2,957,301			2,925,445
Commercial real estate	4,148,895			3,703,297			3,638,238
Construction	1,952,013			1,607,095			1,543,633
Residential real estate	1,988,336			1,802,373			1,778,684
Home equity lines	476,746			505,508			520,214
Consumer	1,043,048			1,032,271			1,039,845
Total loans	12,534,338			11,607,845			11,446,059
Less: allowance for loan losses	(143,853		)	(156,673		)	(157,176		)
Loans, net	12,390,485			11,451,172			11,288,883
Bank premises and equipment, less accumulated depreciation of $152,829 (September 2006), $146,585 (December 2005) and $147,395 (September 2005)	142,664			137,419			146,615
Other real estate owned, net	67			667			777
Goodwill, net	760,347			670,028			670,306
Other intangible assets, net (Note 8)	47,818			46,653			47,485
Other assets	638,813			588,400			580,138
Total assets	$	17,575,247		$	16,421,729		$	16,403,454
COMMITMENTS and CONTINGENCIES (Note 7)
LIABILITIES
Deposits:
Noninterest-bearing deposits	$	3,301,554		$	3,324,650		$	3,329,331
Interest-bearing deposits	9,473,557			8,752,700			8,710,575
Total deposits	12,775,111			12,077,350			12,039,906
Short-term borrowings	1,558,710			1,237,714			1,266,672
Accrued expenses and other liabilities	188,331			169,780			165,398
Long-term debt	659,688			742,163			780,087
Total liabilities	15,181,840			14,227,007			14,252,063
SHAREHOLDERS’ EQUITY
Preferred stock, no par value; authorized 2,000,000 shares; issued and outstanding - None
Common stock, $2 par value; authorized 200,000,000 shares; issued shares - 125,476,310 (September 2006), 82,165,414 (December 2005) and 82,078,721 (September 2005)	250,953			164,331			164,157
Capital surplus	667,307			676,830			669,185
Retained earnings	1,503,226			1,386,405			1,343,076
Accumulated other comprehensive loss	(28,079		)	(32,844		)	(25,027		)
Total shareholders’ equity	2,393,407			2,194,722			2,151,391
Total liabilities and shareholders’ equity	$	17,575,247		$	16,421,729		$	16,403,454

See Notes to Consolidated Financial Statements.

MERCANTILE BANKSHARES CORPORATION
STATEMENTS OF CONSOLIDATED INCOME

	For the 9 months ended September 30,				For the 3 months ended September 30,
(Dollars in thousands, except per share data)	2006		2005		2006		2005

INTEREST INCOME
Interest and fees on loans	$	628,369	$	508,135	$	224,218	$	185,714
Interest and dividends on investment securities:
Taxable interest income	93,323		77,052		32,393		26,686
Tax-exempt interest income	2,273		2,348		730		839
Other investment income	1,986		1,753		660		526
Total interest and dividends on investment securities	97,582		81,153		33,783		28,051
Other interest income	2,611		1,546		855		760
Total interest income	728,562		590,834		258,856		214,525

INTEREST EXPENSE
Interest on deposits	175,638		95,280		68,792		38,591
Interest on short-term borrowings	39,738		17,228		15,215		7,702
Interest on long-term debt	27,394		23,634		8,780		8,990
Total interest expense	242,770		136,142		92,787		55,283

NET INTEREST INCOME	485,792		454,692		166,069		159,242
Provision for credit losses	—		1,576		—		820

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES	485,792		453,116		166,069		158,422

NONINTEREST INCOME
Investment and wealth management	82,582		71,505		27,596		23,668
Service charges on deposit accounts	33,936		32,992		12,776		11,478
Mortgage banking related fees	5,042		10,329		497		5,151
Investment securities gains (losses)	205		458		218		(32		)
Nonmarketable investments	13,383		13,683		1,150		4,190
Other income	49,693		52,042		17,530		18,619
Total noninterest income	184,841		181,009		59,767		63,074

NONINTEREST EXPENSES
Salaries	147,755		148,482		51,424		51,748
Employee benefits	42,538		35,490		13,511		11,637
Net occupancy expense of bank premises	23,991		20,918		8,289		7,139
Furniture and equipment expenses	24,752		23,168		8,353		7,965
Communications and supplies	12,083		11,992		3,796		3,933
Other expenses	77,447		72,398		27,056		25,960
Total noninterest expenses	328,566		312,448		112,429		108,382
Income before income taxes	342,067		321,677		113,407		113,114
Applicable income taxes	126,643		120,221		41,834		42,158

NET INCOME	$	215,424	$	201,456	$	71,573	$	70,956

NET INCOME PER SHARE OF COMMON STOCK (Note 3):
Basic	$	1.74	$	1.67	$	0.57	$	0.58
Diluted	$	1.73	$	1.65	$	0.57	$	0.57
DIVIDENDS PAID PER COMMON SHARE	$	0.82	$	0.74	$	0.28	$	0.25

See Notes to Consolidated Financial Statements.

MERCANTILE BANKSHARES CORPORATION
STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY

	For the 9 months ended September 30, 2006 and 2005
(Dollars in thousands, except per share data)		Total			Common Stock			Capital Surplus			Retained Earnings			Accumulated Other Comprehensive Income (Loss)

BALANCE, DECEMBER 31, 2004		$	1,917,683		$	158,601		$	530,705		$	1,231,102		$	(2,725	)
Net income		201,456									201,456
Unrealized losses on securities available-for-sale, net of reclassification adjustment, net of taxes		(22,302		)										(22,302		)
Comprehensive income (Note 9)		179,154
Cash dividends paid:
Common stock ($0.74 per share)		(89,017		)							(89,017		)
Issuance of 2,444,408 shares for bank acquisition		124,335			4,889			119,446
Fair value of 138,764 converted options related to employee stock option plan of acquired bank		5,182						5,182
Issuance of 82,444 shares for dividend reinvestment and stock purchase plan		4,098			165			3,933
Issuance of 17,550 shares for employee stock purchase dividend reinvestment plan		873			35			838
Stock options
Issuance of 181,808 shares		3,664			364			3,300
Expense		2,519						2,519
Stock awards
Issuance of 41,823 shares		2,211			84			2,127
Deferred compensation		(2,242		)							(2,242		)
Expense		1,972									1,972
Directors’ deferred compensation plan
Issuance of 10,182 shares		439			19			420
Contribution		520						520
Dividend		—						195			(195		)
BALANCE, SEPTEMBER 30, 2005		$	2,151,391		$	164,157		$	669,185		$	1,343,076		$	(25,027	)
BALANCE, DECEMBER 31, 2005		$	2,194,722		$	164,331		$	676,830		$	1,386,405		$	(32,844	)
Net income		215,424									215,424
Unrealized gains on securities available-for-sale, net of reclassification adjustment, net of taxes		4,765												4,765
Comprehensive income (Note 9)		220,189
Cash dividends paid
Common stock ($0.82 per share)		(101,556		)							(101,556		)
Issuance of 1,833,757 shares in connection with bank acquisition		63,140			3,668			59,472
Fair value of 138,066 converted options related to employee stock option plan of acquired bank		1,605						1,605
Issuance of 134,274 shares for dividend reinvestment and stock purchase plan		4,706			268			4,438
Issuance of 26,505 shares for employee stock purchase dividend reinvestment plan		996			53			943
Stock options
Issuance of 107,767 shares		1,975			216			1,759
Expense		2,219						2,219
Stock awards and units
Issuance of 157,243 shares		189			314			(125		)
Repurchase of 38,471 shares for tax settlement		(1,477		)	(77		)	(1,400		)
Expense		5,748						5,748
Directors’ deferred compensation plan
Issuance of 4,995 shares		192			10			182
Contribution		841						841
Dividend		—						253			(253		)
Adjustment for adoption of SFAS No. 123R		—						(3,206		)	3,206
Issuance of 41,084,826 shares for a 3-for-2 stock split		(82		)	82,170			(82,252		)
BALANCE, SEPTEMBER 30, 2006		$	2,393,407		$	250,953		$	667,307		$	1,503,226		$	(28,079	)

See Notes to Consolidated Financial Statements.

MERCANTILE BANKSHARES CORPORATION
STATEMENTS OF CONSOLIDATED CASH FLOWS

	For the 9 months ended September 30,
Increase (decrease) in cash and cash equivalents (Dollars in thousands)	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	215,424		$	201,456
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses	—			1,576
Depreciation	11,857			11,581
Amortization of other intangible assets	7,064			6,482
Tax benefit from the issuance of stock-based awards	115			83
Write-downs of other real estate owned	—			1
Gains on sales of other real estate owned	(7		)	(153		)
Gains on sales of investments securities	(205		)	(458		)
Gains on sales of premises	(103		)	(4,341		)
Net (increase) decrease in assets:
Loans held-for-sale	25,568			(31,307		)
Interest receivable	(11,975		)	(9,332		)
Nonmarketable investments	(8,964		)	11,912
Other assets	(13,246		)	(80		)
Net increase (decrease) in liabilities:
Interest payable	19,359			13,710
Other liabilities	(15,502		)	(11,871		)
Net cash provided by operating activities	229,385			189,259
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities of investment securities held-to-maturity	2,298			3,372
Proceeds from maturities of investment securities available-for-sale	705,128			655,641
Proceeds from sales of investment securities available-for-sale	101,670			121,207
Purchases of investment securities available-for-sale	(723,014		)	(782,084		)
Net increase in customer loans	(511,661		)	(551,290		)
Proceeds from sales of other real estate owned	2,241			273
Capital expenditures	(16,117		)	(12,878		)
Proceeds from sales of premises	536			7,981
Proceeds from sale of interest in Ltd Partnership	6,705			—
Business acquisitions (net of cash received)	(61,251		)	(78,655		)
Business acquisitions contingent consideration	(8,806		)	—
Purchase of nonmarketable investments	(12,112		)	(57,105		)
Net cash used in investing activities	(514,383		)	(693,538		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in noninterest-bearing deposits	(118,812		)	172,450
Net increase in interest-bearing deposits	383,457			442,943
Net increase in short-term borrowings	266,837			369,109
Repayment of long-term debt	(95,362		)	(84,659		)
Tax benefit from the issuance of stock-based awards	1,040			530
Excess tax benefit related to stock-based awards	346			447
Proceeds from issuance of shares	7,677			8,635
Repurchase of common shares	(1,477		)	—
Dividends paid	(101,556		)	(89,017		)
Net cash provided by financing activities	342,150			820,438
Net increase in cash and cash equivalents	57,152			316,159
Cash and cash equivalents at beginning of period	394,840			245,134
Cash and cash equivalents at end of period	$	451,992		$	561,293
SUPPLEMENTAL INFORMATION
Cash payments for interest	$	222,237		$	121,081
Cash payments for income taxes	135,974			133,745

See Notes to Consolidated Financial Statements.

MERCANTILE BANKSHARES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The consolidated financial statements, which include the accounts of Mercantile Bankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of its affiliates, are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practice within the banking industry. In the opinion of management, the consolidated financial statements include all adjustments necessary for a fair presentation of the interim period. These adjustments are of a normal nature and include adjustments to eliminate all significant intercompany transactions. In view of the changing conditions in the national economy, the effect of actions taken by regulatory authorities and normal seasonal factors, the results for the interim period are not necessarily indicative of annual performance. For purposes of comparability, certain prior period amounts have been reclassified to conform to current period presentation.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities in the financial statements, and the disclosure of revenue and expenses during the reporting period. These assumptions are based on information available as of the date of the financial statements and could differ from actual results. See Bankshares’ Annual Report on Form 10-K for more detail.

2. Business Combinations / Restructuring

The following provides information concerning acquisitions and restructurings. Acquisitions were accounted for as purchases with the results of their operations subsequent to the acquisition date included in Bankshares’ Statements of Consolidated Income.

On July 17, 2006, Bankshares completed its acquisition of James Monroe Bancorp, Inc. (“James Monroe”), an Arlington, Virginia-based commercial bank. James Monroe was merged into Mercantile-Safe Deposit & Trust Company (“MSD&T”). At the time of the acquisition, James Monroe operated six full-service branches and a loan production office located in Northern Virginia and suburban Washington, D.C. The total consideration paid to James Monroe shareholders in connection with the acquisition was $71.4 million in cash and 1.8 million shares of Bankshares’ common stock. The results of James Monroe’s operations have been included in Bankshares’ financial results subsequent to July 17, 2006. The assets and liabilities of James Monroe were recorded on the Consolidated Balance Sheet at their respective fair values. The fair values have been determined as of July 17, 2006 and are subject to refinement, as further information becomes available. The transaction resulted in total assets acquired of $552 million, including $414 million in gross loans; and liabilities assumed of $507 million, including $434 million in total deposits. Additionally, Bankshares preliminarily recorded $87.0 million of goodwill. Intangible assets subject to amortization are being amortized on an accelerated basis.

Bankshares’ exit costs, referred to herein as “merger-related” costs, are defined to include those costs for branch closings and related severance, combining operations such as systems conversions, and printing and mailing costs incurred by Bankshares prior to and after the merger date and are included in Bankshares’ results of operations. Bankshares expensed merger-related costs totaling $0.7 million for the three month period ended September 30, 2006. The costs associated with these activities are included in noninterest expense. Merger-related expenses incurred to date consisted largely of expenses for systems conversion costs. Bankshares will incur additional merger-related expenses of $1.5 million during the fourth quarter of 2006 and the first quarter of 2007 as systems conversions, branch closings and integration of operations continue and these expenses will be recorded when incurred.

3. Earnings per Share

Basic earnings per share (“EPS”) are computed by dividing income available to common shareholders by weighted average common shares outstanding. Diluted EPS are computed using the same components as basic EPS with the denominator adjusted for the dilutive effect of weighted average common shares from the various share-based compensation plans. The following tables provide reconciliations between the computation of basic EPS and diluted EPS for the nine and three months ended September 30, 2006 and 2005, respectively.

	For the 9 months ended September 30,
	2006					2005
(In thousands, except per share data)	Net Income		Weighted Average Common Shares	EPS		Net Income		Weighted Average Common Shares	EPS
Basic EPS	$	215,424	123,678	$	1.74	$	201,456	120,818	$	1.67
Dilutive effect of :
Stock options			760					635
Restricted stock awards and units			109					113
Vested directors’ deferred compensation plan shares			295					258
Diluted EPS	$	215,424	124,842	$	1.73	$	201,456	121,824	$	1.65

	For the 3 months ended September 30,
	2006					2005
(In thousands, except per share data)	Net Income		Weighted Average Common Shares	EPS		Net Income		Weighted Average Common Shares	EPS
Basic EPS	$	71,573	124,750	$	0.57	$	70,956	122,797	$	0.58
Dilutive effect of :
Stock options			742					776
Restricted stock awards and units			100					116
Vested directors’ deferred compensation plan shares			301					264
Diluted EPS	$	71,573	125,893	$	$0.57	$	70,956	123,953	$	0.57

Antidilutive weighted average common shares from the various share-based compensation plans excluded from the computation of diluted earnings per share were 430,857 and 666,503 for the nine months and three months ended September 30, 2006. There were no antidilutive weighted average common shares excluded from the computation of diluted earnings per share for the nine months and three months ended September 30, 2005.

4. Investment Securities

At September 30, 2006 and December 31, 2005, securities with an amortized cost of $1.5 billion and $1.3 billion, respectively, were pledged as collateral for repurchase transactions and certain deposits as required by regulatory guidelines. The following table shows the amortized cost and fair value of investment securities at September 30, 2006 and December 31, 2005.

	September 30, 2006								December 31, 2005
(Dollars in thousands)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Investment securities held-to-maturity
States and political subdivisions	$	14,361	$	425	$	20	$	14,766	$	16,659	$	541	$	19	$	17,181

Investment securities available-for-sale
U.S. Treasury	$	409,137	$	512	$	2,041	$	407,608	$	434,893	$	223	$	3,080	$	432,036
U.S. Government agencies	928,550		240		7,996		920,794		992,040		29		12,761		979,308
Mortgage-backed securities	1,710,596		2,116		37,791		1,674,921		1,581,845		685		38,269		1,544,261
States and political subdivisions	61,542		255		127		61,670		70,017		306		188		70,135
Other bonds, notes and debentures	11,678		—		129		11,549		19,083		—		215		18,868
Total bonds	3,121,503		3,123		48,084		3,076,542		3,097,878		1,243		54,513		3,044,608
Other investments	49,597		1,118		487		50,228		43,980		1,236		196		45,020
Total	$	3,171,100	$	4,241	$	48,571	$	3,126,770	$	3,141,858	$	2,479	$	54,709	$	3,089,628

The following table shows the unrealized gross losses and fair value of securities in the securities available-for-sale portfolio at September 30, 2006, by length of time that individual securities in each category have been in a continuous loss position.

	Less than 12 Months				12 months or more				Total
(Dollars in thousands)	Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value
U.S. Treasury	$	94	$	229,867	$	1,947	$	177,741	$	2,041	$	407,608
U.S. Government agencies	709		331,626		7,287		589,168		7,996		920,794
Mortgage-backed securities	2,632		610,473		35,159		1,064,448		37,791		1,674,921
States and political subdivisions	29		45,862		98		15,808		127		61,670
Other bonds, notes and debentures	29		5,497		100		6,052		129		11,549
Total bonds	3,493		1,223,325		44,591		1,853,217		48,084		3,076,542
Other investments	181		35,934		306		14,294		487		50,228
Total	$	3,674	$	1,259,259	$	44,897	$	1,867,511	$	48,571	$	3,126,770

At September 30, 2006, there were $1.9 billion of individual securities that had unrealized losses for a period greater than 12 months. At September 30, 2006, these securities had an unrealized loss of $44.9 million of which approximately 57% were mortgage-backed securities. Management has assessed the impairment of these securities and determined that the impairment is temporary. All principal and interest payments on available-for-sale debt securities in an unrealized loss position for greater than 12 months are expected to be collected given the high credit quality of the U.S. government agency debt securities and Bankshares’ ability and intent to hold the securities until the value recovers or they mature.

5. Allowance for Loan Losses and Reserve for Unfunded Commitments

During the first quarter of 2006, Bankshares refined the model used for determining certain components of the allowance for loan losses. The model refinement did not have a material impact on Bankshares’ recorded allowance for loan losses. Additionally, Bankshares reclassified a portion of the allowance for loan losses to a reserve for unfunded lending commitments reflected in other liabilities in the consolidated balance sheet. As a result of the refinement of the modeling process for the allowance for loan losses, Bankshares was able specifically to identify risk inherent in unfunded commitments and make the reclassification noted above. As no model data existed for previous years, prior period data has not been reclassified for comparability.

Bankshares reclassified $14.0 million and $1.9 million in the first and third quarters of 2006, respectively, of the allowance for loan losses to the reserve for unfunded commitments. The third quarter reclassification resulted from a refinement in the manner in which the required reserves for unfunded commitments were calculated. The acquired allowance from James Monroe was approximately $4.0 million.

The allowance for loan losses and reserve for unfunded commitments is presented below.

	For the 9 months ended September 30,						For the 3 months ended September 30,
(Dollars in thousands)	2006			2005			2006			2005
Allowance for Loan Losses
Balance, beginning of period	$	156,673		$	149,002		$	142,860		$	157,101
Allowance of acquired bank	3,985			7,086			3,985			—
Provision for credit losses	(990		)	1,576			—			820
Transfer to reserve for unfunded commitments	(15,824		)	—			(1,856		)	—
Total	143,844			157,664			144,989			157,921
Charge-offs	(4,137		)	(4,825		)	(1,909		)	(1,710		)
Recoveries	4,146			4,337			773			965
Net recoveries (charge-offs)	9			(488		)	(1,136		)	(745		)
Balance, end of period	$	143,853		$	157,176		$	143,853		$	157,176

Reserve for Unfunded Commitments
Balance, beginning of period	$	—		$	—		$	14,958		$	—
Provision for credit losses	990			—			—			—
Transfer from allowance for loan losses	15,824			—			1,856			—
Balance, end of period	$	16,814		$	—		$	16,814		$	—

6. Impaired Loans

When scheduled principal or interest payments are past due 90 days or more at quarter-end on any loan, the accrual of interest income is discontinued and subsequent receipts on these loans are recorded as a reduction of principal, and interest income is recorded only once principal recovery is reasonably assured. Previously accrued but uncollected interest on these loans is charged against interest income. Generally, a loan may be restored to accruing status when all past due principal, interest and late charges have been paid and the bank expects repayment of the remaining contractual principal and interest on a timely basis.

Under Statements of Financial Accounting Standards (SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of a Loan-an amendment of FASB Statements Nos. 5 and 15,” a loan is considered impaired, based on current information and events, if it is probable that Bankshares will not collect all principal and interest payments according to the contractual terms of the loan agreement. The impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the repayment is expected to be provided predominantly by the underlying collateral. Information with respect to impaired loans and the related valuation allowance (if the measure of the impaired loan is less than the recorded investment) at September 30, 2006, December 31, 2005 and September 30, 2005 is shown in the following table. See Bankshares’ Annual Report on Form 10-K for more detail.

(Dollars in thousands)	September 30, 2006		December 31, 2005		September 30, 2005
Impaired loans with a specific valuation allowance	$	2,488	$	11,512	$	15,579
All other impaired loans	30,293		9,086		9,103
Total impaired loans	$	32,781	$	20,598	$	24,682

Specific allowance for loan losses applicable to impaired loans	$	1,755	$	4,150	$	8,671
General allowance for loan losses applicable to other than impaired loans	142,098		152,523		148,505
Total allowance for loan losses	$	143,853	$	156,673	$	157,176

Year-to-date interest income on impaired loans recorded on the cash basis	$	106	$	128	$	114
Year-to-date average recorded investment in impaired loans during the period	$	23,970	$	26,703	$	27,332
Quarter-to-date interest income on impaired loans recorded on the cash basis	$	30	$	14	$	61
Quarter-to-date average recorded investment in impaired loans during the period	$	27,016	$	24,817	$	26,223

Impaired loans do not include large groups of smaller balance homogeneous loans that are evaluated collectively for impairment (e.g., residential mortgages and consumer installment loans). The allowance for loan losses related to these loans is included in the general allowance for loan losses applicable to other than impaired loans.

There were no loans associated with the James Monroe acquisition that were within the scope of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” As part of the Community Bank of Northern Virginia (“CBNV”) acquisition, two commercial real estate loans totaling $4.9 million were within the scope of SOP 03-3. One of the loans was subsequently paid in full and the remaining loan is deemed to be immaterial for purposes of the required disclosures.

7. Commitments and Contingencies

Bankshares is a party to financial instruments that are not recorded in the balance sheet, which include commitments to extend credit and standby letters of credit. Various commitments to extend credit (lines of credit) are made in the normal course of banking business. Letters of credit are issued for the benefit of customers by affiliated banks. These commitments are subject to loan underwriting standards and geographic boundaries consistent with Bankshares’ loans outstanding. Bankshares’ lending activities are concentrated in Maryland, Delaware and Virginia.

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 fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Total commitments to extend credit were $5.1 billion at September 30, 2006, $4.8 billion at December 31, 2005, and $4.6 billion at September 30, 2005.

Letters of credit are commitments issued to guarantee the performance of a customer to a third party. Outstanding letters of credit were $575.8 million at September 30, 2006, $540.6 million at December 31, 2005 and $506.8 million at September 30, 2005. Fees received for issuing letters of credit are deferred and amortized over the life of the commitment. The unamortized fees on letters of credit at September 30, 2006, December 31, 2005, and September 30, 2005 had a carrying value of $2.5 million, $2.7 million and $2.5 million, respectively.

Bankshares’ mortgage-banking subsidiary is a Fannie Mae Delegated Underwriting and Servicing lender, and has a loss sharing arrangement for loans originated on behalf of and sold to Fannie Mae. The unamortized principal balance of the underlying loans totaled $278.7 million, $249.8 million and $237.2 million at September 30, 2006, December 31, 2005 and September 30, 2005, respectively. The loss reserve for potential losses on loans originated and sold in the secondary market was $100.2 thousand and $60.7 thousand at September 30, 2006 and December 31, 2005, respectively. The mortgage subsidiary also has originated and sold loans with recourse in the event of foreclosure on the underlying real estate.

Bankshares has committed to invest funds in third-party private equity investments. At September 30, 2006, December 31, 2005 and September 30, 2005, $31.1 million, $26.6 million and $28.1 million, respectively, remained unfunded.

In the ordinary course of business, Bankshares and its subsidiaries are involved in a number of pending and threatened legal actions and proceedings. In certain of these actions and proceedings, claims for substantial monetary damages are asserted against Bankshares and its subsidiaries. In view of the inherent difficulty of predicting the outcome of such matters, Bankshares cannot state what the eventual outcome of pending matters will be. However, based on current knowledge, management does not believe that liabilities, if any, arising from pending litigation matters, will have a material adverse effect on the consolidated financial position, earnings or liquidity of Bankshares. If payment associated with a claim becomes probable and the cost can be reasonably estimated, a contingent liability would be established based on information currently available, advice of counsel and available insurance coverage.

8. Goodwill and Other Intangible Assets

Goodwill, net, totaled $760.3 million at September 30, 2006 and $670.0 million at December 31, 2005. In the third quarter of 2006, Bankshares preliminarily recorded $87.0 million in goodwill in connection with the James Monroe acquisition. In the first quarter of 2006, there was an increase in goodwill of $8.8 million related to a contingent payment made to the management of Boyd Watterson Asset Management as they met the performance conditions outlined in the merger agreement.

The following table discloses the gross carrying amount and accumulated amortization of intangible assets subject to amortization at September 30, 2006 and December 31, 2005.

	September 30, 2006							December 31, 2005
(Dollars in thousands)	Gross carrying amount		Accumulated amortization			Net amount		Gross carrying amount		Accumulated amortization			Net amount
Core deposits	$	62,842	$	(25,444	)	$	37,398	$	54,509	$	(20,790	)	$	33,719
Mortgage servicing	2,848		(1,461		)	1,387		2,902		(1,145		)	1,757
Customer lists and other	17,795		(8,762		)	9,033		17,845		(6,668		)	11,177
Total	$	83,485	$	(35,667	)	$	47,818	$	75,256	$	(28,603	)	$	46,653

In connection with the James Monroe acquisition, Bankshares preliminarily recorded $8.3 million in core deposit intangibles. The core deposit intangible from James Monroe is being amortized on an accelerated basis.

Identifiable intangible assets are amortized based on estimated lives of up to 15 years. Management reviews other intangible assets for impairment yearly or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. For those intangible assets subject to amortization, impairment is indicated if the sum of undiscounted estimated future net cash flows is less than the carrying amount of the asset. Impairment is recognized by writing down the carrying value or adjusting the estimated life of the asset. Any impairment recognized in a valuation account is reflected in the income statement in the corresponding period.

The following table shows the current period and estimated future amortization expense for amortized intangible assets. The projections of amortization expense shown for mortgage servicing rights are based on asset balances and the interest rate environment as of September 30, 2006. Future amortization expense may be significantly different depending upon changes in the mortgage-servicing portfolio, mortgage interest rates and market conditions.

(Dollars in thousands)		Core Deposits		Mortgage Servicing		Customer Lists and Other		Total
Nine months ended September 30, 2006 (actual)		$	4,654	$	251	$	2,159	$	7,064
Three months ended December 31, 2006 (estimated)		1,680		59		562		2,301
Twelve months ended December 31, 2006 (estimated)		$	6,334	$	310	$	2,721	$	9,365

Estimate for years ended December 31,
	2007	$	6,517	$	232	$	2,454	$	9,203
	2008	5,423		215		1,617		7,255
	2009	5,272		215		641		6,128
	2010	5,272		215		505		5,992

9. Comprehensive Income

The following table summarizes the market value change and related tax effect of unrealized gains (losses) on securities available-for-sale for the nine months and three months ended September 30, 2006 and 2005, respectively. Total comprehensive income is included in the Statements of Changes in Consolidated Shareholders’ Equity.

	For the 9 months ended September 30,
	2006							2005
(Dollars in thousands)	Pretax Amount		Tax (Expense) Benefit		Net Amount			Pretax Amount		Tax (Expense) Benefit	Net Amount
Net Income					$	215,424					$	201,456
Other comprehensive income
Unrealized holding gains (losses) arising
during the period	8,105		(3,216	)	4,889			(35,258	)	13,234	(22,024		)
Reclassification adjustment for (gains) losses included in net income	(205	)	81		(124		)	(458	)	180	(278		)
Total other comprehensive income	7,900		(3,135	)	4,765			(35,716	)	13,414	(22,302		)
Total comprehensive income					$	220,189					$	179,154

	For the 3 months ended September 30,
	2006							2005
(Dollars in thousands)	Pretax Amount		Tax (Expense) Benefit		Net Amount			Pretax Amount		Tax (Expense) Benefit		Net Amount
Net Income					$	71,573						$	70,956
Other comprehensive income
Unrealized holding gains (losses) arising during the period	34,202		(12,947	)	21,255			(22,781	)	8,459		(14,322		)
Reclassification adjustment for (gains) losses included in net income	(218	)	86		(132		)	32		(13	)	19
Total other comprehensive income	33,984		(12,861	)	21,123			(22,749	)	8,446		(14,303		)
Total comprehensive income					$	92,696						$	56,653

10. Capital Adequacy

Bankshares and its bank affiliates are subject to various regulatory capital adequacy requirements administered by federal and state banking agencies. These requirements include maintaining certain capital ratios above minimum levels. These capital ratios include Tier I Capital and Total Risk-Based Capital as percentages of net risk-weighted assets and Tier I Capital as a percentage of adjusted average total assets (leverage ratio). The minimum ratios for capital adequacy purposes are 4.00%, 8.00% and 4.00%, for the Tier I Capital, Total Capital and Leverage Ratios, respectively. To be categorized as well capitalized, a bank must maintain minimum ratios of 6.00%, 10.00% and 5.00%, for its Tier I Capital, Total Capital and Leverage Ratios, respectively. As of September 30, 2006, Bankshares and each of its bank affiliates exceeded all capital adequacy requirements to be considered well capitalized.

Actual capital amounts and ratios are presented in the following table for Bankshares and its affiliates. The September 30, 2006 MSD&T capital ratios reflect the James Monroe acquisition.

September 30, 2006 (Dollars in thousands)	Tier I Capital		Total Risk-Based Capital		Net Risk-Weighted Assets		Adjusted Average Total Assets		Tier I Capital Ratio		Total Capital Ratio		Leverage Ratio
Bankshares	$	1,639,229	$	2,099,107	$	13,713,845	$	16,413,550	11.95	%	15.31	%	9.99	%
Annapolis Banking & Trust	44,251		51,524		347,132		483,250		12.75		14.84		9.16
Citizens National Bank	108,741		156,454		1,213,369		1,338,333		8.96		12.89		8.13
Farmers & Mechanics Bank	168,335		229,463		1,370,064		1,687,145		12.29		16.75		9.98
Marshall National Bank & Trust	13,957		20,423		144,576		185,805		9.65		14.13		7.51
Mercantile County Bank	82,794		119,526		753,143		955,397		10.99		15.87		8.67
Mercantile Eastern Shore Bank	55,070		86,472		479,466		614,010		11.49		18.04		8.97
Mercantile Peninsula Bank	150,847		222,454		1,405,887		1,783,333		10.73		15.82		8.46
Mercantile-Safe Deposit & Trust Company	617,697		738,896		6,302,877		7,583,480		9.80		11.72		8.15
Mercantile Southern Maryland Bank	95,858		132,791		697,608		1,000,486		13.74		19.04		9.58
National Bank of Fredericksburg	39,402		50,261		395,730		477,679		9.96		12.70		8.25
Westminster Union Bank	70,671		101,193		524,157		822,105		13.48		19.31		8.60

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

Bankshares has an ongoing share repurchase program. Purchases may be made from time to time, subject to regulatory requirements, in open market or in privately negotiated transactions. Purchased shares are retired. During the nine months ended September 30, 2006, Bankshares purchased 38,471 shares in net settlement of the minimum tax liability for vested restricted stock. On June 13, 2006, Bankshares’ Board of Directors authorized the repurchase of two million shares in addition to 676 thousand shares remaining from a previously announced program. At September 30, 2006, there were approximately 2.7 million shares available for repurchase under the program.

11. Segment Reporting

Operating segments as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” are components of an enterprise with separate financial information. The component engages in business activities from which it derives revenues and incurs expenses and the operating results of which management relies on for decision-making and performance assessment. Bankshares has two reportable segments — Banking and Investment and Wealth Management (“IWM”). The Banking segment is comprised of 11 affiliate banks. During 2005, the Private Bank Group of Mercantile-Safe Deposit & Trust Company was consolidated into the Private Banking Group of IWM. The segment results have been reclassified to conform to current presentation for comparability. Additionally, as loans and deposits are now being reflected in the IWM segment, a funds transfer-pricing model was utilized to match the duration of the funding and investment of the IWM segment assets and liabilities.

The tables below present selected segment information for the nine and three months ended September 30, 2006 and 2005. The components in the “Other” column consist of amounts for the nonbank affiliates, unallocated corporate expenses, including income taxes, and intercompany eliminations. Certain expense amounts such as operations overhead were reclassified from internal financial reporting in order to provide for full cost absorption. These reclassifications are shown in the “Adjustments” line.

	For the 9 months ended September 30, 2006												For the 9 months ended September 30, 2005
(Dollars in thousands)	Banking			IWM			Other			Total			Banking			IWM			Other			Total
Net interest income	$	476,760		$	9,324		$	(292	)	$	485,792		$	448,467		$	6,546		$	(321	)	$	454,692
Provision for credit losses	—			—			—			—			(1,576		)	—			—			(1,576		)
Noninterest income	89,868			82,981			11,992			184,841			98,733			71,635			10,641			181,009
Noninterest expenses	(258,397		)	(64,820		)	(5,349		)	(328,566		)	(256,337		)	(53,644		)	(2,467		)	(312,448		)
Adjustments	17,281			(1,298		)	(15,983		)	—			16,757			(3,491		)	(13,266		)	—
Income (loss) before income taxes	325,512			26,187			(9,632		)	342,067			306,044			21,046			(5,413		)	321,677
Income tax expense	(114,405		)	(10,475		)	(1,763		)	(126,643		)	(107,038		)	(8,419		)	(4,764		)	(120,221		)
Net income (loss)	$	211,107		$	15,712		$	(11,395	)	$	215,424		$	199,006		$	12,627		$	(10,177	)	$	201,456

Average loans	$	11,810,175		$	182,120		$	305		$	11,992,600		$	10,724,290		$	147,043		$	391		$	10,871,724
Average earning assets	15,137,858			182,120			(75,968		)	15,244,010			13,703,258			147,043			5,328			13,855,629
Average assets	16,607,674			182,681			56,888			16,847,243			14,983,948			147,370			143,413			15,274,731
Average deposits	12,270,894			298,370			(325,809		)	12,243,455			11,270,896			194,570			(213,685		)	11,251,781
Average equity	2,049,883			38,068			216,792			2,304,743			1,865,378			33,916			158,830			2,058,124

	For the 3 months ended September 30, 2006												For the 3 months ended September 30, 2005
(Dollars in thousands)	Banking			IWM			Other			Total			Banking			IWM			Other			Total
Net interest income	$	162,767		$	3,382		$	(80	)	$	166,069		$	157,023		$	2,324		$	(105	)	$	159,242
Provision for credit losses	—			—			—			—			(820		)	—			—			(820		)
Noninterest income	29,011			27,781			2,975			59,767			36,254			23,794			3,026			63,074
Noninterest expenses	(87,228		)	(21,256		)	(3,945		)	(112,429		)	(92,233		)	(17,821		)	1,672			(108,382		)
Adjustments	6,365			(877		)	(5,488		)	—			8,792			(1,080		)	(7,712		)	—
Income (loss) before income taxes	110,915			9,030			(6,538		)	113,407			109,016			7,217			(3,119		)	113,114
Income tax expense	(38,692		)	(3,612		)	470			(41,834		)	(38,218		)	(2,887		)	(1,053		)	(42,158		)
Net income (loss)	$	72,223		$	5,418		$	(6,068	)	$	71,573		$	70,798		$	4,330		$	(4,172	)	$	70,956

Average loans	$	12,212,585		$	188,248		$	235		$	12,401,068		$	11,236,644		$	152,712		$	375		$	11,389,731
Average earning assets	15,570,864			188,248			(113,262		)	15,645,850			14,353,936			152,712			(15,912		)	14,490,736
Average assets	17,084,515			188,824			23,990			17,297,329			15,791,343			153,061			120,764			16,065,168
Average deposits	12,612,299			307,789			(328,027		)	12,592,061			11,807,861			202,571			(258,442		)	11,751,990
Average equity	2,109,085			39,539			193,921			2,342,545			1,957,448			34,727			187,240			2,179,415

12. Derivative Instruments and Hedging Activities

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities — an amendment to FASB Statement No. 133,” and SFAS No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities” (collectively referred to as “derivatives”), establish accounting and reporting standards for derivative instruments and for hedging activities. Bankshares maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. Currently, derivative instruments that are used as part of the interest rate risk management strategy have been restricted to interest rate swaps. Interest rate swaps generally involve the exchange of fixed-rate and variable-rate interest payments between two parties, based on a common notional principal amount and maturity date. At September 30, 2006, Bankshares had interest rate swaps to convert a portion of its nonprepayable fixed-rate debt to floating-rate debt. Bankshares also arranges interest rate swaps, caps and swaptions for commercial loan customers through its Capital Markets Group. Derivative transactions executed with loan customers are hedged by means of an offsetting derivative trade with a third party. In this way, Bankshares manages the market risk arising from capital markets-related derivative activity.

The fair value of derivative instruments is based on swap and option valuations. The swap value is estimated by using pricing models that incorporate quoted market prices for swap rates and futures contracts and assumes all counterparties have the same credit rating. The option valuation is estimated by using standard market models (such as the modified Black-Scholes model on interest rate options), incorporating quoted market prices and volatilities. The fair value of derivative instruments related to customer accommodations recorded in other assets was $8.4 million (notional $536.1 million) and $5.3 million (notional $345.5 million) at September 30, 2006 and December 31, 2005, respectively. The fair value of derivative instruments relating to hedges and customer accommodations recorded in other liabilities was $16.4 million (notional $655.2 million) and $12.3 million (notional $609.1 million) at September 30, 2006 and December 31, 2005, respectively.

Changes in the fair value of a derivative that is designated and qualifies as a fair value hedge, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk are recorded as other noninterest income in the results of operations. For all hedge relationships, ineffectiveness resulting from differences between the changes in fair values or cash flows of the hedged item and changes in fair value of the derivative are recognized as other noninterest income in the results of operations. The net interest settlement on derivatives designated as fair value or cash flow hedges is treated as an adjustment of the interest income or interest expense of the hedged assets or liabilities. The fair-value hedges of nonprepayable fixed-rate debt were effective for the reported periods and qualified for short-cut hedge accounting treatment. The impact of the hedges increased interest expense $1.6 million in the first nine months of 2006 as compared with a decrease of $3.5 million for the same period in 2005.

The following tables summarize the gross position of derivatives relating to hedging activities at September 30, 2006 and December 31, 2005.

	September 30, 2006							December 31, 2005
(Dollars in thousands)	Notional or Contractual Amount		Credit Risk Amount (1)		Estimated Net Fair Value			Notional or Contractual Amount		Credit Risk Amount (1)		Estimated Net Fair Value
Asset/Liability Management Hedges
Interest Rate Contracts:
Swaps	$	350,000	$	118	$	(12,907	)	$	350,000	$	—	$	(10,349	)

Customer Accommodations
Interest Rate Contracts:
Swaps	$	829,771	$	8,489	$	4,965		$	592,934	$	5,327	$	3,462
Swaptions/Caps Purchased	5,755		40		40			5,850		57		57
Swaptions/Caps Sold	5,755		—		(40		)	5,850		—		(57		)

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

Mortgage loans held-for-sale have inherent forward contract (agreements to sell or purchase loans at a specific rate or yield) characteristics. Risk may arise from the corresponding parties’ inability to meet the terms of their contracts and from movements in interest rates. Bankshares has forward commitments to sell individual fixed-rate and variable-rate mortgage loans that are on its balance sheet at fair value or are approved, but not yet funded. The fair value of the forward contracts was $0.2 million at September 30, 2006 and December 31, 2005.

13. Stock-based Compensation Expense

Bankshares adopted SFAS No. 123(R), “Share-Based Payment,” effective January 1, 2006 under the modified version of prospective application. The following disclosures are provided pursuant to the requirements of SFAS 123(R).

Under SFAS 123(R), awards granted to retirement eligible employees are expensed immediately. Under Bankshares’ Omnibus Stock Plan, retirement eligible is defined as employees reaching normal retirement at age 65. As a practice, Bankshares has not granted awards to retirement eligible employees. As of September 30, 2006, there were no retirement eligible employees with outstanding awards that had not been fully expensed. Prior to implementing SFAS 123(R), Bankshares accrued compensation cost for share-based compensation based on total awards granted, pursuant to SFAS 123. Any subsequent forfeitures were reversed from compensation expense when the performance or service requirement was not achieved. Upon implementation of SFAS 123(R), Bankshares is estimating forfeitures upon the grant of awards and reducing the amount to be charged to expense by this estimate.

We sponsor several share-based plans, which are described below. The compensation cost expensed for those plans was $3.5 million and $1.1 million for the quarters ended September 30, 2006 and 2005, respectively, and $9.0 million and $4.1 million for the nine months ended September 30, 2006 and 2005, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $1.3 million and $416 thousand for the quarters ended September 30, 2006 and 2005, respectively, and $3.4 million and $1.4 million for the nine months ended September 30, 2006 and 2005, respectively. At September 30, 2006, unrecognized compensation cost related to nonvested stock options, restricted stock awards and restricted stock units (“RSUs”) totaled $21.0 million. The cost of these nonvested awards is expected to be recognized over a weighted average period of 2.07 years.

The 1999 Omnibus Stock Plan permitted the grant of stock options and other stock incentives, including restricted stock awards and restricted stock units, to key employees of Bankshares and its affiliates. The 1999 Plan provided for the issuance of up to 4,500,000 shares (as adjusted for the stock split) of Bankshares authorized but unissued common stock. The number of shares of common stock that remained available for future grants under the Plan at September 30, 2006 was 857,965 shares. Options issued as a result of mergers or acquisitions are not considered to be part of the 1999 Omnibus Stock Plan. Options outstanding were granted at market value and included both performance-based and nonperformance-based options. Options become exercisable ratably over three or four years. All options terminate 10 years from date of grant if not exercised. The estimated forfeiture rate used to calculate the current quarter and year-to-date compensation cost was 2.0%. Because of the historically low forfeiture rate, the impact to compensation expense was immaterial for 2006 and 2005.

On March 29, 2006, the Compensation Committee authorized the issuance of up to 317,802 performance-based restricted stock units (“Performance RSUs”) pursuant to the 2006 Performance Stock Program. The vesting of the Performance RSUs will be determined based upon the percentage improvement in Bankshares’ pre-tax operating income (“PTOI”) over a three-year performance period (the “Performance Period”) ending December 31, 2008 (with no adjustments for acquisitions or other extraordinary events). In addition to the performance period, the awards earned are subject to an additional one-year service requirement. Depending on actual performance, the Performance RSUs will vest at levels from 0% to 100%. On the same date, the Committee also awarded 104,630 RSUs to Bankshares’ chief executive officer. The award will vest ratably over four years. The Performance RSUs and the RSUs granted to Bankshares chief executive officer vest and convert into common stock in connection with a change of control of Bankshares.

The table below summarizes activity related to stock options during the nine months ended September 30, 2006.

	Options issued and outstanding		Weighted average exercise price		Options exercisable	Weighted average exercise price
Balance, December 31, 2005	2,659,240		$	25.01	1,489,397	$	20.80
Granted	725,566		34.89
Expired/Forfeited	(7,188	)	25.92
Exercised	(118,006	)	17.74
Balance, September 30, 2006	3,259,612		$	27.46	2,124,075	$	23.35

The total intrinsic value of stock options exercised during the nine months ended September 30, 2006 and 2005 was $2.3 million and $6.2 million, respectively. Cash received from options exercised under all share-based payment arrangements for the nine months ended September 30, 2006 and 2005 was $1.8 million and $3.2 million, respectively. The actual tax return benefit associated with the tax deductions recognized in the income statement from the option exercise of the share-based payment arrangements totaled $1.0 million for the nine months ended September 30, 2006; there was no actual tax return benefit for the nine months ended September 30, 2005.

The following table provides selected information on nonvested stock options as of September 30, 2006, and changes during the nine months ended September 30, 2006.

	Nonvested stock options		Weighted average grant-date fair value
Balance, December 31, 2005	1,164,825		$	30.36
Granted	587,500		37.73
Vested	(616,788	)	28.52
Forfeited	—
Balance, September 30, 2006	1,135,537		$	35.17

The following table provides selected information on stock options outstanding and exercisable at September 30, 2006.

	September 30, 2006
(Dollars in thousands, except per share data)	Outstanding		Exercisable
Number of options	3,259,612		2,124,075
Weighted-average exercise price	$	27.46	$	23.35
Aggregate intrinsic value	$	28,006	$	26,177
Weighted-average remaining contractual term, in years	7.11		6.22

The weighted average grant-date fair value of options granted during the nine months ended September 30, 2006 and 2005 was $7.13 and $9.54, respectively. The total fair value of shares vested during the nine months ended September 30, 2006 and 2005 was $22.9 million and $14.9 million, respectively.

The weighted average fair value of options granted is estimated as of the grant date using the Black-Scholes option-pricing model.

The following weighted average assumptions were used as inputs to the Black-Scholes model for grants in the nine months ended September 30, 2006 and 2005, respectively:

· Dividend yields of 2.76% and 2.69%

· Volatilities of 20.60% and 21.85%

· Risk-free interest rates of 4.68% and 4.12%

· Expected terms of 4.73 and 4.57 years

The expected volatility assumptions were derived by analyzing the historical price volatility of our stock over the past five years. The expected terms of options were determined by reviewing historically the time within which a minimum of 50% of shares granted to an employee were exercised over the past 6 years.

Restricted stock awards outstanding were granted at market value and vest ratably over three years or in total at the end of a specified three-year period. The number of restricted stock awards granted in the nine months ended September 30, 2006 and 2005 was 158,406 and 54,386, respectively. Compensation expense is recognized on a straight-line basis over the vesting period. Relative to awards granted in the nine months ended September 30, 2006, 85,309 shares are subject to a one-year vesting, and 46,327 vest over three years. Additionally, 12,012 shares, representing dividend equivalent shares related to previous awards that vested during the current period, were awarded and vested immediately.

The following table provides selected information related to restricted stock awards and restricted stock units as of September 30, 2006, and changes during the nine months ended September 30, 2006.

	Restricted Stock Awards		Restricted Stock Units
Outstanding at December 31, 2005	249,090		—
Granted	158,406		422,432
Vested	(149,369	)	—
Forfeitures	(1,162	)	—
Outstanding at September 30, 2006	256,965		422,432

Another share-based plan is Bankshares’ directors’ deferred compensation plan. This plan provides for the issuance of up to 667,500 shares of Bankshares’ authorized but unissued common stock. The plan requires all deferred fees to be settled in Bankshares’ stock.

14. Pension & Other Postretirement Benefit Plans

Bankshares sponsors qualified and nonqualified pension plans and other postretirement benefit plans for its employees. The following table summarizes the components of the net periodic benefit cost for the pension plans for the nine and three months ended September 30, 2006 and 2005, respectively.

	For the 9 months ended September 30, 2006								For the 9 months ended September 30, 2005
(Dollars in thousands)	Qualified			Nonqualified		Total			Qualified			Nonqualified			Total
Service cost	$	5,703		$	642	$	6,345		$	5,640		$	455		$	6,095
Interest cost	8,966			323		9,289			8,457			121			8,578
Expected return on plan assets	(13,169		)	—		(13,169		)	(12,430		)	—			(12,430		)
Amortization of prior service cost	888			23		911			877			17			894
Recognized net actuarial loss (gain)	1,613			60		1,673			1,096			(139		)	957
Amortization of transition asset	—			—		—			—			—			—
Net periodic benefit cost	$	4,001		$	1,048	$	5,049		$	3,640		$	454		$	4,094

	For the 3 months ended September 30, 2006								For the 3 months ended September 30, 2005
(Dollars in thousands)	Qualified			Nonqualified		Total			Qualified			Nonqualified			Total
Service cost	$	1,904		$	214	$	2,118		$	1,980		$	151		$	2,131
Interest cost	2,989			108		3,097			2,819			41			2,860
Expected return on plan assets	(4,389		)	—		(4,389		)	(4,143		)	—			(4,143		)
Amortization of prior service cost	296			8		304			292			5			297
Recognized net actuarial loss (gain)	538			20		558			365			(46		)	319
Amortization of transition asset	—			—		—			—			—			—
Net periodic benefit cost	$	1,338		$	350	$	1,688		$	1,313		$	151		$	1,464

The following table summarizes the components of the net periodic benefit cost for the other postretirement benefit plans for the nine and three months ended September 30, 2006 and 2005, respectively.

	For the 9 months ended September 30,				For the 3 months ended September 30,
(Dollars in thousands)	2006		2005		2006		2005
Service cost	$	322	$	400	$	107	$	133
Interest cost	745		747		249		249
Expected return on plan assets	—		—		—		—
Amortization of prior service cost	—		—		—		—
Recognized net actuarial loss	226		264		74		88
Amortization of transition asset	—		—		—		—
Net periodic benefit cost	$	1,293	$	1,411	$	430	$	470

As previously disclosed in its financial statements for the year ended December 31, 2005, Bankshares generally makes cash contributions to the pension plan in amounts up to those permitted by guidelines established under employee benefit and tax laws. Bankshares estimates that it could contribute up to approximately $25 million to the pension plan for 2006. Cash contributions are normally made after valuations have been finalized for the plan year and prior to the tax return filing date. As of September 30, 2006, total contributions of $15 million had been made in 2006. No further contributions are expected to be made in the current year.

15. Recent Accounting Standards

On February 16, 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 155, “Accounting for Certain Hybrid Instruments.” This standard amends the guidance in FASB Statements (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Bankshares does not anticipate this statement will have a material effect on its results of operations or financial condition.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets-An Amendment of FASB Statement No. 140.” This standard amends the guidance in SFAS No.140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Among other requirements, SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract. The standard requires initial measurement of all newly purchased or issued separately recognized servicing assets and servicing liabilities at fair value, if practicable. Subsequent measurements may be made using either the fair value or amortization method. SFAS No. 156 is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006 with early adoption permitted in the quarter-ended March 31, 2006. Bankshares does not anticipate this statement will have a material effect on its results of operations or financial condition.

On July 13, 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. An enterprise shall disclose the cumulative effect of the change on retained earnings in the statement of financial position as of the date of adoption and such disclosure is required only in the year of adoption. Bankshares is in the process of analyzing the implications of FIN 48. Bankshares does not anticipate this statement will have a material effect on its results of operations or financial condition.

On September 15, 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which provides for enhanced guidance for using the fair value to measure assets and liabilities. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. SFAS No. 157 is applicable under other accounting pronouncements that either require or permit fair value measurements and does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Bankshares is in the process of analyzing the implications of SFAS No. 157.

On September 20, 2006, the FASB ratified EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” EITF 06-4 addresses accounting for split-dollar life insurance arrangements after the employer purchases a life insurance policy on the covered employee. This EITF states that an obligation arises as a result of a substantive agreement with an employee to provide future postretirement benefits. Under EITF 06-4, the obligation is not settled upon entering into an insurance arrangement. Since the obligation is not settled, a liability should be recognized in accordance with applicable authoritative guidance. EITF 06-4 is effective for fiscal years beginning after December 15, 2007. Bankshares is in the process of analyzing the implications of EITF 06-4.

On September 20, 2006, the FASB ratified EITF 06-5, “Accounting for Purchases of Life Insurance—Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance.” This issue addresses how an entity should determine the amount that could be realized under the insurance contract at the balance sheet date in applying FTB 85-4 and if the determination should be on an individual or group policy basis. EITF 06-5 is effective for fiscal years beginning after December 15, 2006. The adoption of EITF 06-5 is not expected to have a material affect on Bankshares financial statements.

On September 29, 2006, the FASB issued SFAS No.158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS No. 158 requires an entity to recognize in its statement of financial position the overfunded or underfunded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation. An entity will be required to recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise pursuant to FASB Statements No. 87, “Employers’ Accounting for Pensions” and No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” Furthermore, SFAS No. 158 requires that an entity use a plan measurement date that is the same as its fiscal year-end. An entity will be required to disclose additional information in the notes to financial statements about certain effects on net periodic benefit cost in the upcoming fiscal year that arise from delayed recognition of the actuarial gains and losses and the prior service costs and credits. The requirement to recognize the funded status of a defined benefit postretirement plan and the related disclosure requirements is effective for fiscal years ending after December 15, 2006. The requirement to change the measurement date to the year-end reporting date is for fiscal years ending after December 15, 2008. Bankshares does not anticipate this statement will have a material effect on its results of operations or financial condition.

16. Subsequent Events

On October 9, 2006, Bankshares announced that it had entered into a Merger Agreement with PNC Financial Services Group, Inc. (“PNC”), which was approved by PNC’s board. If the merger is completed, each share of Bankshares’ common stock will be converted into 0.4184 shares of PNC common stock and $16.45 in cash. The merger is currently expected to occur in the first quarter of 2007, and is subject to the approval of Bankshares’ shareholders, receipt of specified governmental approvals (including the approval of the Board of Governors of the Federal Reserve System), and certain other customary conditions.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

MERCANTILE BANKSHARES CORPORATION

HIGHLIGHTS

Consolidated Financial Results

Net income for the quarter ended September 30, 2006 was $71.6 million, a 0.9% increase from net income of $71.0 million for the same period in 2005 and a 2.1% decrease from the $73.1 million reported for the second quarter of 2006. For the quarters ended September 30, 2006 and 2005, diluted net income per share was $0.57 per share, which represented a decrease of 3.4% from the $0.59 reported for the second quarter of 2006. Adjusted weighted average shares outstanding increased from 124.0 million for the quarter ended September 30, 2005 to 125.9 million for the quarter ended September 30, 2006. The results of operations for James Monroe are included from the merger date forward.

Net interest income, on a taxable-equivalent basis, for the quarter ended September 30, 2006 increased 4.3% to $167.9 million from $161.0 million for the third quarter of last year. Compared with the second quarter of 2006, net interest income increased 2.9% from the $163.3 million reported for that period. As noted in prior quarters, the competitive pressures on the lending and the funding fronts have persisted. The result is that the net interest margin continues to be under pressure. The net interest margin for the current quarter was 4.26% as compared with 4.31% for the second quarter of 2006. The net interest margin for the third quarter of 2005 was 4.41%.

At September 30, 2006, nonperforming assets amounted to $36.1 million, or 0.29%, of period-end loans and other real estate owned, an increase of $8.3 million from the $27.8 million at September 30, 2005. Nonperforming assets were $29.3 million at June 30, 2006. The comparable nonperforming asset ratio was 0.24% at September 30, 2005 and June 30, 2006. The level of “monitored” loans, or loans with characteristics suggesting that they could be classified as nonperforming in the near future, amounted to $1.7 million at September 30, 2006. Monitored loans were $3.4 million at September 30, 2005 and $13.5 million at June 30, 2006. The allowance for possible loan losses was 1.15% of loans outstanding at September 30, 2006.

Noninterest income, which includes investment and wealth management fees, service charges on deposit accounts, mortgage banking-related fees, securities gains and losses, nonmarketable investments income and other income, decreased 5.2% to $59.8 million for the third quarter of 2006 from $63.1 million for the third quarter of 2005. This was due to a decrease of $4.7 million in mortgage banking-related fees and of $3.0 million in nonmarketable investments income, partially offset by a $3.9 million increase in investment and wealth management fees. The decline in mortgage banking-related fees was attributable to the sale of Bankshares’ ownership interest in Columbia National Real Estate Finance, LLC (“CNREF”) to the minority partners which closed on August 2, 2006. For the quarter ended September 30, 2006, CNREF’s pretax loss was $249 thousand as compared with a pretax profit of $2.2 million for the same period in 2005. CNREF’s pretax profit for the second quarter of 2006 was $729 thousand.

Noninterest income decreased $4.7 million, or 7.3%, in the third quarter of 2006 from the second quarter of 2006. The decrease was primarily due to declines in commercial mortgage banking-related fees, and nonmarketable investments income.

Noninterest expenses, which include salaries, employee benefits, net occupancy expense of bank premises, furniture and equipment expenses, communications and supplies and other expenses, increased by 3.7% for the quarter ended September 30, 2006 to $112.4 million from $108.4 million for the third quarter of 2005.

Noninterest expenses increased $3.0 million from the second quarter of 2006 due primarily to increased expenses in salaries, marketing and promotions and net occupancy. This increase was due primarily to $2.3 million of operating expenses at James Monroe. Bankshares also incurred $0.7 million of merger expenses related to the James Monroe acquisition.

Bankshares also reports cash operating earnings, defined as “GAAP” (Generally Accepted Accounting Principles) earnings excluding the amortization of intangible assets associated with purchase accounting for business combinations; securities gains and losses; and other significant gains, losses or expenses (such as those associated with integrating acquired entities’ operations into Bankshares) unrelated to Bankshares’ core operations. We believe these non-GAAP measures provide information useful to investors in understanding our ongoing core business and operational performance trends. These measures should not be viewed as a substitute for GAAP. Management believes presentations of financial measures excluding the impact of certain items provide useful supplemental information and better reflect core operating activities. In order to arrive at core business operating results, the effects of certain non-core business transactions such as gains and losses on the sale of securities, amortization of intangibles, restructuring charges and merger-related expenses, have been excluded. Management reviews these same measures internally. For instance, the cash operating efficiency ratio, rather than the GAAP basis efficiency ratio, is used to measure management’s success at controlling ongoing, core operating expenses. We believe these measures are consistent with how investors and analysts typically evaluate our industry, and by providing these measures, we facilitate their analysis. Cash operating earnings totaled $73.4 million for the third quarter of 2006, an increase of 0.67% over $72.9 million for the same period in 2005.

Additionally, management believes that reporting several key measures based on tangible assets (total assets less intangible assets) and tangible equity (total equity less intangible assets) is important, as this more closely approximates the basis for measuring the adequacy of capital for regulatory purposes. The ratio of average tangible equity to average tangible assets was 9.79% for the quarter ended September 30, 2006 compared with 9.53% for the same period in 2005. See Reconciliation of Non-GAAP Measures for the reconciliation of GAAP measures to non-GAAP measures found at the end of this management’s discussion.

For the first nine months of 2006, net income was $215.4 million, an increase of 6.9% over the $201.5 million reported for the same period in 2005. Diluted net income per share was $1.73, an increase of 4.8% from the $1.65 reported for the same period last year. For the nine months ended September 30, 2006, cash operating earnings were $219.9 million compared with $203.1 million for the same period last year. Average tangible equity to average tangible assets for the year-to-date 2006 and 2005 were 9.83% and 9.73%, respectively.

CRITICAL ACCOUNTING POLICIES AND RELATED ESTIMATES

In order to understand Bankshares’ financial position and results of operations, it is important to understand Bankshares’ significant accounting policies and the extent to which judgment and estimates are used in applying those policies. Bankshares’ accounting and reporting policies are in accordance with accounting principles generally accepted in the United States (GAAP), and they conform to general practices within the applicable industries. Management uses a significant amount of judgment and estimates based on assumptions for which the actual results are uncertain when the estimate is made. Bankshares has identified five policies as being particularly sensitive in terms of judgments and the extent to which estimates are used: allowance for loan losses and the reserve for unfunded commitments; loans in nonaccrual status or deemed to be impaired; investment securities; income taxes; and valuation of goodwill and intangible assets. An update of our accounting policy for the allowance for loan losses and the reserve for unfunded commitments is provided in the following section. For more information on our critical accounting policies, please refer to our 2005 Annual Report on Form 10-K.

Allowance for Loan Losses and Reserve for Unfunded Commitments

Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. Bankshares’ allowance for loan losses provides for probable losses based on evaluations of known and inherent risks in the loan portfolio. The allowance for loan losses is maintained at a level considered by management to be adequate to absorb losses inherent in the loan portfolio as of the date of the consolidated financial statements. We have developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses that reflect management’s careful evaluation of credit risk considering all available information. Management uses historical quantitative information to assess the adequacy of the allowance for loan losses as well as qualitative information about the prevailing economic and business environment, among other things. In developing this assessment, management must rely on estimates and exercise judgment in assigning credit risk. Depending on changing circumstances, future assessments of credit risk may yield materially different results from the estimates, which may require an increase or decrease in the allowance for loan losses.

We employ a variety of modeling and estimation tools in developing the appropriate allowance. Bankshares’ allowance consists of formula-based components for business and retail loans, an allowance for impaired loans and an unallocated component. The following provides a description of each of these components of the allowance, the techniques used and the estimates and judgments inherent in each. In the first quarter of 2006, management refined the methodologies for the formula-based components to align more appropriately the allowance methodology with our current framework for analyzing credit losses. Formula-based allowance calculations for business and retail components permit us to address specifically the current trends and events affecting the credit risk in the loan portfolio.

Business loans are comprised of commercial, commercial real estate and construction loans, which are evaluated separately for impairment. For business loans, the formula-based component of the allowance for loan losses is based on statistical migration estimates of the average losses observed for business loans classified by credit grade. Average losses for each credit grade are computed using the annualized historical rate at which loans in each credit grade have defaulted (probability of default rates or “PD”) and the historical average losses realized for defaulted loans (loss-given-default or “LGD”). We have developed default rates by analyzing four years of our default experience and more than 14 years of comparable external data. Default rates, which are validated annually, are estimates derived from long-term averages and are not based on short-term economic or environmental factors. LGD rates have been developed using industry benchmarks.

Retail loans are comprised of consumer installment and residential mortgage loans. For retail loans, the formula-based component of the allowance for loan losses is primarily based on the probability of default rates and LGD rates for specific groups of similar loans by product category. The probability of default rates are based on four years of our default experience and between 14 and 19 years of comparable industry data. LGD rates were developed using industry benchmarks.

For both business and retail loans, the formula-based components include additional qualitative amounts to establish reasonable ranges that consider observed historical variability in losses. Factors we may consider in setting these amounts include, but are not limited to, industry-specific data, portfolio-specific risks or concentrations, and macroeconomic conditions. Including these variability components in the model enables us to capture probable incurred losses that are not yet evident in current default rates, delinquencies and other credit-risk measurement tools.

The specific allowance allocation is based on an analysis of the loan portfolio. Each loan with an outstanding balance in excess of a specified threshold that is either in nonaccrual status or on the “Watchlist” is evaluated. The Watchlist includes loans identified and closely followed by management. These loans possess certain qualities or characteristics that may lead to collection and loss issues. The identified loans are evaluated for potential loss by analyzing current collateral values or present value of cash flows, as well as the capacity of the guarantor, as applicable. This is in accordance with SFAS No. 114, “Accounting for Creditors for Impairment of a Loan,” and SFAS No. 118, “Accounting for Creditors for Impairment of a Loan — Income Recognition and Disclosure.”

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

In first quarter of 2006, we reclassified a portion of the allowance for loan losses to a reserve for unfunded commitments, which is included in the other liabilities section of the consolidated balance sheet. The modeling process used in the first quarter of 2006 for the determination of the reserve for unfunded lending commitments is consistent with the process described above for the formula-based component of the allowance for loan losses, also including as a key factor a benchmark average rate at which unfunded exposures have been funded at the time of default. The development of this modeling in 2006 enabled Bankshares to evaluate specifically the risk inherent in unfunded commitments and make the reclassification discussed above. As no model data existed in previous years, prior period data has not been reclassified for comparability. In the third quarter of 2006, Bankshares reclassified $1.9 million of the allowance for loan losses to the reserve for unfunded commitments. This resulted from a refinement in the manner in which the required reserves for unfunded commitments were calculated.

SEGMENT REPORTING

As noted in Note No. 11 - Segment Reporting, Bankshares reports two business segments — (1) Banking and (2) Investment and Wealth Management (“IWM”) - for which financial information is segregated for use in assessing performance and allocating resources when reporting to the Board of Directors. Segment financial information is subjective and, unlike financial accounting, is not necessarily based on GAAP. As a result, the financial information of the reporting segments is not necessarily comparable with similar information reported by others and may not be comparable with Bankshares’ consolidated results. Certain expense amounts, such as operations overhead, have been reclassified for internal financial reporting purposes in order to provide for proper allocation of costs in the reported data.

A schedule disclosing the details of these operating segments can be found in Note No. 11 - Segment Reporting.

Banking

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

In the third quarter of 2006, the acquisition of James Monroe as part of the Mercantile Potomac Division of Mercantile-Safe Deposit and Trust Company was completed. This acquisition allowed us to increase our presence in the northern Virginia and Washington, D.C. markets. The Banking segment was the primary beneficiary of the James Monroe acquisition.

Net income for the nine months ended September 30, 2006 increased 6.1%, to $211.1 million, from the $199.0 million earned during the same period last year. Net interest income for Banking increased 6.3% to $476.8 million for the nine months ended September 30, 2006. The growth in net interest income reflected a 10.5% increase in average earning assets, offset by a 13 basis point decline in the net interest margin from 4.44% at September 30, 2005 to 4.31% at September 30, 2006. Average loan balances increased 10.1% year-over-year. Commercial real estate loan balances increased 13.8%, residential real estate loan balances increased 7.8% and construction loan balances increased 25.2%. Average deposits included growth in money market accounts, time deposits greater than $100,000 and noninterest-bearing checking, offset by a reduction in balances associated with savings accounts and checking plus interest accounts in the first nine months of 2006, compared with the first nine months of 2005. The decline in the net interest margin was primarily attributable to the growth in premium money market accounts and certificates of deposit as customers shifted to these higher rate products, and yields on loans and investments lagging the increase in funding costs.

Reflecting the favorable credit quality within the loan portfolio, Banking recorded no provision for credit losses for the first nine months of 2006 as compared with a $1.6 million provision for the same period of 2005. During the first quarter of 2006, Banking established a reserve for unfunded commitments of $15 million by a reclassification of $14 million from the allowance for loan losses and the recording of a $1.0 million provision related to increased unfunded commitments during the quarter. In the third quarter of 2006, $1.9 million was reclassified from the reserve for loan losses to the reserve for unfunded commitments recorded in other liabilities. The reclassification in the third quarter resulted from a refinement in the manner in which the required reserves were calculated. The allowance for loan losses as a percent of loans was 1.15% at September 30, 2006 compared with 1.35% at December 31, 2005 and 1.37% at September 30, 2005.

Noninterest expenses were $258.4 million for the nine months of 2006 compared with $256.3 million for the same period of 2005, an increase of $2.1 million, or 0.8%. Noninterest expenses net of adjustments were $241.1 million for the nine months of 2006, a $1.5 million increase, or 0.6%, over $239.6 million for the same period of 2005. The increase in noninterest expenses was primarily related to normal merit and salary increases, higher benefit costs, and the addition of new branches.

Investment & Wealth Management

Investment and Wealth Management (“IWM”) includes Asset Management, Private Banking, Trust Services, Retail Brokerage Services and Custody Services. IWM provides a full line of investment products and retirement, tax and estate planning services. IWM products include:

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

· Asset Management Services: Proprietary and nonproprietary mutual funds, proprietary and nonproprietary separate account management, customized wealth advisory services, defined benefit and defined contribution retirement services, family office services, individual and institutional trust services and custody services.

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

· Mercantile Funds: Proprietary mutual funds and Mercantile’s hedge funds of funds.

Net income for the first nine months of 2006 increased 24.4%, or $3.1 million, to $15.7 million over the $12.6 million in the first nine months of 2005. Pretax profit margins, prior to corporate overhead allocations, were 29.8% and 31.4% for the first nine months of 2006 and 2005, respectively. For more information on corporate overhead, see “Other” in Segment Reporting.

While equity markets rose during the past twelve months, a slump in the second quarter was followed by a strong recovery in the third quarter of 2006. The S&P 500 Index ended September, 2006 at 1,336, up 8.7% from 1,229 at the end of September 2005, and rose 5.2% from the second quarter of this year. Between September 30, 2005 and September 30, 2006, the Dow Jones Industrial Average increased 10.5% to 11,679 and the Nasdaq rose 5.0% to 2,258. The fixed income markets, as measured by the Lehman Brothers US Aggregate Bond Index, were down 1.6% for the twelve-month period ended September 30, 2006. Bankshares’ investment asset base is relatively balanced between equities (including real estate) and fixed income, cash and other securities. As of September 30, 2006, 45% of IWM managed assets were invested in equities, including real estate. Approximately 39% were invested in fixed income securities and 16% were invested in cash and other.

	As of September 30,
Market Indices	2006		2005
Dow Jones Industrial Average	11,679		10,569
Year-over-Year % Change	10.5	%	4.8	%
S&P 500 Index-period-end	1,336		1,229
Year-over-Year % Change	8.7	%	10.2	%
Nasdaq	2,258		2,152
Year-over-Year % Change	5.0	%	13.4	%
Lehman Brothers US Aggregate Bond Index	101.0		102.6
Year-over-Year % Change	-1.6	%	-2.2	%

Revenues in the first nine months of 2006 increased $14.1 million, or 18.1%, to $92.3 million from $78.2 million in the same period last year. Exceptional revenue growth was realized in Institutional Management (driven by the restructuring of a major pension advisory relationship in Bankshares’ IWM Real Estate Advisory Unit) and the Private Bank (driven by the adoption of Funds Transfer Pricing). Solid revenue growth was realized in Mercantile Funds, Private Wealth Management and Brokerage.

Private Wealth Management benefited from the rise in equity markets during the past year and a fee increase on some accounts at the beginning of 2006. Personal Assets under Administration, at September 30, 2006, increased $0.7 billion, or 5.6%, to $13.2 billion from September 30, 2005. At September 30, 2006 compared with September 30, 2005, Personal Assets with Investment Responsibility increased $0.3 billion, or 3.4%, to $9.1 billion and Assets with No Investment Responsibility increased $0.4 billion, or 10.8%, to $4.1 billion.

Institutional Investment Management benefited principally from the restructuring of a major real estate pension advisory relationship. The impact of this change was to increase revenues approximately $7.0 million and to increase expenses approximately $4.5 million. Revenue declined in our Boyd Watterson Asset Management subsidiary due to decreased assets under management. Higher terminations in our institutional business continued to impede institutional revenue growth in the first nine months of 2006, evidenced by the loss of a $6.5 billion institutional custody account in the third quarter of 2006. At September 30, 2006 compared with September 30, 2005, Total Institutional Assets under Administration (including Boyd Watterson) declined $5.4 billion, or 16.0%, to $28.3 billion; Institutional Assets with Investment Responsibility declined $0.4 billion, or 3.3%, to $11.6 billion; and Assets under Administration with No Investment Responsibility declined $5.0 billion, or 23.0%, to $16.7 billion.

The Mercantile Funds benefited from higher asset flows into the funds, improved equity markets, and solid performance in the hedge funds of funds. Mercantile Fund assets increased $248 million, or 6.4 %, to $4.1 billion, driven by a 6.3% increase in personal trust assets, at September 30, 2006 compared with September 30, 2005.

Brokerage commissions and income benefited from growth in the number of accounts and assets held in accounts. Brokerage assets increased $181 million, or 19%, to $1.1 billion at September 30, 2006 compared with September 30, 2005.

Private Banking revenues benefited from $35.1 million in loan growth and $103.8 million in deposit growth during the past year.

IWM Asset Data (Dollars in billions)	At September 30,
	2006		2005
Personal
Assets with Investment Responsibility	$	9.1	$	8.8
Assets with No Investment Responsibility	4.1		3.7
Total Personal	13.2		12.5

Institutional
Assets with Investment Responsibility	11.6		12.0
Assets with No Investment Responsibility	16.7		21.7
Total Institutional	28.3		33.7

Mutual Funds Not Included Above	0.3		0.2

Total
Assets with Investment Responsibility	21.0		21.0
Assets with No Investment Responsibility	20.8		25.4
Total Assets under Administration	$	41.8	$	46.4

At September 30, 2006, Assets under Administration by IWM were $41.8 billion, a decrease of $4.6 billion, or 9.9%, from the prior year. Bankshares had investment responsibility for $21 billion, unchanged from last year.

Additional revenue growth will depend on new sales and increased distribution, equity and bond market conditions and acquisitions, if any.

In the first nine months of 2006, expenses increased 20.8%, or $11.2 million, to $64.8 million, compared with $53.6 million in the first nine months of last year. Increases occurred in employee-related, technology, marketing, professional services, general operating and occupancy expenses. The real estate advisory business restructuring-related expenses including salaries and benefits, marketing, incentive compensation, recruiting and license fees totaled approximately $4.5 million.

BANKSHARES EARNINGS PERFORMANCE

Analysis of Interest Rates and Interest Differentials

The following table presents the distribution of the average consolidated balance sheet, interest income/expense and annualized yields earned and rates paid for the nine months ended September 30, 2006 and 2005.

	2006							2005
(Dollars in thousands)	Average Balance (2)			Income (1) / Expense		Yield (1) / Rate		Average Balance (2)			Income (1) / Expense		Yield (1) / Rate
Earning assets
Loans:
Commercial	$	2,938,055		$	161,084	7.33	%	$	2,896,725		$	136,123	6.28	%
Commercial real estate	3,837,512			201,638		7.03		3,370,926			163,681		6.49
Construction	1,801,245			109,643		8.14		1,439,235			72,480		6.73
Residential real estate	1,886,917			87,165		6.18		1,749,577			77,867		5.95
Home equity lines	486,724			27,843		7.65		505,630			22,016		5.82
Consumer	1,042,147			45,011		5.77		909,631			39,435		5.80
Total loans	11,992,600			632,384		7.05		10,871,724			511,602		6.29
Federal funds sold, et al	63,384			2,609		5.50		43,658			1,544		4.73
Securities:
Taxable securities
U.S. Treasury and government agencies	1,424,119			40,631		3.81		1,413,240			35,747		3.38
Mortgage-backed	1,619,045			52,692		4.35		1,375,285			41,305		4.02
Other investments	64,114			2,007		4.19		63,765			1,763		3.70
Tax-exempt securities
States and political subdivisions	80,548			3,761		6.24		87,760			3,885		5.92
Total securities	3,187,826			99,091		4.16		2,940,050			82,700		3.76
Interest-bearing deposits in other banks	200			2		1.44		197			2		1.15
Total earning assets	15,244,010			734,086		6.44		13,855,629			595,848		5.75
Cash and due from banks	310,123							306,434
Bank premises and equipment, net	139,780							144,362
Other assets	1,301,824							1,121,574
Less: allowance for loan losses	(148,494		)					(153,268		)
Total assets	$	16,847,243						$	15,274,731
Interest-bearing liabilities
Deposits:
Savings	$	1,277,603		4,756		0.50		$	1,447,797		3,983		0.37
Checking plus interest	1,290,233			1,887		0.20		1,399,352			1,719		0.16
Money market	2,000,814			39,246		2.62		1,606,528			14,653		1.22
Time deposits $100,000 and over	2,065,129			67,829		4.39		1,574,236			35,254		2.99
Other time deposits	2,370,668			61,920		3.49		2,088,820			39,671		2.54
Total interest-bearing deposits	9,004,447			175,638		2.61		8,116,733			95,280		1.57
Short-term borrowings	1,411,287			39,738		3.76		1,069,792			17,228		2.15
Long-term debt	689,474			27,394		5.31		743,381			23,634		4.25
Total interest-bearing funds	11,105,208			242,770		2.92		9,929,906			136,142		1.83
Noninterest-bearing deposits	3,239,008							3,135,048
Other liabilities and accrued expenses	198,284							151,653
Total liabilities	14,542,500							13,216,607
Shareholders’ equity	2,304,743							2,058,124
Total liabilities & shareholders’ equity	$	16,847,243						$	15,274,731
Net interest rate spread				$	491,316	3.52	%				$	459,706	3.92	%
Effect of noninterest-bearing funds						0.79							0.52
Net interest margin on earning assets						4.31	%						4.44	%
Tax-equivalent adjustment included in:
Loan income				$	4,015						$	3,467
Investment securities income				1,509							1,547
Total				$	5,524						$	5,014

(1) Presented on a tax-equivalent basis using the statutory federal corporate income tax rate of 35%; see Reconciliation of Non-GAAP Measures.

(2) Average investment securities are reported at amortized cost; excludes unrealized gains (losses) on securities available-for-sale. Nonaccrual loans are included in average loans.

Analysis of Interest Rates and Interest Differentials

The following table presents the distribution of the average consolidated balance sheet, interest income/expense and annualized yields earned and rates paid for the three months ended September 30, 2006 and 2005.

	2006							2005
(Dollars in thousands)	Average Balance (2)			Income (1) / Expense		Yield (1) / Rate		Average Balance (2)			Income (1) / Expense		Yield (1) / Rate
Earning assets
Loans:
Commercial	$	2,924,627		$	55,810	7.57	%	$	2,914,761		$	48,635	6.62	%
Commercial real estate	4,085,822			73,607		7.15		3,610,170			60,538		6.65
Construction	1,911,222			40,571		8.42		1,544,082			28,077		7.21
Residential real estate	1,951,620			30,525		6.21		1,775,023			26,771		5.98
Home equity lines	479,436			9,723		8.05		517,798			8,126		6.23
Consumer	1,048,341			15,341		5.81		1,027,897			14,797		5.71
Total loans	12,401,068			225,577		7.22		11,389,731			186,944		6.51
Federal funds sold, et al	61,342			854		5.52		57,932			759		5.20
Securities:
Taxable securities
U.S. Treasury and government agencies	1,381,027			13,769		3.96		1,431,397			12,078		3.35
Mortgage-backed	1,662,093			18,624		4.45		1,455,475			14,608		3.98
Other investments	63,393			669		4.19		62,318			526		3.35
Tax-exempt securities
States and political subdivisions	76,727			1,209		6.25		93,683			1,390		5.89
Total securities	3,183,240			34,271		4.27		3,042,873			28,602		3.73
Interest-bearing deposits in other banks	200			1		1.45		200			1		1.02
Total earning assets	15,645,850			260,703		6.61		14,490,736			216,306		5.92
Cash and due from banks	324,675							326,515
Bank premises and equipment, net	142,120							147,248
Other assets	1,330,705							1,257,846
Less: allowance for loan losses	(146,021		)					(157,177		)
Total assets	$	17,297,329						$	16,065,168
Interest-bearing liabilities
Deposits:
Savings	$	1,229,751		1,749		0.56		$	1,420,283		1,519		0.42
Checking plus interest	1,231,558			622		0.20		1,428,344			626		0.17
Money market	2,202,466			16,612		2.99		1,692,684			6,566		1.54
Time deposits $100,000 and over	2,243,487			26,784		4.74		1,674,265			13,939		3.30
Other time deposits	2,429,730			23,025		3.76		2,295,608			15,941		2.76
Total interest-bearing deposits	9,336,992			68,792		2.92		8,511,184			38,591		1.80
Short-term borrowings	1,487,948			15,215		4.06		1,185,142			7,702		2.58
Long-term debt	665,300			8,780		5.24		797,527			8,990		4.47
Total interest-bearing funds	11,490,240			92,787		3.20		10,493,853			55,283		2.09
Noninterest-bearing deposits	3,255,069							3,240,806
Other liabilities and accrued expenses	209,475							151,094
Total liabilities	14,954,784							13,885,753
Shareholders’ equity	2,342,545							2,179,415
Total liabilities & shareholders’ equity	$	17,297,329						$	16,065,168
Net interest rate spread				$	167,916	3.41	%				$	161,023	3.83	%
Effect of noninterest-bearing funds						0.85							0.58
Net interest margin on earning assets						4.26	%						4.41	%
Tax-equivalent adjustment included in:
Loan income				$	1,359						$	1,230
Investment securities income				488							551
Total				$	1,847						$	1,781

(1) Presented on a tax-equivalent basis using the statutory federal corporate income tax rate of 35%; see Reconciliation of Non-GAAP Measures.

(2) Average investment securities are reported at amortized cost; excludes unrealized gains (losses) on securities available-for-sale. Nonaccrual loans are included in average loans.

Rate / Volume Analysis

A rate/volume analysis, which demonstrates changes in interest income and expense for significant assets and liabilities, appears below.

	For the 9 months ended September 30,									For the 3 months ended September 30,
	2006 vs. 2005									2006 vs. 2005
	Due to variances in									Due to variances in
(Dollars in thousands)	Total			Rates (6)			Volumes (5),(6)			Total			Rates (6)			Volumes (5),(6)
Interest earned on:
Loans:
Commercial (1)	$	24,961		$	22,756		$	2,205		$	7,175		$	6,986		$	189
Commercial real estate (2)	37,957			13,491			24,466			13,069			4,526			8,543
Construction (3)	37,163			15,161			22,002			12,494			4,717			7,777
Residential real estate	9,298			2,960			6,338			3,754			1,008			2,746
Home equity lines	5,827			6,914			(1,087		)	1,597			2,370			(773		)
Consumer	5,576			(173		)	5,749			544			248			296
Taxable securities (4)	16,515			8,692			7,823			5,850			4,176			1,674
Tax-exempt securities (4)	(124		)	212			(336		)	(181		)	85			(266		)
Federal funds sold, et al	1,065			253			812			95			47			48
Interest-bearing deposits in other banks	—			—			—			—			—			—
Total interest income	138,238			71,340			66,898			44,397			25,230			19,167

Interest paid on:
Savings deposits	773			1,383			(610		)	230			516			(286		)
Checking plus interest deposits	168			372			(204		)	(4		)	109			(113		)
Money market accounts	24,593			16,853			7,740			10,046			6,197			3,849
Time deposits $100,000 and over	32,575			16,500			16,075			12,845			6,062			6,783
Other time deposits	22,249			14,875			7,374			7,084			5,784			1,300
Short-term borrowings	22,510			12,919			9,591			7,513			4,412			3,101
Long-term debt	3,760			5,905			(2,145		)	(210		)	1,539			(1,749		)
Total interest expense	106,628			81,162			25,466			37,504			29,460			8,044
Net interest earned	$	31,610		$	(9,822	)	$	41,432		$	6,893		$	(4,230	)	$	11,123

(1) Interest year-to-date tax-equivalent adjustments of $2.4 million and $2.3 million for 2006 and 2005, respectively, and quarter-to-date tax-equivalent adjustments of $0.8 million for 2006 and 2005 are included in the calculation of commercial loan rate variances.

(2) Interest year-to-date tax-equivalent adjustments of $0.6 million and $0.4 million for 2006 and 2005, respectively, and quarter-to-date tax-equivalent adjustments of $0.2 million for 2006 and 2005 are included in the calculation of commercial real estate loan rate variances.

(3) Interest year-to-date tax-equivalent adjustments of $1.0 million and $0.7 million for 2006 and 2005, respectively, and quarter-to-date tax-equivalent adjustments of $0.4 million and $0.3 million for 2006 and 2005, respectively, are included in the calculation of construction loan rate variances.

(4) Interest year-to-date tax-equivalent adjustments of $1.5 million for 2006 and 2005, respectively, and quarter-to-date tax-equivalent adjustments of $0.5 million and $0.6 million for 2006 and 2005, respectively, are included in the calculation of investment securities rate variances.

(5) Changes attributable to mix (rate and volume) are included in the volume variances.

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

Net Interest Income and Net Interest Margin

Net interest income for the quarter ended September 30, 2006, on a taxable-equivalent basis, increased 4.3% to $167.9 million from $161.0 million for the third quarter of 2005. The increase was due to growth in average earning assets of $1.2 billion, or 8.0%. The net interest margin declined 15 basis points from 4.41% for the third quarter of 2005 to 4.26% for the third quarter of 2006. The decline was due primarily to growth in premium money market accounts and certificates of deposit as customers shifted to these higher rate products; increased competition affecting yields on new loans and the increase in the overall yield on the investment portfolio lagging the increase in funding costs. Bankshares paid an average rate of 3.2% on interest-bearing liabilities during the third quarter of 2006, an increase of 111 basis points over the third quarter of 2005. By contrast, the yield on average loans and investments increased by 71 basis points and 54 basis points, respectively, over the third quarter of 2005.

On a linked-quarter basis, taxable-equivalent net interest income increased by 2.9% to $167.9 million from $163.3 million. The increase in linked-quarter net interest income was attributable to average earning asset growth of $448.9 million (primarily from the James Monroe acquisition) partially offset by a five basis point decline in the net interest margin. The net interest margin decline was attributable primarily to a 33 basis point increase in the average rate paid for deposits for the third quarter of 2006 compared with the second quarter of 2006. By contrast, the yield on interest earning assets increased only 18 basis points.

Net interest income, on a taxable-equivalent basis, for the first nine months of 2006 increased to $491.3 million, or 6.9%, over the $459.7 million for the first nine months of 2005 due to average earning asset growth of $1.4 billion, or 10.0%. The net interest margin declined from 4.44% to 4.31% as increases in funding costs of 109 basis points outpaced the 69 basis point increase in the yield on earning assets.

Average earning assets in the third quarter of 2006 increased $1.2 billion, or 8.0%, over the same period in 2005. Loans averaged $12.4 billion for the third quarter of 2006, an increase of 8.9% over the $11.4 billion for the third quarter of 2005, with James Monroe contributing 33% of that growth based on $337.7 million in average acquired loans. Loans increased $480.0 million, or 4.0%, on a linked-quarter basis. The increase in average loans outstanding in the third quarter of 2006 compared to the third quarter of 2005 was driven by commercial real estate loan growth of $475.7 million, or 13.2%; construction loan growth of $367.1 million, or 23.8%; and residential mortgage loan growth of $176.6 million, or 9.9%.

Average investment securities for the third quarter of 2006 increased by $140.4 million, or 4.6%, compared with the same period in 2005.

Average deposits for the third quarter of 2006 increased 7.1% year-over-year with James Monroe contributing 42% of that growth, based on $353.5 million in average acquired deposits. Average noninterest-bearing deposits for the third quarter of 2006 increased by $14.3 million, or 0.4%, compared with the same period in 2005. Total average interest-bearing deposits increased by $825.8 million, or 9.7%, for the third quarter of 2006, compared with the same period in 2005.

Given the current rate environment, the flatness of the yield curve and competitive pressure on both loan and deposit pricing, we anticipate that the net interest margin will remain under some pressure throughout the year.

Noninterest Income

Noninterest income for the quarter ended September 30, 2006 decreased by $3.3 million, or 5.2%, to $59.8 million compared with $63.1 million for the same period in 2005. Noninterest income decreased 7.3% compared with the second quarter of 2006.

The table below shows the major components of noninterest income.

	For the 9 months ended September 30,				% Change		For the 3 months ended September 30,						% Change
(Dollars in thousands)	2006		2005		2006/2005		2006			2005			2006/2005
Investment and wealth management	$	82,582	$	71,505	15.5	%	$	27,596		$	23,668		16.6	%
Service charges on deposit accounts	33,936		32,992		2.9		12,776			11,478			11.3
Mortgage banking related fees	5,042		10,329		(51.2	)	497			5,151			(90.4	)
Net investment securities (losses) gains	205		458		(55.2	)	218			(32		)	781.3
Nonmarketable investments:
Private equity and other investments	4,958		7,069		(29.9	)	263			39			574.4
Hedge funds	3,599		3,616		(0.5	)	(801		)	2,897			(127.6	)
Bank-owned life insurance	4,826		2,998		61.0		1,688			1,254			34.6
Total nonmarketable investments	13,383		13,683		(2.2	)	1,150			4,190			(72.6	)
Other income:
Electronic banking fees	19,547		18,137		7.8		7,424			7,010			5.9
Charges and fees on loans	8,936		9,601		(6.9	)	3,065			3,786			(19.0	)
Insurance	12,542		11,578		8.3		3,680			3,480			5.7
All other income	8,668		12,726		(31.9	)	3,361			4,343			(22.6	)
Total other income	49,693		52,042		(4.5	)	17,530			18,619			(5.8	)
Total	$	184,841	$	181,009	2.1		$	59,767		$	63,074		(5.2	)

Noninterest income, which includes investment and wealth management (“IWM”) fees, service charges on deposit accounts, mortgage banking-related fees, securities gains and losses, income from nonmarketable investments and other income, decreased $3.3 million, or 5.2%, to $59.8 million for the third quarter of 2006 from $63.1 million for the third quarter of 2005. IWM revenue increased $3.9 million, or 16.6%, for the third quarter of 2006 from the third quarter of 2005. Mortgage banking-related fees decreased $4.7 million for the third quarter of 2006 from the third quarter of 2005 due primarily to the sale of Columbia National Real Estate Finance, LLC (“CNREF”). Nonmarketable investments revenue for the third quarter of 2006 decreased by $3.0 million from the same period in 2005 due to losses in the hedge funds of funds (“hedge funds”). Increases in electronic banking fees of $0.4 million, $1.3 million in additional fees on deposit accounts and insurance revenues were offset partially by a $0.7 million decline in charges and fees on loans.

Noninterest income for the third quarter of 2006 decreased by $4.7 million, or 7.3%, from the second quarter of 2006. The decrease was due to a $4.8 million decline in nonmarketable investments income. This consisted of a $3.1 million decline in revenues from private equity investments and a $1.8 million decline in hedge fund revenues driven by a $1.0 million loss related to Amaranth, in which one of our hedge funds of funds was invested. Furthermore, a $1.3 million decrease in IWM revenues and a $1.8 million decline in mortgage banking-related fees were offset by increases of $1.9 million in service charges on deposit accounts and $1.2 million in other income and earnings on bank-owned life insurance (“BOLI”).

Noninterest income for the nine months ended September 30, 2006 increased to $184.8 million, or 2.1%, over the $181.0 million for the nine months ended September 30, 2005. The year-over-year increase was due principally to an increase of $11.1 million in IWM revenues of which approximately $7.0 million was attributable to real estate advisory fees from the restructured real estate advisory relationship. Furthermore, electronic banking fees increased $1.4 million; service charges on deposits increased $0.9 million; insurance revenues increased $1.0 million; and earnings on BOLI increased $1.8 million. The increases were offset by a decrease of $5.3 million in mortgage banking-related fees from the same period in 2005 and a $2.1 million decrease in private equity income. In addition, the nine months ended September 30, 2005 included gains of $4.3 million on sales of bank premises that were not repeated this year.

Noninterest Expenses

Noninterest expenses for the quarter ended September 30, 2006 increased by $4.0 million, or 3.7%, to $112.4 million compared with $108.4 million for the quarter ended September 30, 2005. Noninterest expenses increased $3.0 million, or 2.7%, over the second quarter of 2006. This increase was due primarily to $2.3 million of operating expenses associated with the James Monroe acquisition discussed previously. Bankshares also incurred $0.7 million of merger expenses related to James Monroe.

The table below shows the major components of noninterest expenses.

	For the 9 months ended September 30,				% Change		For the 3 months ended September 30,				% Change
(Dollars in thousands)	2006		2005		2006/2005		2006		2005		2006/2005
Salaries	$	147,755	$	148,482	(0.5	)%	$	51,424	$	51,748	(0.6	)%
Employee benefits	42,538		35,490		19.9		13,511		11,637		16.1
Net occupancy expense of bank premises	23,991		20,918		14.7		8,289		7,139		16.1
Furniture and equipment expenses	24,752		23,168		6.8		8,353		7,965		4.9
Communications and supplies	12,083		11,992		0.8		3,796		3,933		(3.5	)
Other expenses:
Professional services	17,955		16,047		11.9		6,042		6,040		—
Advertising and promotional expenses	7,572		6,550		15.6		3,719		2,162		72.0
Electronic banking expense	11,031		10,443		5.6		4,375		4,025		8.7
Amortization of intangible assets	7,064		6,482		9.0		2,522		2,231		13.0
Outsourcing expense	8,256		8,166		1.1		2,792		3,093		(9.7	)
All other expenses	25,569		24,710		3.5		7,606		8,409		(9.5	)
Total other expenses	77,447		72,398		7.0		27,056		25,960		4.2
Total	$	328,566	$	312,448	5.2		$	112,429	$	108,382	3.7

The efficiency ratio, a key measure of expense management, increased in the third quarter of 2006 compared with the same quarter of 2005. The efficiency ratio is computed by dividing noninterest expenses by the sum of net interest income on a taxable-equivalent basis and noninterest income. Bankshares’ efficiency ratio was 49.38% for the three months ended September 30, 2006 compared with 48.36% for the three months ended September 30, 2005. On a non-GAAP basis, the cash operating efficiency ratio excludes the amortization of intangible assets associated with purchase accounting for business combinations; securities gains and losses; and other significant gains, losses or expenses (such as those associated with integrating acquired entities’ operations into Bankshares) unrelated to Bankshares’ core operations. Bankshares’ cash operating efficiency ratio was 48.02% for the three months ended September 30, 2006 compared with 46.99% for the same period last year. The reconciliation of GAAP to non-GAAP measures can be found at the end of this management’s discussion.

Salaries, which include base compensation, commissions, incentive compensation and stock-based compensation, are the largest component of noninterest expense at 45.7%. Salary expense decreased $0.3 million, or 0.6% from the third quarter of 2005. Normal merit and staff increases of approximately $2.5 million and an additional $1.3 million increase related to James Monroe were largely offset by a reduction of $4.4 million in salaries expense due to an increase in the amount of deferred loan origination costs. Furthermore, reductions to incentive compensation accruals of $2.6 million were partially offset by a $2.3 million increase in stock-based compensation. The $1.9 million increase in employee benefit expenses was due principally to increased medical and pension costs.

Net occupancy expenses, which include premises depreciation, rents, maintenance and utilities increased $1.2 million, or 16.1%, over the same period in the prior year. This increase was due to increases in bank-leased premises throughout the organization.

Total other expenses consist of professional services, marketing, electronic banking and several other categories such as travel and membership, amortization, licensing, insurance and sundry expenses. For the three months ended September 30, 2006 compared with the same period last year, total other expenses increased $1.1 million. This increase was due primarily to an increase of $1.6 million in advertising and promotion expenses related to the restructuring of the real estate advisory relationship, a $1.3 million loss on the sale of CNREF and $1.6 million in increased other professional fees.

Offsetting these increase were a decline in legal fees of $1.1 million, an insurance claim recovery of $1.4 million and a reduction in minority interest expense of $0.7 million.

Noninterest expenses for the nine months ended September 30, 2006 increased $16.1 million, or 5.2%, to $328.6 million from $312.4 million for the nine months ended September 30, 2005.

Salary expenses for the nine months ended September 30, 2006 decreased $0.7 million from the prior year. Normal merit and staff increases resulted in $9.8 million of additional expense; directors’ fees and stock-based compensation increased $5.2million; severance increased $1.8 million; and the James Monroe acquisition added $1.3 million in salary expenses. Offsetting these increases were reductions of $14.5 million in salaries expense due to an increase in the amount of deferred loan origination costs and $4.6 million in incentive compensation. Employee benefits expense was $7.0 million higher than 2005 due principally to increased pension related costs of $3.7 million, $2.0 million in increased health insurance costs and $1.1 million in higher payroll taxes.

Net occupancy expenses increased $3.1 million year-to-date 2006 over 2005. The increase was primarily due to the Community Bank of Northern Virginia (“CBNV”) and James Monroe acquisitions and increased costs of leasing bank premises and additional branches.

Total other expenses for the first nine months of 2006 were $77.4 million, or 7.0%, higher than the same period in 2005. This increase was due primarily to $1.9 million in professional fees principally related to efforts to improve efficiency throughout the organization; $1.9 million in licensing fees related to the restructuring of the real estate pension advisory relationship; a $1.3 million loss on the sale of CNREF; a $1.0 million increase in advertising and promotional expenses; increased travel expenses of $0.6 million; an increase of $0.6 million in electronic banking expenses and $0.6 million of additional amortization expenses. Offsetting these increases were $1.4 million from an insurance recovery related to CBNV and a decrease in other expenses of $1.5 million primarily related to legal settlements during the first nine months of 2005.

ANALYSIS OF FINANCIAL CONDITION

At September 30, 2006 compared with September 30, 2005, total assets increased 7.1%, or $1.2 billion. At September 30, 2006 compared with December 31, 2005, total assets increased 7.0%, or $1.2 billion. This increase is attributable, in part, to the acquisition of James Monroe on July 17, 2006. On the merger date, James Monroe had total loans of $414 million, total assets of $552 million and total deposits of $434 million.

A comparative schedule of average balances is included in the Analysis of Interest Rates and Interest Differentials table.

Securities Available-for-Sale

The securities available-for-sale portfolio includes both debt and marketable equity securities. Bankshares holds debt securities available-for-sale primarily for liquidity, interest rate risk management and yield enhancement purposes. Accordingly, this portfolio primarily includes very liquid, high quality federal agency-backed debt securities. At September 30, 2006 and December 31, 2005, the portfolio totaled $3.1 billion. At September 30, 2006, there was a net unrealized loss of $44.3 million. Two hundred ninety-one securities were in a continuous loss position for 12 months or more at September 30, 2006, which consisted primarily of mortgage-backed securities. Management concluded that because the declines in fair value were due to changes in market interest rates, not in estimated cash flows, no other-than-temporary impairment was required to be recorded at September 30, 2006. There was a net unrealized loss on debt securities available-for-sale of $44.9 million and $32.8 million at September 30, 2006 and December 31, 2005, respectively.

The weighted-average expected maturity of debt securities available-for-sale was 2.3 years at September 30, 2006. Since approximately 54% of this portfolio was mortgage-backed securities, the expected remaining maturity may differ from contractual maturity because borrowers may have the right to prepay obligations before the underlying mortgages mature. See Note No. 4 - Investment Securities to the Financial Statements for securities available-for-sale by security type.

Loan Portfolio

Total loans at September 30, 2006 were $12.5 billion, compared with $11.6 billion at December 31, 2005. The increase in total loans was primarily driven by growth in construction lending, commercial real estate and residential mortgages and the acquisition of James Monroe, which added $414.3 million in loans. Construction loans totaled $2.0 billion at September 30, 2006, compared with $1.6 billion at December 31, 2005, an increase of $344.9 million, or 21.5%. Commercial real estate loans increased $445.6 million, or 12.0%, from December 31, 2005. Residential real estate loans increased $186.0 million, or 10.3%, from December 31, 2005. Total loans at September 30, 2006 increased $1.1 billion, or 9.5%, over September 30, 2005.

			% of				% of				% of
	September 30,		Total		December 31,		Total		September 30,		Total
(Dollars in thousands)	2006		Loans		2005		Loans		2005		Loans
Commercial	$	2,925,300	23.3	%	$	2,957,301	25.5	%	$	2,925,445	25.6	%
Commercial real estate	4,148,895		33.1		3,703,297		31.9		3,638,238		31.8
Construction	1,952,013		15.6		1,607,095		13.8		1,543,633		13.5
Residential real estate	1,988,336		15.9		1,802,373		15.5		1,778,684		15.5
Home equity lines	476,746		3.8		505,508		4.4		520,214		4.5
Consumer	1,043,048		8.3		1,032,271		8.9		1,039,845		9.1
Total loans at end of period	$	12,534,338	100.0	%	$	11,607,845	100.0	%	$	11,446,059	100.0	%

Deposits

Total deposits at September 30, 2006, were $12.8 billion, an increase of $697.8 million, or 5.8%, over December 31, 2005. Noninterest-bearing deposits were $3.3 billion at September 30, 2006 and December 31, 2005. Interest-bearing deposits totaled $9.5 billion at September 30, 2006, compared with $8.8 billion at December 31, 2005, an increase of $720.1 million, or 8.2%.

At September 30, 2006, total deposits increased 6.1%, or $735.2 million, compared with the year-earlier period. The increase in total deposits was primarily driven by the acquisition of James Monroe which added $433.6 million in deposit growth in money market accounts and time deposits $100,000 and over. These products are priced at competitive rates, which move with the overall interest rate environment. Money market accounts and time deposits $100,000 and over increased $465.2 million, or 25.4%, and $542.4 million, or 30.7%, respectively, from September 30, 2005. Traditional low-cost savings and checking plus interest accounts declined by 13.6% and 15.5%, respectively, from September 30, 2005 as customers moved liquidity to higher yielding alternative products.

							% change
(Dollars in thousands)	September 30, 2006		December 31, 2005		September 30, 2005		September 30, 2006 / December 31, 2005		September 30, 2006 / September 30, 2005
Noninterest-bearing deposits	$	3,301,554	$	3,324,650	$	3,329,331	(0.7	)%	(0.8	)%
Savings	1,196,573		1,339,215		1,385,106		(10.7	)	(13.6	)
Checking plus interest	1,229,760		1,430,524		1,454,488		(14.0	)	(15.5	)
Money market	2,295,341		1,944,513		1,830,111		18.0		25.4
Time deposits $100,000 and over	2,308,686		1,743,885		1,766,250		32.4		30.7
Other time deposits	2,443,197		2,294,563		2,274,620		6.5		7.4
Total deposits at end of period	$	12,775,111	$	12,077,350	$	12,039,906	5.8		6.1

Borrowings

Bankshares utilizes both short-term and long-term borrowings to fund growth of earning assets in excess of deposit growth. Short-term borrowings, which include federal funds purchased, securities sold under agreements to repurchase and other short-term borrowings, were $1.6 billion at September 30, 2006, compared with $1.2 billion at December 31, 2005. Short-term funding is managed to levels deemed appropriate given alternative funding sources. Long-term debt was $659.7 million at September 30, 2006, a decrease of $82.5 million, or 11.1%, compared with the $742.2 million at December 31, 2005.

Capital

Shareholders’ equity at September 30, 2006 was $2.4 billion, an increase of $198.7 million from December 31, 2005, due in part to the shares issued in the James Monroe acquisition. The 1.8 million shares issued in the acquisition were valued at $63.1 million.

On June 13, 2006, Bankshares’ Board of Directors authorized the repurchase of up to two million shares of the Corporation’s common stock. This is in addition to the 676 thousand shares remaining from a previously announced program. During the first nine months of 2006, Bankshares repurchased 38,471 shares in the privately negotiated net settlement of the minimum tax liability for vested restricted stock awards.

On January 10, 2006, Bankshares announced a three-for-two stock split on its common stock payable in the form of a stock dividend on January 27, 2006 to stockholders of record as of the close of business on January 20, 2006. For comparative purposes, certain share, average share and per share amounts have been restated. At September 30, 2006 and December 31, 2005, the cash-dividend payout ratio was 47.13% and 43.42%, respectively. For more details, see the Statements of Changes in Consolidated Shareholders’ Equity.

RISK MANAGEMENT

Credit Risk Analysis

Bankshares’ loans and commitments are substantially to borrowers located in its immediate region. Bankshares has limited its participation in multibank credits where Bankshares is not the managing or agent bank. Central to the operation of a sound and successful financial institution is the balanced management of asset growth and credit quality. Responsibility for loan underwriting and monitoring is clearly fixed on key management personnel in each of our affiliates and, ultimately, on the board of directors of each affiliate. These responsibilities are supported at the holding company level by appropriate underwriting guidelines and ongoing loan review. In addition, Bankshares has set an internal limit for each affiliate bank that is well below the regulatory limit on the maximum amount of credit that may be extended to a single borrower.

For more information on credit risk see “Risk Management — Credit Risk Analysis” in Bankshares’ 2005 Annual Report on Form 10-K.

Nonperforming Assets

Nonperforming assets consist of nonaccrual loans, renegotiated loans and other real estate owned (i.e., real estate acquired in foreclosure or in lieu of foreclosure). With respect to nonaccrual loans, Bankshares’ policy is that, regardless of the value of the underlying collateral and/or guarantees, no interest is accrued on the entire balance once either principal or interest payments on any loan become 90 days past due at the end of a calendar quarter. All accrued and uncollected interest on such loans is eliminated from the income statement and is recognized only as collected. If a loan is impaired and has a specific loss allocation based on an analysis under SFAS No. 114, “Accounting by Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and 15,” all payments are then applied against the loan’s principal. A loan may be placed on nonaccrual status sooner than this standard if, in management’s judgment, such action is warranted.

Nonperforming loans increased to $36.0 million at September 30, 2006 from $22.6 million at December 31, 2005. The increase resulted from loans to a single borrower aggregating $18.0 million.

Other real estate owned declined to $67 thousand at September 30, 2006 from $667 thousand at December 31, 2005. The decline resulted from the sale of an OREO property owned as a result of the CBNV acquisition.

During the nine months ended September 30, 2006, total nonperforming assets increased to $36.1 million from $23.2 million at December 31, 2005. Nonperforming assets as a percent of period-end loans and other real estate owned was 0.29% at September 30, 2006 and 0.20% at December 31, 2005.

At September 30, 2006 and December 31, 2005, monitored loans, or loans with characteristics suggesting that they could be classified as nonperforming in the near future, were $1.7 million and $2.2 million, respectively. Loans past due 30-89 days were $34.5 million at September 30, 2006 compared with $65.2 million at December 31, 2005.

The table below presents a comparison of nonperforming assets at September 30, 2006, December 31, 2005 and September 30, 2005.

	September 30,			December 31,			September 30,
(Dollars in thousands)	2006			2005			2005
Nonaccrual loans(1)
Commercial	$	8,206		$	15,771		$	21,065
Commercial real estate	5,056			4,451			3,240
Construction	19,519			376			377
Residential real estate	2,640			1,505			1,845
Home equity lines	151			88			89
Consumer	430			374			406
Total	36,002			22,565			27,022
Renegotiated loans (1)	—			—			—
Loans contractually past due 90 days or more
And still accruing interest	—			—			—
Total nonperforming loans	36,002			22,565			27,022
Other real estate owned	67			667			777
Total nonperforming assets	$	36,069		$	23,232		$	27,799
Nonperforming loans as a percent of period-end loans	0.29		%	0.19		%	0.24		%
Nonperforming assets as a percent of period-end loans and other real estate owned	0.29		%	0.20		%	0.24		%

(1) Aggregate gross interest income of $2.4 million, $2.1 million and $1.9 million for the first nine months of 2006, the year 2005 and the first nine months of 2005, respectively, on nonaccrual and renegotiated loans, would have been recorded if these loans had been accruing on their original terms throughout the period or since origination if held for part of the period. The amount of interest income on the nonaccrual and renegotiated loans that was recorded totaled $0.5 million for the first nine months of 2006 and 2005 and the year 2005.

Net Recoveries/Charge-offs

Net recoveries for the nine months ended September 30, 2006 were $9 thousand as compared to net charge-offs of $488 thousand in 2005.

Provision for Credit Losses

There were no provisions for credit losses for the nine months ended September 30, 2006 compared with $1.6 million for the nine months ended September 30, 2005, reflecting improved loan quality and continued favorable economic conditions.

Allowance for Loan Losses and Reserve for Unfunded Commitments

The allowance for loan losses declined $12.8 million to $143.9 million at September 30, 2006, or 1.15% of period-end loans, compared with $156.7 million, or 1.35% of period-end loans, at December 31, 2005 and declined $13.3 million compared with $157.2 million, or 1.37% of period end loans, at September 30, 2005. The decline from year-end 2005 was primarily related to the reclassification of $14.0 million and $1.9 million in the first and third quarters of 2006, respectively, from the reserve for loan losses to establish the reserve for unfunded commitments in other liabilities. The reclassification in the third quarter resulted from a refinement in the manner in which the required reserves for unfunded commitments were calculated. The acquired allowance from James Monroe was approximately $4.0 million.

The following table presents a summary of the activity in the Allowance for Loan Losses and the Reserve for Unfunded Commitments.

	For the 9 months ended September 30,						For the 3 months ended September 30,
(Dollars in thousands)	2006			2005			2006			2005
Allowance for loan losses, beginning of period	$	156,673		$	149,002		$	142,860		$	157,101
Allowance of acquired bank	3,985			7,086			3,985			—
Charge-offs:
Commercial	(1,470		)	(2,252		)	(876		)	(570		)
Commercial real estate	(362		)	(32		)	—			—
Construction	—			—			—			—
Residential real estate	(54		)	(42		)	(52		)	(28		)
Home equity lines	—			(69		)	—			—
Consumer	(2,251		)	(2,430		)	(981		)	(1,112		)
Total	(4,137		)	(4,825		)	(1,909		)	(1,710		)
Recoveries:
Commercial	2,440			1,813			358			233
Commercial real estate	88			151			28			27
Construction	2			446			1			445
Residential real estate	60			232			7			167
Home equity lines	24			—			—			—
Consumer	1,532			1,695			379			93
Total	4,146			4,337			773			965
Net recoveries (charge-offs)	9			(488		)	(1,136		)	(745		)
Provision for credit losses	(990		)	1,576			—			820
Transfer to reserve for unfunded commitments	(15,824		)	—			(1,856		)	—
Allowance for loan losses, end of period	$	143,853		$	157,176		$	143,853		$	157,176

	For the 9 months ended September 30,						For the 3 months ended September 30,
(Dollars in thousands)	2006			2005			2006			2005
Reserve for unfunded lending commitments, beginning of period	$	—		$	—		$	14,958		$	—
Provision for credit losses	990			—			—			—
Transfer from allowance for loan losses	15,824			—			1,856			—
Reserve for unfunded lending commitments, end of period	$	16,814		$	—		$	16,814		$	—

Average loans	$	11,992,600		$	10,871,724		$	12,401,068		$	11,389,731
Period-end loans	$	12,534,338		$	11,446,059

Allowance for loan losses
Percent of net (recoveries) charge-offs, (annualized), to average loans	—		%	0.01		%	0.04		%	0.03		%
Percent of allowance for loan losses to period-end loans	1.15		%	1.37		%

Interest Rate Risk

The objective of interest rate risk management is to contain the risks associated with interest rate fluctuations. The process involves identification and management of the sensitivity of net interest income to changing interest rates and other market factors. Interest rate risk, one of the more prominent risks in terms of potential earnings impact, is an inevitable part of being a financial intermediary. For more information see “Risk Management — Interest Rate Risk” in Bankshares 2005 Annual Report on Form 10-K.

EARNINGS SIMULATION MODEL PROJECTIONS

Bankshares assesses interest rate risk by comparing projected net interest income in the current rate environment with various interest rate scenarios that differ in the direction of interest rate changes, the degree of change over time, the speed of the change and the projected shape of the yield curve. This analysis incorporates substantially all of Bankshares’ assets and liabilities and off-balance sheet instruments. Through these simulations, management estimates the impact on net interest income of a 200 basis point upward and downward change in interest rates. The following table summarizes the effect that a +/- 200 basis point change in interest rates would have on Bankshares’ net interest income over the next 12 months.

	Calculated increase / (decrease) in projected net interest income
Change in interest rates (basis points)	September 30, 2006		September 30, 2005
+200	0.97	%	2.32	%
+100	0.53	%	1.25	%
–100	(0.94	)%	(1.77	)%
–200	(2.66	)%	(4.57	)%

At September 30, 2006, Bankshares’ interest sensitivity position was less asset sensitive than it was at September 30, 2005. Based on its most recent simulation model, Bankshares’ net interest income would increase by $3.5 million, or 0.53%, and $6.3 million, or 0.97%, if interest rates were to move up gradually over the next six months by 100 basis points or 200 basis points, respectively. A downward movement of 100 basis points would reduce net interest income by $6.1 million, or 0.94%. A downward movement of 200 basis points would reduce net interest income by $17.4 million, or 2.66%. Bankshares manages the interest rate risk profile within policy limits. At September 30, 2006, and December 31, 2005, Bankshares was within its policy guidelines. In response to action by the Federal Reserve to increase short-term interest rates, Bankshares’ prime interest rate continues to rise. At September 30, 2006, Bankshares had approximately $4.7 billion in loans that will reprice daily or monthly as market rates change. The effects of a rising rate environment on interest expense are less predictable due to customer behavior that can result in changes in the mix of deposit products. Current trends have generated growth in higher-rate premium money market and certificate of deposit accounts. Given the current rate environment, the flatness of the yield curve and competitive pressure on both loan and deposit pricing, we anticipate that the net interest margin will remain under some pressure throughout the year.

Bankshares also utilizes interest rate derivatives to hedge interest rate risk exposures. The credit risk amount and estimated net fair values of these derivatives as of September 30, 2006 and December 31, 2005 are presented in Note No. 12 - Derivative Instruments and Hedging Activities. Derivatives are used for asset/liability management in three ways:

· To convert long-term fixed-rate debt to floating-rate payments by entering into receive-fixed swaps at issuance;

· To convert the cash flows from selected asset and/or liability instruments/portfolios from fixed to floating payments or vice versa; and

· To hedge the mortgage origination pipeline by utilizing forward rate commitments for loans held-for-sale.

MARKET VALUE OF EQUITY MODELING

Bankshares also utilizes the market value of equity as a measurement tool in managing interest rate sensitivity. The market value of equity measures the degree to which the market values of Bankshares’ assets and liabilities and off-balance sheet instruments will change given a change in interest rates. The Asset/Liability Management Committee guidelines limit the change in market value of equity in a 200 basis point parallel rate shock to 12.5% of the market value of equity assuming interest rates at September 30, 2006. The up 200 basis point scenario resulted in a 4.6% decrease at September 30, 2006 compared with a 2.9% decrease at December 31, 2005. The down 200 basis point scenario resulted in a 1.1% decrease at September 30, 2006 and a 3.9% decrease at December 31, 2005. At September 30, 2006 and December 31, 2005, Bankshares was within its policy guidelines.

The valuation analysis is dependent upon certain key assumptions about the nature of indeterminate maturities of assets and liabilities. Management estimates the average life and rate characteristics of asset and liability accounts based on historical analysis and management’s expectation of rate behavior. These assumptions are periodically validated and updated.

Market Risk

Market risk is defined as the constraint imposed by lower market values of assets and liabilities as interest rates and equity markets fluctuate. Changes in market values also affect the fee income earned by IWM, where a significant portion of the fee schedule is tied to current asset values under management or administration. Bankshares has designated substantially all of its investment portfolio as available-for-sale, and in accordance with financial reporting standards, this portfolio is reported at fair value. Changes in fair value, net of tax, are reflected as a component of shareholders’ equity.

Trading Activities

Bankshares provides capital market products to its customers. From a market risk perspective, Bankshares’ net income is exposed to changes in interest rates, credit spreads, and equities and their implied volatilities. The primary purpose of Bankshares’ capital markets business is to accommodate customers in the management of their market price risks. Derivative transactions executed with customers are simultaneously hedged in the capital markets. All derivatives transacted with customers used to hedge capital market transactions with customers are carried at fair value. The Asset/Liability Management Committee establishes and monitors counterparty risk limits. The notional amount, exposure amount and estimated net fair value of all customer accommodation derivatives at September 30, 2006 are included in Note No. 12 - Derivative Instruments and Hedging Activities.

Equity Markets

Bankshares is directly and indirectly affected by changes in the equity markets. Bankshares has made investments in private equities. These investments are made within capital allocations approved by management. Management reviews these investments at least quarterly and assesses them for possible other-than-temporary impairment. Private equity investments totaled $24.8 million at September 30, 2006 and $22.1 million at September 30, 2005.

Changes in equity market prices may also indirectly affect Bankshares’ net income by affecting (1) the value of third party assets under management or administration within IWM and, hence, fee income; (2) particular borrowers, whose ability to repay principal and/or interest may be affected by the stock market; or (3) brokerage activity, related commission income and other business activities.

Liquidity Risk

Liquidity risk is the possibility that Bankshares will not be able to fund present and future financial obligations. The objective of liquidity management is to maintain the ability to meet commitments to fund loans, purchase securities and repay deposits and other liabilities in accordance with their terms. To achieve this objective, the Asset/Liability Management Committee establishes and monitors liquidity guidelines that require sufficient asset-based liquidity to cover potential funding requirements and to avoid over-reliance on volatile, less reliable funding markets. Debt securities in the available-for-sale portfolio provide liquidity, in addition to the immediately liquid resources of cash and due from banks, federal funds sold and securities purchased under resale agreements. By limiting the maturity of securities and maintaining a conservative investment posture, management can rely on the investment portfolio to help meet any short-term funding needs. U.S. Treasury and agency securities, which provide the greatest liquidity, averaged $1.4 billion in the third quarter of 2006 and 2005 and the second quarter of 2006.

Core customer deposits have historically provided a substantial source of relatively stable and low-cost funds. For the three months ended September 30, 2006, core deposits (total deposits less certificates of deposit of $100,000 and over), averaged $10.3 billion compared with $10.1 billion for the second quarter of 2006 and for the third quarter of 2005. Although not viewed as core deposits, a substantial portion of short-term borrowings, comprised of securities sold under agreements to repurchase and commercial paper, originate from core deposit relationships tied to the overnight cash management program offered to customers. Long-term debt and short-term borrowings funded the remaining assets.

In addition to these sources, Bankshares has access to national markets for certificates of deposit, commercial paper and debt financing. Should it need to supplement its liquidity, Bankshares has $2.1 billion in lines with the Federal Home Loan Bank of Atlanta (FHLB) and back-up commercial paper lines of $40 million with commercial banks. Bankshares is required to obtain approval from holders of Bankshares’ 6.80% unsecured senior notes if it incrementally borrows in excess of $150 million under the FHLB lines.

Liquidity is also available through Bankshares’ ability to raise funds in the capital markets. Bankshares accesses capital markets for long-term funding by issuing registered debt and private placements. In September 2005, Moody’s Investors Service affirmed Bankshares’ commercial paper rating of “P-1” and Bankshares’ subordinated debt rating of “A2.” Also in September 2005, Standard & Poor’s Ratings Service affirmed Bankshares’ rating of “A+/Stable/A-1”, and counterparty rating of “A+/Stable/A-1.” Rating agencies base their ratings on many quantitative and qualitative factors, including capital adequacy, liquidity, asset quality, quality of the management team, business mix and level and quality of earnings.

For additional information see “Risk Management — Liquidity Risk” in Bankshares’ 2005 Annual Report on Form 10-K.

Contractual Obligations and Commitments

In the normal course of business, Bankshares enters into certain contractual obligations and other commitments. Such obligations generally relate to funding operations through debt arrangements as well as leases of premises and equipment. As a financial services provider, Bankshares routinely enters into commitments to extend credit, including loan commitments, standby letters of credit and financial guarantees. For a discussion of these commitments, see Note No. 7 - Commitments and Contingencies. For a discussion of contractual commitments see “Off-Balance Sheet Arrangements and Contractual Obligations” in Bankshares’ 2005 Annual Report on Form 10-K. Items disclosed in the Annual Report on Form 10-K have not changed materially since the report was filed.

Cautionary Statement

This report contains financial information determined by methods other than in accordance with Generally Accepted Accounting Principles (“GAAP”). Bankshares’ management uses these non-GAAP measures in their analysis of the Company’s performance. In particular, net interest income, net interest margin and the cash operating efficiency ratio are calculated on a fully tax-equivalent basis (“FTE”). The FTE basis is determined by adjusting net interest income to reflect tax-exempt interest income on a before-tax equivalent basis. These measures typically adjust GAAP performance measures to exclude intangible assets and the amortization of intangible assets related to the consummation of mergers. These operating earnings measures may also exclude other significant gains, losses or expenses that are not considered components of core earnings. Since these items and their impact on Bankshares’ performance are difficult to predict, management believes presentations of financial measures excluding the impact of these items provide useful supplemental information that is essential to a proper understanding of the operating results and financial position of Bankshares’ core businesses. These disclosures should not be viewed as a substitute for results determined in accordance with GAAP, nor are they necessarily comparable to operating earnings performance measures that may be presented by other companies.

This report contains forward-looking statements within the meaning of and pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. A forward-looking statement encompasses any estimate, prediction, opinion or statement of belief contained in this report and the underlying management assumptions. Such statements in this report include: identification of trends; loan growth; deposit retention; comments on adequacy of the allowance for loan losses; credit quality; effects of asset sensitivity and interest rate changes; and information concerning market risk referenced in Item 3. Forward-looking statements are based on current expectations and assessments of potential developments affecting market conditions, interest rates and other economic conditions, and results may ultimately vary from the statements made in this report. In addition, the following factors, among others, could cause actual results to differ materially from the anticipated results or expectations expressed in the forward-looking statements: administrative and operational efficiencies may not improve to the degree projected; and competitive pressures and regulatory complexities that affect our banks may be more severe than expected.

Supplemental Information by Quarter
Select Financial Data
In thousands, except per share data
(unaudited)

	3Q 06			2Q 06			1Q 06			4Q 05
OPERATING RESULTS
Net interest income (1)	$	166,069		$	161,410		$	158,313		$	162,434
Net interest income — taxable equivalent (1)	167,916			163,254			160,146			164,267
Provision for credit losses	—			—			—			—
Net income	71,573			73,092			70,759			74,863

PER COMMON SHARE DATA*
Basic net income	$	0.57		$	0.59		$	0.58		$	0.61
Diluted net income	0.57			0.59			0.57			0.60
Dividends paid	0.28			0.28			0.26			0.25
Book value at period end	19.07			18.34			18.05			17.81
Market value at period end	36.27			35.67			38.45			37.63
Market range:
High	37.96			39.53			39.82			40.09
Low	34.29			35.00			36.88			34.11

AVERAGE BALANCE SHEET DATA
Total loans	$	12,401,068		$	11,921,540		$	11,646,904		$	11,497,885
Total earning assets	15,645,850			15,196,996			14,880,775			14,698,731
Total assets	17,297,329			16,798,972			16,435,964			16,258,275
Total deposits	12,592,061			12,190,193			11,940,956			11,894,394
Shareholders’ equity	2,342,545			2,309,149			2,261,646			2,210,050

STATISTICS AND RATIOS (Net income annualized)
Return on average assets	1.64		%	1.75		%	1.75		%	1.83		%
Return on average equity (2)	12.12			12.70			12.69			13.44
Return on average tangible equity (2)	17.87			18.80			18.97			20.26
Average equity to average assets (2)	13.54			13.75			13.76			13.59
Average tangible equity to average tangible assets (2)	9.79			9.88			9.81			9.61
Net interest rate spread — taxable equivalent	3.41			3.51			3.64			3.78
Net interest margin on earning assets — taxable equivalent	4.26			4.31			4.36			4.43
Efficiency ratio (1),(3)	49.38			48.05			48.34			47.87
Cash operating efficiency ratio (1),(3)	48.02			47.08			47.30			46.69
Dividend payout ratio*	49.12			47.46			44.83			40.98

Bank offices	241			237			238			240
Employees	3,592			3,667			3,658			3,606

CREDIT QUALITY DATA AT PERIOD END
Net charge-offs/(recoveries)	$	1,136		$	(986	)	$	(159	)	$	503
Nonaccrual loans	36,002			29,245			22,890			22,565
Restructured loans	—			—			—			—
Total nonperforming loans	36,002			29,245			22,890			22,565
Other real estate owned, net	67			49			713			667
Total nonperforming assets	36,069			29,294			23,603			23,232

CREDIT QUALITY RATIOS
Net charge-offs/(recoveries), annualized, as a percent of period-end loans	0.04		%	(0.03		)%	(0.01		)%	0.02		%
Nonperforming loans as a percent of period-end loans	0.29			0.24			0.20			0.19
Allowance for loan losses as a percent of period-end loans**	1.15			1.19			1.21			1.35
Allowance for loan losses as a percent of nonperforming loans	399.57			488.49			619.81			694.32
Other real estate owned as a percent of period-end loans and other real estate owned	—			—			0.01			0.01
Nonperforming assets as a percent of period-end loans and other real estate owned	0.29			0.24			0.20			0.20
Nonperforming assets as a percent of total assets	0.21			0.17			0.14			0.14

Supplemental Information by Quarter (continued)
Select Financial Data
In thousands, except per share data
(unaudited)

	3Q 05			3Q 06 vs 2Q 06		3Q 06 vs 3Q 05
OPERATING RESULTS
Net interest income (1)	$	159,242		2.9	%	4.3	%
Net interest income — taxable equivalent (1)	161,023			2.9		4.3
Provision for credit losses	820			—		(100.0	)
Net income	70,956			(2.1	)	0.9

PER COMMON SHARE DATA*
Basic net income	$	0.58		(3.4	)%	(1.7	)%
Diluted net income	0.57			(3.4	)	—
Dividends paid	0.25			—		12.0
Book value at period end	17.47			4.0		9.2
Market value at period end	35.92			1.7		1.0
Market range:
High	37.46			(4.0	)	1.3
Low	34.13			(2.0	)	0.5

AVERAGE BALANCE SHEET DATA
Total loans	$	11,389,731		4.0	%	8.9	%
Total earning assets	14,490,736			3.0		8.0
Total assets	16,065,168			3.0		7.7
Total deposits	11,751,990			3.3		7.1
Shareholders’ equity	2,179,415			1.4		7.5

STATISTICS AND RATIOS (Net income annualized)
Return on average assets	1.75		%
Return on average equity (2)	12.92
Return on average tangible equity (2)	19.62
Average equity to average assets (2)	13.57
Average tangible equity to average tangible assets (2)	9.53
Net interest rate spread — taxable equivalent	3.83
Net interest margin on earning assets — taxable equivalent	4.41
Efficiency ratio (1),(3)	48.36
Cash operating efficiency ratio (1),(3)	46.99
Dividend payout ratio*	43.10

Bank offices	238			4		3
Employees	3,607			(75	)	(15	)

CREDIT QUALITY DATA AT PERIOD END
Net charge-offs/(recoveries)	$	745		(215.2	)%	52.5	%
Nonaccrual loans	27,022			23.1		33.2
Restructured loans	—			—		—
Total nonperforming loans	27,022			23.1		33.2
Other real estate owned, net	777			36.7		(91.4	)
Total nonperforming assets	27,799			23.1		29.7

CREDIT QUALITY RATIOS
Net charge-offs/(recoveries), annualized, as a percent of period-end loans	0.03		%
Nonperforming loans as a percent of period-end loans	0.24
Allowance for loan losses as a percent of period-end loans**	1.37
Allowance for loan losses as a percent of nonperforming loans	581.66
Other real estate owned as a percent of period-end loans and other real estate owned	0.01
Nonperforming assets as a percent of period-end loans and other real estate owned	0.24
Nonperforming assets as a percent of total assets	0.17

*In January 2006, Bankshares announced a three-for-two stock split on its common stock. Per share amounts and other applicable information have been adjusted to give effect to the split.

** The decline in the allowance for loan losses was due primarily to the reclassification of $14.0 million in the first quarter of 2006 and $1.9 million in the third quarter of 2006 out of the allowance for loan losses to a separate reserve for unfunded commitments, which is recorded in other liabilities in the consolidated balance sheet.

(1), (2), (3) See Reconciliation of Non-GAAP Measures

Statements of Consolidated Income
In thousands, except per share data
(unaudited)

														3Q 06		3Q 06
														vs		vs
	3Q 06		2Q 06		1Q 06			4Q 05			3Q 05			2Q 06		3Q 05
INTEREST INCOME
Interest and fees on loans	$	224,218	$	208,096	$	196,055		$	192,697		$	185,714		7.7	%	20.7	%
Interest and dividends on investment securities:
Taxable interest income	32,393		31,135		29,795			30,081			26,686			4.0		21.4
Tax-exempt interest income	730		765		778			813			839			(4.6	)	(13.0	)
Other investment income	660		699		627			722			526			(5.6	)	25.5
	33,783		32,599		31,200			31,616			28,051			3.6		20.4
Other interest income	855		1,098		658			890			760			(22.1	)	12.5
Total interest income	258,856		241,793		227,913			225,203			214,525			7.1		20.7

INTEREST EXPENSE
Interest on deposits	68,792		57,603		49,243			44,637			38,591			19.4		78.3
Interest on short-term borrowings	15,215		13,500		11,023			9,038			7,702			12.7		97.5
Interest on long-term debt	8,780		9,280		9,334			9,094			8,990			(5.4	)	(2.3	)
Total interest expense	92,787		80,383		69,600			62,769			55,283			15.4		67.8

NET INTEREST INCOME	166,069		161,410		158,313			162,434			159,242			2.9		4.3
Provision for credit losses	—		—		—			—			820			—		(100.0	)

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES	166,069		161,410		158,313			162,434			158,422			2.9		4.8

NONINTEREST INCOME
Investment and wealth management	27,596		28,865		26,121			24,251			23,668			(4.4	)	16.6
Service charges on deposit accounts	12,776		10,868		10,292			10,893			11,478			17.6		11.3
Mortgage banking-related fees	497		2,335		2,210			4,690			5,151			(78.7	)	(90.4	)
Investment securities gains and (losses)	218		—		(13		)	(53		)	(32		)	—		781.3
Nonmarketable investments	1,150		5,964		6,269			6,199			4,190			(80.7	)	(72.6	)
Other income	17,530		16,436		15,727			16,131			18,619			6.7		(5.8	)
Total noninterest income	59,767		64,468		60,606			62,111			63,074			(7.3	)	(5.2	)

NONINTEREST EXPENSES
Salaries	51,424		47,232		49,099			51,740			51,748			8.9		(0.6	)
Employee benefits	13,511		14,292		14,735			10,685			11,637			(5.5	)	16.1
Net occupancy expense of bank premises	8,289		7,931		7,771			7,678			7,139			4.5		16.1
Furniture and equipment expenses	8,353		8,094		8,305			8,491			7,965			3.2		4.9
Communications and supplies	3,796		4,469		3,818			4,414			3,933			(15.1	)	(3.5	)
Other expenses	27,056		27,404		22,987			25,365			25,960			(1.3	)	4.2
Total noninterest expenses	112,429		109,422		106,715			108,373			108,382			2.7		3.7

Income before income taxes	113,407		116,456		112,204			116,172			113,114			(2.6	)	0.3
Applicable income taxes	41,834		43,364		41,445			41,309			42,158			(3.5	)	(0.8	)

NET INCOME	$	71,573	$	73,092	$	70,759		$	74,863		$	70,956		(2.1	)	0.9

Weighted average shares outstanding*	124,750		123,222		123,043			122,923			122,797			1.2		1.6
Adjusted weighted average shares outstanding*	125,893		124,324		124,294			124,134			123,953			1.3		1.6

NET INCOME PER COMMON SHARE:*
Basic	$	0.57	$	0.59	$	0.58		$	0.61		$	0.58		(3.4	)	(1.7	)
Diluted	$	0.57	$	0.59	$	0.57		$	0.60		$	0.57		(3.4	)	—

*In January 2006, Bankshares announced a three-for-two stock split on its common stock. Per share amounts and other applicable information have been adjusted to give effect to the split.

Statements of Consolidated Noninterest Income and Noninterest Expenses
In thousands
(unaudited)

															3Q 06		3Q 06
															vs		vs
Noninterest Income	3Q 06			2Q 06		1Q 06			4Q 05			3Q 05			2Q 06		3Q 05
Investment and wealth management	$	27,596		$	28,865	$	26,121		$	24,251		$	23,668		(4.4	)%	16.6	%
Service charges on deposit accounts	12,776			10,868		10,292			10,893			11,478			17.6		11.3
Mortgage banking-related fees	497			2,335		2,210			4,690			5,151			(78.7	)	(90.4	)
Investment securities gains and (losses)	218			—		(13		)	(53		)	(32		)	—		781.3
Nonmarketable investments:
Private equity and other investments	263			3,371		1,324			3,310			39			(92.2	)	574.4
Hedge funds	(801		)	1,005		3,395			1,104			2,897			(179.7	)	(127.6	)
Bank-owned life insurance	1,688			1,588		1,550			1,785			1,254			6.3		34.6
Total nonmarketable investments	1,150			5,964		6,269			6,199			4,190			(80.7	)	(72.6	)
Other income:
Electronic banking fees	7,424			6,487		5,636			5,832			7,010			14.4		5.9
Charges and fees on loans	3,065			3,106		2,765			3,063			3,786			(1.3	)	(19.0	)
Insurance	3,680			3,761		5,101			3,439			3,480			(2.2	)	5.7
All other income	3,361			3,082		2,225			3,797			4,343			9.1		(22.6	)
Total other income	17,530			16,436		15,727			16,131			18,619			6.7		(5.8	)
Total	$	59,767		$	64,468	$	60,606		$	62,111		$	63,074		(7.3	)	(5.2	)

											3Q 06		3Q 06
											vs		vs
Noninterest Expenses	3Q 06		2Q 06		1Q 06		4Q 05		3Q 05		2Q 06		3Q 05
Salaries	$	51,424	$	47,232	$	49,099	$	51,740	$	51,748	8.9	%	(0.6	)%
Employee benefits	13,511		14,292		14,735		10,685		11,637		(5.5	)	16.1
Net occupancy expense of bank premises	8,289		7,931		7,771		7,678		7,139		4.5		16.1
Furniture and equipment expenses	8,353		8,094		8,305		8,491		7,965		3.2		4.9
Communications and supplies	3,796		4,469		3,818		4,414		3,933		(15.1	)	(3.5	)
Other expenses:
Professional services	6,042		6,743		5,170		5,867		6,040		(10.4	)	—
Advertising and promotional expenses	3,719		2,355		1,498		2,553		2,162		57.9		72.0
Electronic banking expenses	4,375		3,529		3,127		3,503		4,025		24.0		8.7
Amortization of intangible assets	2,522		2,217		2,325		2,291		2,231		13.8		13.0
Outsourcing expenses	2,792		2,641		2,823		3,065		3,093		5.7		(9.7	)
All other expenses	7,606		9,919		8,044		8,086		8,409		(23.3	)	(9.5	)
Total other expenses	27,056		27,404		22,987		25,365		25,960		(1.3	)	4.2
Total	$	112,429	$	109,422	$	106,715	$	108,373	$	108,382	2.7		3.7

Consolidated Average Balance Sheets
In thousands
(unaudited)

	3Q 06					2Q 06					1Q 06
Earning assets	Average			Yield(1)		Average			Yield(1)		Average			Yield(1)
Loans:	Balance			/ Rate		Balance			/ Rate		Balance			/ Rate
Commercial and leasing	$	2,924,627		7.57	%	$	2,956,420		7.35	%	$	2,933,214		7.06	%
Commercial real estate	4,085,822			7.15		3,748,795			7.02		3,673,385			6.89
Construction	1,911,222			8.42		1,808,734			8.09		1,681,253			7.86
Residential real estate	1,951,620			6.21		1,876,209			6.16		1,831,603			6.16
Home equity lines	479,436			8.05		484,396			7.65		496,526			7.25
Consumer	1,048,341			5.81		1,046,986			5.78		1,030,923			5.73
Total loans	12,401,068			7.22		11,921,540			7.05		11,646,904			6.87
Federal funds sold, et al	61,342			5.52		71,448			6.16		57,318			4.65
Securities: (2)
Taxable securities
U.S. Treasury and government agencies	1,381,027			3.96		1,451,800			3.85		1,440,180			3.64
Mortgage-backed	1,662,093			4.45		1,605,222			4.30		1,589,017			4.30
Other investments	63,393			4.19		65,748			4.30		63,199			4.06
Tax-exempt securities
States and political subdivisions	76,727			6.25		81,038			6.26		83,957			6.22
Total securities	3,183,240			4.27		3,203,808			4.14		3,176,353			4.05
Interest-bearing deposits in other banks	200			1.45		200			1.51		200			1.36
Total earning assets	15,645,850			6.61		15,196,996			6.43		14,880,775			6.26
Cash and due from banks	324,675					304,132					301,305
Bank premises and equipment, net	142,120					138,941					138,237
Other assets	1,330,705					1,301,459					1,272,673
Less: allowance for loan losses	(146,021		)			(142,556		)			(157,026		)
Total assets	$	17,297,329				$	16,798,972				$	16,435,964

Interest-bearing liabilities
Deposits:
Savings	$	1,229,751		0.56		$	1,282,700		0.48		$	1,321,364		0.45
Checking plus interest	1,231,558			0.20		1,298,636			0.20		1,341,714			0.19
Money market	2,202,466			2.99		1,947,364			2.62		1,848,724			2.18
Time deposits $100,000 and over	2,243,487			4.74		2,044,074			4.37		1,904,098			4.00
Other time deposits	2,429,730			3.76		2,362,074			3.47		2,318,985			3.23
Total interest-bearing deposits	9,336,992			2.92		8,934,848			2.59		8,734,885			2.29
Short-term borrowings	1,487,948			4.06		1,423,480			3.80		1,320,595			3.39
Long-term debt	665,300			5.24		673,599			5.53		730,236			5.18
Total interest-bearing funds	11,490,240			3.20		11,031,927			2.92		10,785,716			2.62
Noninterest-bearing deposits	3,255,069					3,255,345					3,206,071
Other liabilities and accrued expenses	209,475					202,551					182,531
Total liabilities	14,954,784					14,489,823					14,174,318
Shareholders’ equity	2,342,545					2,309,149					2,261,646
Total liabilities & shareholders’ equity	$	17,297,329				$	16,798,972				$	16,435,964

Net interest rate spread				3.41	%				3.51	%				3.64	%
Effect of noninterest-bearing funds				0.85					0.80					0.72
Net interest margin on earning assets				4.26	%				4.31	%				4.36	%

Consolidated Average Balance Sheets (continued)
In thousands
(unaudited)

	4Q 05					3Q 05					Average Balance
											3Q 06		3Q 06
Earning assets	Average			Yield(1)		Average			Yield(1)		vs		vs
Loans:	Balance			/ Rate		Balance			/ Rate		2Q 06		3Q 05
Commercial and leasing	$	2,912,089		6.86	%	$	2,914,761		6.62	%	(1.1	)%	0.3	%
Commercial real estate	3,664,491			6.79		3,610,170			6.65		9.0		13.2
Construction	1,574,597			7.56		1,544,082			7.21		5.7		23.8
Residential real estate	1,798,686			6.05		1,775,023			5.98		4.0		9.9
Home equity lines	511,673			6.73		517,798			6.23		(1.0	)	(7.4	)
Consumer	1,036,349			5.68		1,027,897			5.71		0.1		2.0
	11,497,885			6.69		11,389,731			6.51		4.0		8.9
Federal funds sold, et al	76,062			4.64		57,932			5.20		(14.1	)	5.9
Securities: (2)
Taxable securities:
U.S. Treasury and government agencies	1,429,583			3.41		1,431,397			3.35		(4.9	)	(3.5	)
Mortgage-backed	1,545,324			4.56		1,455,475			3.98		3.5		14.2
Other investments	60,998			4.77		62,318			3.35		(3.6	)	1.7
Tax-exempt securities:
States and political subdivisions	88,679			6.01		93,683			5.89		(5.3	)	(18.1	)
	3,124,584			4.08		3,042,873			3.73		(0.6	)	4.6
Interest-bearing deposits in other banks	200			1.35		200			1.02		—		—
	14,698,731			6.13		14,490,736			5.92		3.0		8.0
Cash and due from banks	319,176					326,515					6.8		(0.6	)
Bank premises and equipment, net	139,662					147,248					2.3		(3.5	)
Other assets	1,258,868					1,257,846					2.2		5.8
Less: allowance for loan losses	(158,162		)			(157,177		)			2.4		(7.1	)
Total assets	$	16,258,275				$	16,065,168				3.0		7.7

Interest-bearing liabilities
Deposits:
Savings	$	1,371,020		0.45		$	1,420,283		0.42		(4.1	)	(13.4	)
Checking plus interest	1,398,809			0.18		1,428,344			0.17		(5.2	)	(13.8	)
Money market	1,785,001			1.86		1,692,684			1.54		13.1		30.1
Time deposits $100,000 and over	1,784,340			3.66		1,674,265			3.30		9.8		34.0
Other time deposits	2,300,075			3.03		2,295,608			2.76		2.9		5.8
	8,639,245			2.05		8,511,184			1.80		4.5		9.7
Short-term borrowings	1,213,396			2.96		1,185,142			2.58		4.5		25.6
Long-term debt	766,451			4.71		797,527			4.47		(1.2	)	(16.6	)
	10,619,092			2.35		10,493,853			2.09		4.2		9.5
Noninterest-bearing deposits	3,255,149					3,240,806					—		0.4
Other liabilities and accrued expenses	173,984					151,094					3.4		38.6
	14,048,225					13,885,753					3.2		7.7
Shareholders’ equity	2,210,050					2,179,415					1.4		7.5
	$	16,258,275				$	16,065,168				3.0		7.7

Net interest rate spread				3.78	%				3.83	%
Effect of noninterest-bearing funds				0.65					0.58
Net interest margin on earning assets				4.43	%				4.41	%

(1) Presented on a tax-equivalent basis using the statutory federal corporate income tax rate of 35%; see Reconciliation of Non-GAAP Measures.

(2) Average investment securities are reported at amortized cost; excludes unrealized gains (losses) on securities available-for-sale. Nonaccrual loans are included in average loans.

Reconciliation of Non-GAAP Measures

We believe the non-GAAP measures we use provide information useful to investors in understanding our ongoing core business and operational performance trends. These measures should not be viewed as a substitute for GAAP. Management believes presentations of financial measures excluding the impact of certain items provide useful supplemental information and better reflect its core operating activities. In order to arrive at core business operating results, the effects of certain non-core business transactions such as gains and losses on the sales of securities, amortization of intangibles, restructuring charges and merger-related expenses, have been excluded. Management reviews these same measures internally. For instance, the cash operating efficiency ratio, rather than the GAAP basis efficiency ratio, is used to measure management’s success at controlling ongoing, core operating expenses. Additionally, management believes that reporting several key measures based on tangible assets (total assets less intangible assets) and tangible equity (total equity less intangible assets) is important as this more closely approximates the basis for measuring the adequacy of capital for regulatory purposes.

YTD

2006

2005

3Q 06

2Q 06

1Q 06

4Q 05

3Q 05

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

Net interest income (GAAP basis)	$	485,792	$	454,692	$	166,069	$	161,410	$	158,313	$	162,434	$	159,242
Taxable-equivalent adjustment	5,524		5,014		1,847		1,844		1,833		1,833		1,781
Net interest income - taxable equivalent	$	491,316	$	459,706	$	167,916	$	163,254	$	160,146	$	164,267	$	161,023

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

Return on average equity (GAAP basis)	12.50	%	13.09	%	12.12	%	12.70	%	12.69	%	13.44	%	12.92	%
Impact of excluding average intangible assets and amortization	6.03		6.20		5.75		6.10		6.28		6.82		6.70
Return on average tangible equity	18.53	%	19.29	%	17.87	%	18.80	%	18.97	%	20.26	%	19.62	%

Average equity to average assets (GAAP basis)	13.68	%	13.47	%	13.54	%	13.75	%	13.76	%	13.59	%	13.57	%
Impact of excluding average intangible assets and amortization	(3.85	)	(3.74	)	(3.75	)	(3.87	)	(3.95	)	(3.98	)	(4.04	)
Average tangible equity to average tangible assets	9.83	%	9.73	%	9.79	%	9.88	%	9.81	%	9.61	%	9.53	%

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

Efficiency ratio (GAAP basis)	48.59	%	48.77	%	49.38	%	48.05	%	48.34	%	47.87	%	48.36	%
Impact of excluding:
Securities gains and (losses)	0.02		0.03		0.05		—		—		(0.01	)	—
Gains/(losses) on sales of premises	0.01		0.33		—		0.01		0.02		—		(0.05	)
Amortization of deposit intangibles	(0.70	)	(0.66	)	(0.74	)	(0.66	)	(0.68	)	(0.66	)	(0.65	)
Amortization of other intangibles	(0.35	)	(0.35	)	(0.37	)	(0.32	)	(0.38	)	(0.35	)	(0.34	)
Restructuring charges	—		—		—		—		—		—		—
Merger-related expenses	(0.10	)	(0.18	)	(0.30	)	—		—		(0.16	)	(0.33	)
Cash operating efficiency ratio	47.47	%	47.94	%	48.02	%	47.08	%	47.30	%	46.69	%	46.99	%

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

Net income (GAAP basis)	$	215,424		$	201,456		$	71,573		$	73,092		$	70,759		$	74,863	$	70,956
Less: Securities (gains) and losses, net of tax	(124		)	(277		)	(132		)	—			8			32		19
(Gains)/losses on sales of premises, net of tax	(62		)	(2,624		)	—			(14		)	(48		)	—		117
Plus: Amortization of deposit intangibles, net of tax	2,813			2,593			1,015			899			899			899		892
Amortization of other intangibles, net of tax	1,457			1,326			510			440			507			486		458
Restructuring charges, net of tax	—			—			—			—			—			—		—
Merger-related expenses, net of tax	411			661			411			—			—			216		449
Cash operating earnings	$	219,919		$	203,135		$	73,377		$	74,417		$	72,125		$	76,496	$	72,891

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Information responsive to this item as of December 31, 2005 appears under the caption “Asset/Liability and Market Risk Management” of Bankshares’ Form 10-K for the year ended December 31, 2005. There was no material change in such information as of September 30, 2006.

Item 4. Controls and Procedures

As of September 30, 2006, Bankshares’ management, under the supervision and with the participation of Bankshares’ principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures, (as that term is defined in Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)) under the Securities and Exchange Act of 1934, as amended. Based on the evaluation, the principal executive officer and principal financial officer concluded that Bankshares’ disclosure controls and procedures are effective. There were no significant changes in Bankshares’ internal controls over financial reporting during the quarter.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

Item 1A. Risk Factors

There has been no material change in the risk factors previously disclosed under Item 1A. of Bankshares’ 2005 Form 10-K.

Item 6. Exhibits

Exhibits

31.1 Section 302 Certification of Chief Executive Officer. Filed as an exhibit hereto and incorporated herein by reference.

31.2 Section 302 Certification of Chief Financial Officer. Filed as an exhibit hereto and incorporated herein by reference.

32.1 Section 906 Certification of Chief Executive Officer. Filed as an exhibit hereto and incorporated herein by reference.

32.2 Section 906 Certification of Chief Financial Officer. Filed as an exhibit hereto and incorporated herein by reference.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

				Mercantile Bankshares Corporation
				(Registrant)


October 30, 2006				/s/ Edward J. Kelly, III
Date				By: Edward J. Kelly, III
				Chairman of the Board,
				President and Chief Executive Officer


October 30, 2006				/s/ Terry L. Troupe
Date				By: Terry L. Troupe
				Executive Vice President and
				Chief Financial Officer


October 30, 2006				/s/ William T. Skinner, Jr.
Date				By: William T. Skinner, Jr.
				Controller