Merchants Bancshares 10-K 2005 FY Annual report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X]	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended		December 31, 2005
or
[   ]	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	0-11595
Merchants Bancshares, Inc.
(Exact name of registrant as specified in its charter)
Delaware				03-0287342
State or other jurisdiction of				(I.R.S. Employer
incorporation or organization				Identification No.)
275 Kennedy Drive, South Burlington, Vermont				05403
(Address of principal executive offices)				(Zip Code)
Registrant's telephone number, including area code			(802) 658 - 3400
Securities registered pursuant to Section 12(b) of the Act:
Title of each class				Name of each exchange on which registered
Common Stock, par value $.01 per share				NASDAQ
Securities registered pursuant to section 12(g) of the Act:
None
(Title of class)
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [   ] Yes   [X] No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act [   ] Yes    [X] No
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. [X] Yes [   ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [   ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a nonaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Large Accelerated Filer [   ]		Accelerated Filer [X]			Nonaccelerated Filer [   ]
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). [   ] Yes   [X] No
The aggregate market value of the registrant's voting common stock held by non-affiliates was $103,726,089 as computed using the per share price, as reported on the NASDAQ, as of market close on June 30, 2005.
The number of shares outstanding for each of the registrant's classes of common stock, as of February 23, 2006, is:
Class: Common stock, par value $.01 per share
Outstanding: 6,302,586 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement to Shareholders for the Registrant's Annual Meeting of Shareholders to be held on May 2, 2006 are incorporated herein by reference in Part III.

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FORM 10-K
The following is a copy, except for the exhibits, of the Annual Report of Merchants Bancshares, Inc. and its wholly owned subsidiaries Merchants Bank and Merchants Properties, Inc.; as well as Merchants Bank's wholly owned subsidiary Merchants Trust Company (collectively referred to herein as "Merchants") on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission (the "SEC").
TABLE OF CONTENTS
Part I			Page Reference
	Item 1 -	Business	4 - 10
	Item 1A -	Risk Factors	11
	Item 1B -	Unresolved Staff Comments	11
	Item 2 -	Properties	11 - 12
	Item 3 -	Legal Proceedings	12
	Item 4 -	Submission of Matters to a Vote of Security Holders	12
Part II
	Item 5 -	Market for Registrant's Common Equity, Related Stockholder Matters and
		Issuer Purchases of Equity Securities	13
	Item 6 -	Selected Financial Data	14 - 16
	Item 7 -	Management's Discussion and Analysis of Financial Condition
		and Results of Operations	17 - 35
	Item 7A -	Quantitative and Qualitative Disclosures about Market Risk	36 - 39
	Item 8 -	Financial Statements and Supplementary Data	40 - 67
	Item 9 -	Changes in and Disagreements with Accountants on Accounting and
		Financial Disclosures	71
	Item 9A -	Controls and Procedures	71
	Item 9B -	Other Information	71
Part III *
	Item 10 -	Directors and Executive Officers of the Registrant	71
	Item 11 -	Executive Compensation	71
	Item 12 -	Security Ownership of Certain Beneficial Owners and Management
		and Related Stockholder Matters	71
	Item 13 -	Certain Relationships and Related Transactions	71
	Item 14 -	Principal Accountant Fees and Services	71
Part IV **
	Item 15 -	Exhibits and Financial Statement Schedules	72 − 73
	Signatures		74
*	The information required by Part III is incorporated herein by reference from Merchants' Proxy Statement for the Annual Meeting of Shareholders to be held on May 2, 2006.
**	A list of exhibits to the Form 10-K is set forth on the Exhibit Index included in the Form 10-K filed with the SEC. Copies of any exhibit to the Form 10-K may be obtained from Merchants by contacting Investor Relations, Merchants Bancshares, Inc., P.O. Box 1009, Burlington, VT 05402-1009. All financial statement schedules are omitted since the required information is included in the consolidated financial statements of the Company and notes thereto in the Form 10-K.

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FORWARD-LOOKING STATEMENTS
Except for the historical information contained herein, this Annual Report on Form 10-K of Merchants may contain forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act"). Investors are cautioned that forward looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward looking statements due to certain risks and uncertainties, including, without limitation:
	(i)	the fact that Merchants' success is dependent upon general economic conditions in Vermont and Vermont's ability to attract new business;
	(ii)	the fact that Merchants' earnings depend to a great extent upon the level of net interest income (the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings) generated by Merchants and thus Merchants' results of operations may be adversely affected by increases or decreases in interest rates or by the shape of the yield curve;
	(iii)	the fact that the banking business is highly competitive and the profitability of Merchants depends upon Merchants' ability to attract loans and deposits in Vermont, where Merchants competes with a variety of traditional banking and nontraditional institutions such as credit unions and finance companies;
	(iv)	the fact that at December 31, 2005, approximately 46% of Merchants' loan portfolio was comprised of commercial and commercial real estate loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans;
	(v)	the fact that at December 31, 2005, approximately 87% of Merchants' loan portfolio was comprised of residential real estate and commercial real estate loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Accordingly, Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;
	(vi)	the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States of America generally and in Merchants' markets, which could adversely affect Merchants' financial performance and that of Merchants' borrowers and on the financial markets and the price of Merchants' common stock;
	(vii)	the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;
	(viii)	the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation; and
	(ix)	the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.
These factors, as well as general economic and market conditions in the United States of America, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward looking statements contained herein represent Merchants' judgment as of the date of this Form 10-K; Merchants cautions readers not to place undue reliance on such statements.

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PART I

ITEM 1 - BUSINESS

GENERAL

Merchants Bancshares, Inc. is a bank holding company originally organized under Vermont law in 1983 (and subsequently reincorporated in Delaware) for the purposes of owning all of the outstanding capital stock of Merchants Bank and providing greater flexibility in helping Merchants achieve its business objectives. Merchants Bank, which is Merchants' primary subsidiary, is a Vermont commercial bank with 35 full-service banking offices.

The Merchants Bank was organized in 1849 and assumed a national bank charter in 1865, becoming The Merchants National Bank of Burlington, Vermont. On September 6, 1974, The Merchants National Bank of Burlington converted its national charter to a Vermont state commercial bank charter, adopting its current name, Merchants Bank. As of December 31, 2005, Merchants operated one of the largest commercial banking operations in Vermont, with deposits totaling $855 million, gross loans of $606 million, and total assets of $1.08 billion.

Merchants Trust Company, a wholly owned subsidiary of Merchants Bank, is a Vermont corporation chartered in 1870 for the purpose of offering fiduciary services including trust management and administration, investment management and estate settlement services. As of December 31, 2005,Merchants Trust Company had fiduciary responsibility for assets having a market value in excess of $411 million, of which more than $285 million constituted managed assets.Total revenue of Merchants Trust Company for 2005 was $1.7 million and total expenses were $1.1 million.

Merchants Properties, Inc., a wholly owned subsidiary of Merchants Bancshares, Inc. was organized for the purpose of developing and owning affordable rental housing units throughout the state of Vermont. As of December 31, 2005, Merchants Properties, Inc. owned one development located in Enosburg, Vermont, consisting of a 24-unit low-income family rental housing project. Total assets of Merchants Properties, Inc. at December 31, 2005 were approximately $1.0 million.

MBVT Statutory Trust I was formed on December 15, 2004 as part of Merchants' private placement of an aggregate of $20 million of trust preferred securities through a pooled trust preferred program. The Trust was formed for the sole purpose of issuing non-voting capital securities. The proceeds from the sale of the capital securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust.

As used herein the term "Merchants" shall mean Merchants Bancshares, Inc. and its subsidiaries unless otherwise noted or the context otherwise requires.

RETAIL SERVICES

Merchants' products are designed to provide high value within a defined range of offerings. Individual categories are anchored by lead products that are attractively packaged and easy for Merchants' staff to deliver. This is a clear contrast to most of the other local, regional and national financial service providers. Merchants has consciously focused on business lines that are supportable at the most competitive standard. The business lines it has chosen are robust, with employees proficient in selling and servicing all programs. Merchants' customers appreciate the value that is offered via well defined product features and services that function in a straightforward, effective manner. That formula, in combination with highly motivated and well-trained front line professionals, provides the company with a competitive advantage in its markets.

Merchants' retail deposit products include interest bearing and non-interest bearing checking accounts, money market accounts, club accounts, and short-term and long-term certificates of deposit including a popular flexible CD instrument called TimeLYNX^(R). Merchants also offers customary check collection services, wire transfers, safe deposit box rentals, and automated teller machine ("ATM") and debit cards. Credit programs include secured and unsecured installment lending, home equity lines of credit, home mortgages, and credit cards (in partnership with a third party).

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Free Checking For Life^(R)is available to all applicants of good standing in Merchants' market area, and is free of monthly service charges for the life of the account. The only condition to holding the account is that the customer accept check safekeeping. The account pays interest at tiered levels beginning with the first dollar, and no minimum balance is required. Merchants opened just over 9,600 Free Checking For Life^(R)accounts during 2005.

Free Checking For Life^(R) customers may choose either a Debit Card or an ATM card. Customers who choose the Debit Card can pay for purchases at locations that accept VISA^(R). Customers can use a money market account and/or a home equity line of credit as overdraft coverage for a checking account. The customer may choose either or both accounts to cover overdrafts via an automatic transfer of funds (ATF).

Merchants' primary retail deposit savings product is its MoneyLYNX^(R) Money Market Account. MoneyLYNX^(R) pays interest at tiered levels beginning with the first dollar in the account, and fees are charged only under certain limited circumstances. Merchants' rates on this product remained competitive during the last year, but were not at the top of the market. New account activity rose during 2005, with average individual account balances dropping. At the beginning of 2004, the product was enhanced by lowering the minimum balance required to open an account, contributing to greater demand for this offering.

Merchants' flexible TimeLYNX^(R)certificate of deposit allows multiple deposits and penalty free withdrawals within regulatory guidelines. It is an attractive alternative for customers who wish to retain some of the liquidity features of a money market or savings account while receiving a higher yield than what is offered by those accounts. From April through mid-June 2005, Merchants offered another TimeLYNX^(R) certificate of deposit with a longer term (24 months). Merchants saw the deposits in the TimeLYNX^(R) category rise by 82% during 2005.

Merchants offers ATF to cover overdrafts, electronic funds transfer ("EFT") to automate transfers between accounts, and the PhoneLYNX^SM telephone banking system. Merchants offers eLYNX^(R), a free online banking service as well as a free bill payment service delivered via the Internet, which has proven to be a popular addition.

Each of Merchants' 35 full-service branch offices is led by a branch president who has responsibility for the full range of retail and small business credit services. Merchants' semi-autonomous branch system is core to its strategy of providing one-stop shopping to its customers. Currently most customer inquiries can be handled at any branch location. The branch serves as both a sales and a delivery channel. Branch personnel can explain various deposit options and open new accounts online via internal systems. Additionally, qualified branch staff have the ability to take loan applications, approve loans within defined approval limits, and to close consumer, mortgage and small business loans. Merchants also operates 41 ATMs throughout Vermont, and maintains a customer call center with expanded hours of operation. Customer calls are answered by well-trained employees operating from Merchants' Service Center in South Burlington. There is no automated attendant.

Work was done to build relationships with all of Merchants' households via a communication process known as XSell. More of the mortgage and home equity options were introduced to customers, with growth of the residential portfolio as a result. Financing is available for one-to-four-family residential mortgages, residential construction and seasonal dwelling mortgages. Merchants offers both fixed rate and adjustable rate mortgages for residential properties, and provides a unique two-way rate lock protection feature. Merchants currently holds all originated mortgages in its loan portfolio.

Merchants offers a wide variety of consumer loans. Home improvement and home equity lines of credit and various personal loans are available. Financing is also provided for new or used automobiles, boats, airplanes, recreational vehicles and new mobile homes.

COMMERCIAL SERVICES

Merchants' corporate sales staff services the majority of the commercial customers, which are primarily larger operating companies, real estate investors and developers. Nine corporate banking officers and ten corporate banking administrators provide commercial credit services throughout Vermont to customers requiring business credit above the prescribed authorities of the branch presidents. Branch presidents are trained for small business loan origination.

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Financing is available for business inventory, accounts receivable, fixed assets, real estate, lines of credit for working capital, community development, irrevocable letters of credit, U.S. Small Business Administration guaranteed loans and USDA guaranteed loans. Merchants has increased the emphasis placed on small business loans originated in its branches. The Q-LYNX small business loan program was expanded mid-year 2005, increasing the maximum loan size from $75 thousand to $200 thousand. As a result, program activity grew significantly in the second half of the year.

CommerceLYNX^(R) is a package of business banking services including a low cost business checking account, a CommerceLYNX^(R) Money Market Account, and a streamlined overdraft protection line of credit application. Merchants' philosophy of simplifying product offerings and minimizing fees has been applied to this program. Consistent with Merchants' goal of promoting electronic transactions, CommerceLYNX^(R) provides Internet banking, bill payment and debit and electronic services. Branch presidents are trained to offer this service leading with the introduction of small business deposit options and the value of utilizing the efficient transaction accounts.

Merchants offers a variety of commercial checking accounts. Commercial checking uses an earnings credit rate to help offset service charges. Merchants offers the CommerceLYNX^(R) Money Market Account as the savings vehicle for businesses. The CommerceLYNX^(R) Money Market Account pays interest at tiered levels beginning with the first dollar in the account. Merchants' cash management services provide additional investment opportunities through the Cash Sweep Program. Other cash management services include funds concentration. Merchants offers eLYNX^(R) Online Banking, a commercial banking and bill payment service delivered via the Internet. This product allows businesses to view their account histories, print statements, view check images, order stop payments, transfer between accounts, transmit ACH batches, and order wire transfers. Other miscellaneous commercial banking services include night depository, coin and currency handling, and balance r eporting services.

COMPETITION

The competitive landscape continued to change in 2005. Several large credit unions and a mutual savings bank continued to make substantial commitments in new bricks and mortar in Merchants' primary markets. Citizens Bank completed the name change of all its branches after the merger with Charter One Bank was completed in 2004. TD Banknorth also completed the name change of all its Banknorth branches after the merger of Toronto Dominion and Banknorth Group in 2004. Like most financial institutions in America, Merchants competes with an ever increasing array of financial service providers. As the national economy moves further toward a concentration of service companies and the overall health of the financial service industry continues to be strong, competitive pressures mount. Merchants competes in Vermont for deposit and loan business with numerous other commercial and savings banks, savings and loan associations, credit unions, and other non-bank financial providers. As of De cember 31, 2005, there were more than 18 state and national banking institutions operating in Vermont. In addition, the number of non-bank financial service providers competing in Vermont has increased. As a bank holding company and state-chartered commercial bank, Merchants is subject to extensive regulation and supervision, including, in many cases, regulation that limits the type and scope of its activities. The non-bank financial service providers that compete with Merchants may be subject to less restrictive regulation and supervision. Competition from nationally chartered banks, as well as local institutions, continues to be aggressive.

Merchants expects to see continued competitive pressure on its franchise. Merchants is the largest independent bank with offices exclusively in the state of Vermont. Assertive direct marketing of core financial products continues to result in increased market share, even in mature market areas. Several smaller community banks have continued their commitment to increase their footprints in Merchants' markets. A mutual savings bank headquartered in the central section of Vermont has continued to move into Chittenden County with at least one new retail location added to its prior de novo entries in the county. Several of the credit unions have also continued to open additional branch locations. In a state that already has one of the nation's highest branch-to-population ratios it is necessary to have a very competitive product offering and exceptional service levels in order to compete effectively.

From a retail product standpoint, Merchants has seen a significant change in the competitive landscape in the past few years. When Merchants' free checking product was introduced there was only one other competitor with a similar product offering. Since that time all of Merchants' largest competitors have introduced free checking products. Merchants continues to see this program as the major driver in its new household penetration. It is now attractively packaged with other products and services as a component of FreedomLYNX^(R) Banking.

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No material part of Merchants' business is dependent upon one, or a few, customers, or upon a particular industry segment, the loss of which would have a material adverse impact on the operations of Merchants.

NUMBER OF EMPLOYEES

As of December 31, 2005, Merchants Bancshares, Inc. had three officers: Joseph L. Boutin, President and Chief Executive Officer; Janet P. Spitler, Chief Financial Officer and Treasurer; and Lisa Razo, Secretary. As of December 31, 2005, Merchants Bank employed 245 full-time and 51 part-time employees and Merchants Trust Company employed 11 full-time employees and 1 part-time employee, representing a combined full time equivalent complement of 283 employees. Merchants Bank and Merchants Trust Company maintain comprehensive employee benefits programs for employees, which provide major medical insurance, hospitalization, dental insurance, long-term and short-term disability insurance, life insurance and a 401(k) Plan. Merchants Bank believes that relations with its employees are good.

REGULATION AND SUPERVISION

General

As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"), Merchants is subject to extensive regulation and supervision by the Board of Governors of the Federal Reserve System. As a state-chartered commercial bank, Merchants Bank is subject to substantial regulation and supervision by the Federal Deposit Insurance Corporation (the "FDIC") and by applicable Vermont regulatory agencies. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to those particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of Merchants.

Financial Services Modernization

The Gramm-Leach-Bliley Act ("Gramm-Leach"), which significantly altered banking laws in the United States, was signed into law in 1999. Gramm-Leach enabled combinations among banks, securities firms and insurance companies beginning in 2000. As a result of Gramm-Leach, many of the depression-era laws which restricted these affiliations and other activities which may be engaged in by banks and bank holding companies were repealed. Under Gramm-Leach bank holding companies are permitted to offer their customers virtually any type of service that is financial in nature or incidental thereto, including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking.

In order to engage in these new financial activities a bank holding company must qualify and register with the Federal Reserve Board as a "financial holding company" by demonstrating that each of its bank subsidiaries is "well capitalized," "well managed," and has at least a "satisfactory" rating under the Community Reinvestment Act of 1977 ("CRA").

These new financial activities authorized by Gramm-Leach may also be engaged in by a "financial subsidiary" of a national or state bank, except for insurance or annuity underwriting, insurance company portfolio investments, real estate investment and development, and merchant banking, which must be conducted in a financial holding company. In order for the new financial activities to be engaged in by a financial subsidiary of a national or state bank, Gramm-Leach requires the parent bank (and its sister-bank affiliates) to be "well capitalized" and "well managed"; the aggregate consolidated assets of all of that bank's financial subsidiaries may not exceed the lesser of 45% of its consolidated total assets or $50 billion; the bank must have at least a "satisfactory" CRA rating; and, if that bank is one of the 100 largest national banks, it must meet certain financial rating or other comparable requirements. Gramm-Leach establishes a system of functional regulation, under which the federal banking agencies will regulate the banking activities of financial holding companies and banks' financial subsidiaries, the U.S. Securities and Exchange Commission (the "SEC") will regulate their securities activities and state insurance regulators will regulate their insurance activities. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers' nonpublic, personal information.

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Bank Holding Company Regulation

Although Merchants believes that it meets the qualifications to become a financial holding company under Gramm-Leach, it has elected to retain its pre-Gramm-Leach bank holding company regulatory status for the present time. This means that Merchants can engage in those activities which are closely related to banking. Merchants is required by the BHCA to file an annual report and additional reports required with the Federal Reserve Board. The Federal Reserve Board also makes periodic inspections of Merchants and its subsidiaries.

The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of a bank, if, after such acquisition, it would own or control, directly or indirectly, more than five percent of the voting shares of such bank. Additionally, as a bank holding company Merchants is prohibited from acquiring ownership or control of five percent or more of any class of voting securities of any company that is not a bank, or from engaging in activities other than banking or controlling banks except where the Federal Reserve Board has determined that such activities are so closely related to banking as to be a "proper incident thereto."

Dividends

Merchants Bancshares, Inc. is a legal entity separate and distinct from Merchants Bank and its other non-bank subsidiary. The revenue of Merchants (on a parent company only basis) is derived primarily from interest and dividends paid to it by its subsidiaries. The right of Merchants, and consequently the right of shareholders of Merchants, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of banking subsidiaries), except to the extent that certain claims of Merchants in a creditor capacity may be recognized.

The payment of dividends by Merchants is determined by its Board of Directors based on Merchants' consolidated liquidity, asset quality profile, capital adequacy, and recent earnings history, as well as economic conditions and other factors, including applicable government regulations and policies and the amount of dividends payable to Merchants by its subsidiaries.

It is the policy of the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the Federal Reserve Board that a bank holding company is expected to act as a source of financial strength to its subsidiary banks.

Vermont law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed prescribed limits. The payment of any dividends by Merchants' subsidiaries will be determined based on a number of factors, including the subsidiary's liquidity, asset quality profile, capital adequacy and recent earnings history.

Capital Adequacy and Safety and Soundness

Capital Guidelines. Under the uniform capital guidelines adopted by the Federal banking agencies, in order to be "well capitalized" a financial institution must have a minimum ratio of total capital to risk-adjusted assets of ten percent (including certain off-balance sheet items, such as standby letters of credit), a minimum ratio of Tier 1 capital to total risk-based assets of six percent (comprised of common equity, retained earnings, minority interests in the equity accounts of consolidated subsidiaries and a limited amount of noncumulative perpetual preferred stock, less deductible intangibles), and a minimum leverage ratio of five percent (Tier 1 capital to average quarterly assets, net of goodwill). As of December 31, Merchants and Merchants Bank were "well capitalized" under the uniform capital guidelines.

Under Federal banking laws, failure to meet the minimum regulatory capital requirements could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC and seizure of the institution.

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Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 (as amended) (the "FDICIA"), provides the Federal banking agencies with broad powers to take prompt corrective action to resolve problems of insured depository institutions, depending upon a particular institution's level of capital. The FDICIA establishes five tiers of capital measurement for regulatory purposes ranging from "well capitalized" to "critically undercapitalized." A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position under certain circumstances. As of December 31, 2005, Merchants Bank was classified as "well capitalized" under the applicable prompt corrective action regulations.

Under the FDICIA a depository institution that is "well capitalized" may accept brokered deposits. A depository institution that is adequately capitalized may accept brokered deposits only if it obtains the approval of the FDIC, and may not offer interest rates on deposits "significantly higher" than the prevailing rate in its market. An "undercapitalized" depository institution may not accept brokered deposits. Merchants had no brokered deposits at December 31, 2005.

Safety and Soundness Standards. The FDICIA, as amended, directs each Federal banking agency to prescribe safety and soundness standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, asset-quality, earnings and stock valuation. The Community Development and Regulatory Improvement Act of 1994 amended the FDICIA by allowing Federal banking activities to publish guidelines rather than regulations concerning safety and soundness.

The FDICIA also contains a variety of other provisions that may affect Merchants' operations, including reporting requirements, regulatory guidelines for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.

Community Reinvestment Act

Pursuant to the CRA and similar provisions of Vermont law, regulatory authorities review the performance of Merchants in meeting the credit needs of the communities it serves. The applicable regulatory authorities consider compliance with this law in connection with the applications for, among other things, approval for de novo branches, branch relocations and acquisitions of banks and bank holding companies. Merchants received a "satisfactory" rating at its most recent CRA examination.

Interstate Banking Act

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the "Interstate Banking Act"), generally permits bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed.

USA Patriot Act

Under Title III of the USA Patriot Act, also known as the "International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001," all financial institutions are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions. Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of Gramm-Leach for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any a pplication submitted by the financial institution under the Bank Merger Act and Bank Holding Company Act.

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Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002, signed into law July 30, 2002, addresses, among other issues, corporate governance, auditor independence and accounting standards, executive compensation, insider loans, whistleblower protection and enhanced and timely disclosure of corporate information. The SEC has adopted a substantial number of implementing rules, and the National Association of Securities Dealers, Inc. have adopted corporate governance rules applicable to Merchants that have been approved by the SEC. The changes are intended to allow shareholders to monitor more effectively the performance of companies and management.

As directed by Section 302(a) of the Sarbanes-Oxley Act of 2002, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports do not contain any untrue statement of a material fact. This requirement has several parts, including certification that these officers are responsible for establishing, maintaining and regularly evaluating the effectiveness of Merchants' disclosure, controls and procedures and internal control over financial reporting. The officers certify that they have made certain disclosures to Merchants' auditors and the Audit Committee of the board of directors about Merchants' disclosure, controls and procedures and internal control over financial reporting and that they have included information in Merchants' quarterly and annual reports about their evaluation of those controls. In addition, the officers also certify in this report whether there have been any significant changes in Merc hants' disclosure, controls and procedures, internal controls over financial reporting, or in other factors that could significantly affect, that has materially affected, or is reasonably likely to materially affect, Merchants' disclosure controls and procedures and internal controls over financial reporting and compliance with certain other disclosure obligations.

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports fully comply with the requirements of Sections 13(a) or 15(d) of the Securities Exchange Act and that the information contained in the report fairly presents, in all material respects, Merchants' financial condition and results of operations.

Other Proposals

Other legislative and regulatory proposals regarding changes in banking, the regulation of banks and other financial institutions, and public companies generally, are regularly considered by the executive branch of the Federal government, Congress and various state governments, including Vermont, and state and federal regulatory authorities. It cannot be predicted what additional legislative and/or regulatory proposals, if any, will be considered in the future, whether any such proposals will be adopted or, if adopted, how any such proposals would affect Merchants.

Available Information

Merchants files annual, quarterly, and current reports, proxy statements, and other documents with the SEC under the Exchange Act. The public may read and copy any materials that Merchants has filed with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Room 2521, Washington, D. C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including Merchants, that file electronically with the SEC. The public can obtain any documents that Merchants has filed with the SEC at http://www.sec.gov.

Merchants also makes available free of charge on or through its Internet website (http://www.mbvt.com) its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act, as soon as reasonably practicable after Merchants electronically files such materials with or furnishes them to, the SEC. Merchants also makes all filed insider transactions available through its website free of charge. In addition, Merchants' Audit Committee and Nominating and Governance Committee Charters as well as its Code of Ethics Policy for Senior Financial Officers are available free of charge on its website.

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ITEM 1A - RISK FACTORS
Merchants has identified the following risk factors that may affect its performance and results of operations:
	(i)	the fact that Merchants' success is dependent upon general economic conditions in Vermont and Vermont's ability to attract new business;
	(ii)	the fact that Merchants' earnings depend to a great extent upon the level of net interest income (the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings) generated by Merchants and thus Merchants' results of operations may be adversely affected by increases or decreases in interest rates or by the shape of the yield curve;
	(iii)	the fact that the banking business is highly competitive and the profitability of Merchants depends upon Merchants' ability to attract loans and deposits in Vermont, where Merchants competes with a variety of traditional banking and nontraditional institutions such as credit unions and finance companies;
	(iv)	the fact that at December 31, 2005, approximately 46% of Merchants' loan portfolio was comprised of commercial and commercial real estate loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans;
	(v)	the fact that at December 31, 2005, approximately 87% of Merchants' loan portfolio was comprised of residential real estate and commercial real estate loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Accordingly, Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;
	(vi)	the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States of America generally and in Merchants' markets, which could adversely affect Merchants' financial performance and that of Merchants' borrowers and on the financial markets and the price of Merchants' common stock;
	(vii)	the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;
	(viii)	the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation; and
	(ix)	the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.
ITEM 1B - UNRESOLVED STAFF COMMENTS
The SEC's Division of Corporate Finance uses a comment letter process to communicate SEC staff concerns and potential deficiencies to issuers in order to improve disclosure. No comments received by Merchants from the SEC during the year ended December 31, 2005 remain unresolved.
ITEM 2 - PROPERTIES
As of December 31, 2005, Merchants operated 35 full-service banking offices, and 41 ATMs throughout the state of Vermont. Merchants' headquarters are located in Merchants' service center at 275 Kennedy Drive, South Burlington, Vermont, which also houses Merchants' operations and administrative offices and Merchants Trust Company.
Merchants leases certain premises from third parties under current market terms and conditions. The offices of all subsidiaries are in good physical condition with modern equipment and facilities considered adequate to meet the

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banking needs of customers in the communities served. Additional information relating to Merchants' properties is set forth in Note 4 to the consolidated financial statements included in Item 8 of this 2005 Annual Report on Form 10-K.

ITEM 3 - LEGAL PROCEEDINGS

Merchants and certain of its subsidiaries have been named as defendants in various legal proceedings arising from their normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, based upon the opinion of counsel on the outcome of such proceedings, any such liability will not have a material effect on the consolidated financial position of Merchants and its subsidiaries.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the fourth quarter of calendar year 2005 no matters were submitted to a vote of security holders through a solicitation of proxies or otherwise.

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PART II
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
The common stock of Merchants is traded on the NASDAQ National Stock Market under the trading symbol MBVT. Quarterly stock prices and dividends per share paid for each quarterly period during the last two years were as follows:
							Dividends
	Quarter Ended			High		Low	Paid
	December 31, 2005			$26.61		$23.85	$0.27
	September 30, 2005			28.35		25.60	0.27
	June 30, 2005			27.25		25.78	0.27
	March 31, 2005			29.00		25.30	0.27
	December 31, 2004			35.00		26.77	4.77
	September 30, 2004			29.20		26.01	0.27
	June 30, 2004			32.39		25.00	0.27
	March 31, 2004			31.54		27.05	0.27
High and low stock prices are based upon quotations as provided by the National Association of Securities Dealers, Inc. Prices of transactions between private parties may vary from the ranges quoted above.
Purchases of Issuer Equity Securities by the Issuer
					(c) Total Number of
		(a) Total			Shares Purchased as			(d) Maximum Number
		Number of	(b) Average		Part of Publicly			of Shares that May Yet
		Shares	Price Paid		Announced Plans			Be Purchased Under
Period		Purchased	per Share		or Programs			the Plans or Programs
October 1 - 31, 2005		--	$      --		--			220,719
November 1- 30, 2005		4,375	$25.61		4,375			216,344
December 1 - 31, 2005		18,450	$24.69		18,450			197,894
Total		22,825			22,825			--
In January 2001, Merchants' Board of Directors approved a stock repurchase program. In January 2005, the Board of Directors voted to extend the program until January 2006. Under the program, Merchants is authorized to repurchase up to 300,000 shares of its own common stock. Under the plan, Merchants has purchased 300,000 shares of its own common stock on the open market, at an average per share price of $23.44 through December 31, 2005; 122,119 of these shares were purchased in 2005 at an average price of $26.25. On December 23, 2005, Merchants repurchased 6,500 shares of its stock from Michael R. Tuttle, the Chief Operating Officer of Merchants Bank at the market price of $24.25 per share.
In October of 2005 Merchants' Board of Directors approved a new stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its stock from time to time through October 2006. The new program commenced when there were no shares remaining under the previous stock repurchase program.
As of January 31, 2006, Merchants had 853 registered shareholders. Merchants declared and distributed dividends totaling $1.08 per share during 2005. In January 2006 Merchants declared a dividend of $0.28 per share, which was paid on February 16, 2006, to shareholders of record as of February 2, 2006. Future dividends will depend upon the financial condition and earnings of Merchants and its subsidiaries, its need for funds and other factors, including applicable government regulations.
American Stock Transfer & Trust Company provides transfer agent services for Merchants. Inquiries may be directed to: American Stock Transfer & Trust Company, 59 Maiden Lane, New York, New York, 10038, telephone: 1-800-937-5449, Internet address: http://www.amstock.com, or email: info@amstock.com.

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ITEM 6 - SELECTED FINANCIAL DATA

The supplementary financial data presented in the following tables contain information highlighting certain significant trends in Merchants' financial condition and results of operations over an extended period of time.

The following information should be analyzed in conjunction with Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations and with the audited consolidated financial statements included in Item 8 of this 2005 Annual Report on Form 10-K.

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Merchants Bancshares, Inc.
Five Year Summary of Financial Data
	At or For the Years Ended December 31,
(In thousands except per share data)	2005		2004		2003		2002		2001
Results for the Year
Interest and Dividend Income	$	53,809	$	47,432	$	45,561	$	48,350	$	53,998
Interest Expense		13,874		7,876		7,933		11,016		18,482
Net Interest Income		39,935		39,556		37,628		37,334		35,516
Provision for Loan Losses		--		--		--		(945)		(1,004)
Net Interest Income after Provision for Loan Losses		39,935		39,556		37,628		38,279		36,520
Noninterest Income		7,271		7,241		7,955		7,337		7,702
Noninterest Expense		31,553		30,793		29,619		28,182		27,961
Income before Income Taxes		15,653		16,004		15,964		17,434		16,261
Provision for Income Taxes		3,751		4,071		4,372		4,817		4,097
Net Income	$	11,902	$	11,933	$	11,592	$	12,617	$	12,164
Share Data
Basic Earnings per Common Share	$	1.88	$	1.91	$	1.87	$	2.05	$	1.99
Diluted Earnings Per Common Share	$	1.87	$	1.90	$	1.86	$	2.02	$	1.98
Cash Dividends Declared per Common Share	$	1.08	$	5.58	$	1.04	$	0.96	$	0.88
Year-end Book Value	$	10.55	$	10.44	$	13.93	$	13.39	$	12.32
Weighted Average Common Shares Outstanding		6,318,524		6,225,417		6,183,919		6,163,546		6,097,775
Period End Common Shares Outstanding		6,290,889		6,243,710		6,196,053		6,178,438		6,132,533
Key Performance Ratios
Return on Average Shareholders' Equity		18.26%		13.81%		13.75%		15.73%		17.06%
Return on Average Assets		1.13%		1.17%		1.28%		1.54%		1.59%
Tier 1 Leverage Ratio		8.54%		8.09%		8.70%		9.17%		9.12%
Allowance for Loan Loss to Total Loans at
Year-End		1.17%		1.29%		1.40%		1.71%		1.84%
Nonperforming Loans as a Percentage of Total
Loans		0.39%		0.57%		0.39%		0.75%		0.54%
Net Interest Margin		4.03%		4.15%		4.43%		4.86%		4.96%
Average Balances
Total Assets	$	1,053,861	$	1,016,618	$	905,098	$	819,886	$	767,133
Earning Assets		990,495		954,428		849,366		768,887		717,699
Loans		589,408		581,259		536,095		479,253		479,052
Investments		400,268		372,005		304,748		264,730		201,967
Total Deposits		843,952		822,828		781,927		728,801		683,838
Shareholders' Equity		65,179		86,396		84,332		80,219		71,287
At Year-End
Total Assets	$	1,075,236	$	1,032,405	$	969,902	$	854,495	$	800,467
Gross Loans		605,926		584,332		568,997		495,588		479,685
Allowance for Loan Losses		7,083		7,512		7,954		8,497		8,815
Investments		390,460		376,547		340,337		270,215		212,454
Deposits		854,576		834,164		808,083		755,274		711,812
Shareholders' Equity		66,397		65,184		86,313		82,758		75,563

<PAGE>  15

Merchants Bancshares, Inc.
Summary of Quarterly Financial Information
(Unaudited)
(In thousands except per share data)	2005					2004
	Q4	Q3	Q2	Q1	Year	Q4	Q3	Q2	Q1	Year
Interest and Dividend Income	$14,105	$13,641	$13,285	$12,778	$53,809	$12,276	$12,012	$11,505	$11,639	$47,432
Interest Expense	4,143	3,604	3,363	2,764	13,874	2,169	2,052	1,796	1,859	7,876
Net Interest Income	9,962	10,037	9,922	10,014	39,935	10,107	9,960	9,709	9,780	39,556
Noninterest Income	1,742	1,892	1,883	1,754	7,271	1,880	1,842	1,781	1,738	7,241
Noninterest Expense	7,850	7,933	7,814	7,956	31,553	7,680	7,649	7,700	7,764	30,793
Income before Income Taxes	3,854	3,996	3,991	3,812	15,653	4,307	4,153	3,790	3,754	16,004
Provision for Income Taxes	925	980	934	912	3,751	1,114	1,075	948	934	4,071
Net Income	$  2,929	$  3,016	$  3,057	$  2,900	$11,902	$  3,193	$  3,078	$  2,842	$  2,820	$11,933
Basic Earnings Per Share	$    0.46	$    0.48	$    0.48	$    0.46	$    1.88	$    0.51	$    0.49	$    0.46	$    0.45	$    1.91
Diluted Earnings Per Share	0.46	0.47	0.48	0.46	1.87	0.51	0.49	0.45	0.45	1.90
Cash Dividends Declared
and Paid Per Share	$    0.27	$    0.27	$    0.27	$    0.27	$    1.08	$    4.77	$    0.27	$    0.27	$    0.27	$    5.58

<PAGE>  16

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

                RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

Management's discussion and analysis of Merchants' financial condition is based on the consolidated financial statements which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates its estimates on an ongoing basis. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about financial statement amounts. Actual results could differ from the amount derived from management's estimates and assumptions under different assumptions or conditions.

Merchants' significant accounting policies are described in more detail in Note 1 to the consolidated financial statements included in Item 8 of this Form 10-K. Management believes the following accounting policies are the most critical to the preparation of the consolidated financial statements.

Allowance for Loan Losses: The allowance for loan losses, which is established through the provision for loan losses, is based on management's evaluation of the level of allowance required in relation to the estimated loss exposure in the loan portfolio. Management believes the allowance for loan losses is a significant estimate and therefore evaluates it for adequacy each quarter. Management considers factors such as previous loss experience, the size and composition of the loan portfolio, current economic and real estate market conditions, the performance of individual loans in relation to contract terms, and estimated fair value of collateral that secures the loans. The use of different estimates or assumptions could produce a different allowance for loan losses.

Income Taxes: Merchants estimates its income taxes for each period for which a statement of income is presented. This involves estimating Merchants' actual current tax exposure, as well as assessing temporary differences resulting from differing timing of recognition of expenses, income and tax credits, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in Merchants consolidated balance sheets. Merchants must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and to the extent that recovery is not likely a valuation allowance must be established. Significant management judgment is required in determining income tax expense, and deferred tax assets and liabilities. As of December 31, 2005 no valuation allowance for deferred tax assets was deemed necessary by management.

Interest Income Recognition on Loans: Interest on loans is included in income as earned based upon the unpaid principal balance of the loan. Merchants' policy is to discontinue the accrual of interest, and to reverse any uncollected interest recorded on loans, when scheduled payments become contractually past due in excess of 90 days unless the ultimate collectibility of principal and interest is assured.

GENERAL

The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three years ended December 31, 2005, should be read in conjunction with the Consolidated Financial Statements and Notes thereto and selected statistical information appearing elsewhere in this Form 10-K. The information about asset yields, interest rate spreads and net interest margins is discussed on a fully taxable equivalent basis. The financial condition and operating results of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. Certain statements contained in this section constitute "Forward-Looking Statements" and are subject to certain risks and uncertainties described in this 10-K under the heading "Forward-Looking Statements".

OUTLOOK

Merchants market area generally witnessed continued economic growth during 2005. Job growth during 2005 is estimated to be around 1.5%. Although the housing market remained strong, changes may be underway. Rising

<PAGE>  17

mortgage rates may reduce demand for new housing and refinancing activity. In addition, higher energy prices have affected Vermont households, and prices are expected to remain elevated in 2006. Employment growth has been at the national average. Vermont's seasonally adjusted unemployment rate closed the year at 3.6%, compared to 3.4% at the end of 2004. The national unemployment rate at the end of 2005 was 4.9%. The Federal Reserve Board increased its target for the federal funds rate by 200 basis points during 2005, and indicated it will be monitoring economic data closely during 2006 for signs of inflation.The economies and real estate markets in Merchants' primary market areas will continue to be significant determinants of the quality of Merchants' assets in future periods and, thus, its results of operations, liquidity and financial condition. Merchants believes future economic activity will depend on consumer confidence, business expenditures for new capital equipment and personal consumption expenditures. For a description of other factors which could affect Merchants' financial performance and that of its common stock, see "Forward-Looking Statements" at the beginning of this report.

RESULTS OF OPERATIONS

Merchants realized net income of $11.90 million, $11.93 million and $11.59 million for the years ended December 31, 2005, 2004 and 2003, respectively. Basic earnings per share were $1.88, $1.91, and $1.87 and diluted earnings per share were $1.87, $1.90, and $1.86 for the years ended December 31, 2005, 2004 and 2003, respectively. Merchants declared and distributed total dividends of $1.08, $5.58, and $1.04 per share during 2005, 2004 and 2003, respectively. In January 2006, Merchants declared a dividend of $.28 per share, which was paid on February 16, 2006, to shareholders of record as of February 2, 2006.

Net income as a percentage of average equity capital was 18.26%, 13.81%, and 13.75% for 2005, 2004 and 2003, respectively. Net income as a percentage of average assets was 1.13%, 1.17% and 1.28% in 2005, 2004 and 2003, respectively.

Net Interest Income

2005 compared with 2004

Net interest income on a tax equivalent basis for the full year 2005 was $39.96 million, a $400 thousand increase over net interest income for 2004 of $39.56 million. Merchants continued to experience decreases in its net interest margin as the spread between the yield on interest earning assets and the cost of interest bearing liabilities has continued to shrink. Merchants' margin compression is reflective of the current flat yield curve environment. During 2005 the federal funds rate increased by 200 basis points, while the ten-year Treasury increased by only 17 basis points. The net interest margin for 2005 was 4.03%, compared to 4.15% for 2004. The average rate paid on Merchants' interest bearing liabilities increased 63 basis points to 1.61% for 2005, compared to 0.98% for 2004. At the same time the average rate earned on Merchants' interest earning assets increased by 47 basis points to 5.44% for 2005, compared to 4.97% for 2004. Merchants' non-core funding sources exper ienced the largest rate increases during 2005. Merchants is exploring the use of alternative non-core funding sources, and borrowed $20 million in a structured repurchase agreement during December 2005. Merchants has compensated for some of the spread compression by growing its overall balance sheet; average interest earning assets have increased by $36.07 million to $990.5 million from $954.43 million. As shown in the schedule on page 21, although asset yields continue to rise in response to higher short-term market rates, funding costs increased further due to deposit pricing pressure and higher cost borrowings. Merchants' larger base of interest earning assets helped to mitigate the effect of the decrease in the net interest margin, and to protect Merchants' overall net interest income.

Merchants' average loan portfolio increased $8.15 million to $589.41 million for 2005 compared to 2004. The average rate on the portfolio has increased 59 basis points to 6.22%. This increase was driven primarily by increased rates on prime-based loans, and by new loans being originated at overall higher interest rates. Merchants experienced a shift from prime-based variable rate loans to fixed rate loans during 2005 as short term rates continued to rise. At December 31, 2005 the variable rate portion of total commercial and commercial mortgage loans had decreased to approximately 62% from approximately 81% at December 31, 2004. Absent this shift in the portfolio Merchants would have seen a larger overall increase in the average rate earned on its loan portfolio. Merchants was able to control increases in its deposit costs during 2005, and the average rate paid on interest bearing deposits increased by only 38 basis points to 1.24% for 2005. However, deposit rate movements dur ing the fourth quarter of 2005 were more aggressive than during the earlier part of the year, and the average rate paid on interest bearing deposits for the fourth quarter of 2005 was 67 basis points higher than the same quarter in 2004. Merchants

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faces aggressive competition from other banks in the marketplace to raise rates on deposits, particularly in the time deposit area.

Merchants' average investment portfolio increased $28.26 million to $400.27 million during 2005. The average rate on the portfolio increased 34 basis points to 4.29% for 2005 compared to 3.95% for 2004. Merchants targets a 2.5 year duration, and generally has no credits rated below an A by the national credit rating services in the portfolio. The low duration of the portfolio, coupled with the slope of the yield curve has slowed growth in margin dollars as rates have risen. Merchants' total borrowed funds position (excluding trust preferred securities) increased $21.62 million during 2005. The average rate on the short-term borrowed funds increased 192 basis points to 3.35% during 2005, and the average rate on the long-term funds increased 62 basis points to 3.05%. As mentioned previously, Merchants is exploring alternative non-core funding sources, and borrowed $20 million in a variable rate repurchase agreement with a cap during December 2005. The cost of this funding will b e reduced by the cash flows from an embedded floor if short term rates start to decrease. Merchants closed its private placement of an aggregate of $20 million of trust preferred securities on December 15, 2004. The securities bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts quarterly at a fixed spread over three month LIBOR. The impact on net interest income for 2005 from the additional interest expense was $1.19 million, and was $50 thousand for 2004.

2004 compared with 2003

Net interest income, on a fully taxable equivalent basis increased $1.93 million to $39.58 million for 2004 from $37.65 million for 2003. Merchants continued to increase net interest income dollars through balance sheet growth and leverage. At the same time Merchants experienced decreases in its net interest margin as the spread between the yield on interest earning assets and the cost of interest bearing liabilities continued to shrink. Merchants' net interest margin decreased 28 basis points to 4.15% from 4.43% over the course of 2004. This decrease was driven by a number of factors. The spread earned between interest earning assets and interest bearing liabilities is dependent to a large extent on the slope of the yield curve. The spread between the two-year treasury and the ten-year treasury decreased by approximately 125 basis points during 2004. During 2004 the average rate earned on interest earning assets decreased 40 basis points to 4.97% from 5.37%; at the same time the average rate paid on interest bearing liabilities decreased 14 basis points to .98% from 1.12%. Merchants' worked to compensate for the margin compression by growing its overall balance sheet; average interest earning assets increased by $105.06 million for 2004 to $954.43 million from $849.37 million compared to 2003.

Merchants' average loan portfolio increased $45.16 million to $581.26 million from $536.10 million during 2004; however, the average rate on the portfolio decreased 44 basis points over the course of the year. This decrease was driven by repricing of both fixed rate balloon notes and mortgages into lower variable rates. Merchants' year-end loan portfolio grew to $584.33 million at December 31, 2004 from $569.00 million at December 31, 2003. The fixed rate portion of the portfolio decreased over the course of the year to $294.66 million from $306.36 million; while variable rate loans increased to $289.67 million from $262.63 million. Over $250 million of the variable rate loans reprice with prime, which helped offset increased funding costs as rates continued to rise. The repricing of these variable rate loans during the last six months of the year was not enough to offset the overall decline in fixed rate loan yields.

The average investment portfolio grew by $67.26 million to $372.01 million from $304.75 million; however, Merchants also experienced decreases in the average yield on that portfolio as it decreased 28 basis points to 3.95% for 2004 from 4.23% for 2003. Merchants continued to take advantage of opportunities to use leverage to maximize net interest income. Average short-term borrowings increased $30.31 million to $53.39 million for 2004 from $23.08 million for 2003. As a result of the increase in the federal funds rate, the average cost of short-term borrowings during 2004 increased to 1.43% from 1.09% for 2003. The average cost of short-term borrowings for the fourth quarter of the year was 2.05%. Merchants' average long-term borrowings increased $35.48 million to $41.00 million for 2004 from $5.52 million for 2003. The average cost of those funds decreased during 2004 to 2.43% from 2.92% as Merchants was able to lock in long term lower cost funding in the early part of 2004.

Overall, Merchants' cost of funds decreased over the course of the year, but not enough to offset the decreases in rates experienced on the asset side. Total average interest bearing liabilities increased $92.47 million to $803.44 million for 2004 compared to $710.97 million for 2003. The cost of those funds decreased to .98% for 2004 from 1.12% for 2003. Average interest bearing deposits increased $25.92 million to $708.27 million for 2004 from $682.35 million for 2003. Short-term interest rates remained low for the first six months of the year. The federal

<PAGE>  19

funds rate was 1.0% from June 30, 2003 through June 30, 2004. Although short-term rates moved up 1.25% from June 2004, Merchants' average cost of interest bearing deposits for 2004 was 24 basis points lower than 2003 at .86% compared to 1.10%. Merchants' was able to control deposit costs as short-term rates began to rise in the second half of 2004.

Merchants entered into a $25 million, three year, interest rate swap early in the second quarter of 2002. Merchants received a fixed interest rate and paid prime under the swap. Merchants terminated the swap and received proceeds of $1.3 million during October 2002. This gain on swap termination was accreted into interest income monthly, using the effective yield method, through April 2005.

The following table presents the condensed annual average balance sheets for 2005, 2004 and 2003. The total dollar amount of interest income from assets and the related yields are calculated on a taxable equivalent basis:

<PAGE>  20

Merchants Bancshares, Inc. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Net Interest Margin
	2005			2004			2003
		Interest	Average		Interest	Average		Interest	Average
Taxable Equivalent	Average	Income/	Yield/	Average	Income/	Yield/	Average	Income/	Yield/
(In thousands)	Balance	Expense	Rate	Balance	Expense	Rate	Balance	Expense	Rate
ASSETS:
Investment Securities:
U.S. Treasury and Agencies	$   152,751	$  6,979	4.57%	$   149,056	$  6,746	4.53%	$155,445	$  7,812	5.03%
Other, Including FHLB Stock	247,517	10,182	4.11%	222,949	7,947	3.56%	149,303	5,089	3.41%
Total Investment Securities	400,268	17,161	4.29%	372,005	14,693	3.95%	304,748	12,901	4.23%
Loans, Including Fees on Loans:
Commercial	85,795	5,768	6.72%	93,883	5,618	5.98%	95,518	6,021	6.30%
Real Estate	496,134	30,484	6.14%	479,497	26,698	5.57%	431,262	25,945	6.02%
Consumer	7,479	403	5.39%	7,879	431	5.47%	9,315	593	6.37%
Total Loans (a) (b)	589,408	36,655	6.22%	581,259	32,747	5.63%	536,095	32,559	6.07%
Federal Funds Sold, Securities Sold under
Agreements to Repurchase and Interest
Bearing Deposits with Banks	819	21	2.61%	1,164	15	1.29%	8,523	120	1.41%
Total Earning Assets	990,495	53,837	5.44%	954,428	47,455	4.97%	849,366	45,580	5.37%
Allowance for Loan Losses	(7,391)			(7,990)			(8,195)
Cash and Due From Banks	38,139			38,495			35,917
Premises and Equipment	12,418			13,115			11,814
Other Assets	20,200			18,570			16,196
Total Assets	$1,053,861			$1,016,618			$905,098
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest Bearing Deposits:
Savings, Money Market & NOW Accounts	$   505,303	$  3,940	0.78%	$   515,372	$  2,616	0.51%	$485,705	$  2,918	0.60%
Time Deposits	220,190	5,061	2.30%	192,895	3,454	1.79%	196,646	4,600	2.34%
Total Interest Bearing Deposits	725,493	9,001	1.24%	708,267	6,070	0.86%	682,351	7,518	1.10%
Federal Funds Purchased	-	-	0.00%	-	-	0.00%	30	-	1.28%
Demand Notes Due U.S. Treasury	1,137	35	3.08%	743	8	1.08%	827	11	1.33%
Other Short-term Borrowings	44,278	1,482	3.35%	52,649	754	1.43%	22,249	243	1.09%
Long-Term Debt	70,599	2,155	3.05%	40,974	994	2.43%	5,517	161	2.92%
Securities sold under agreement to repurchase	214	11	5.15%	-	-	-	-	-	-
Junior Subordinated Debentures Issued to
Unconsolidated Subsidiary Trust	20,619	1,190	5.77%	811	50	6.17%	-	-	-
Total Interest Bearing Liabilities	862,340	13,874	1.61%	803,444	7,876	0.98%	710,974	7,933	1.12%
Demand Deposits	118,459			114,561			99,576
Other Liabilities	7,883			12,217			10,216
Stockholders' Equity	65,179			86,396			84,332
Total Liabilities & Stockholders' Equity	$1,053,861			$1,016,618			$905,098
Net Interest Income (a)		$39,963			$39,579			$37,647
Yield Spread			3.83%			3.99%			4.25%
Net Interest Margin			4.03%			4.15%			4.43%

(a)	Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.
(b)	Includes principal balance of non-accrual loans and fees on loans.

<PAGE>  21

The following table presents the extent to which changes in interest rates and changes in the volume of earning assets and interest bearing liabilities have affected interest income and interest expense during the periods indicated. Information is presented in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) changes in volume/rate (change in volume multiplied by change in rate).

<PAGE>  22

Merchants Bancshares, Inc.
Analysis of Changes in Fully Taxable Equivalent Net Interest Income
	2005 vs 2004
				Due to
			Increase			Volume/
(In thousands)	2005	2004	(Decrease)	Volume	Rate	Rate
Fully Taxable Equivalent Interest Income:
Loans	$36,655	$32,747	$3,908	$   459	$3,401	$   48
Investments	17,161	14,693	2,468	1,116	1,257	95
Federal Funds Sold, Securities Sold under
Agreements to Repurchase and Interest
Bearing Deposits with Banks	21	15	6	(4)	15	(5)
Total Interest Income	53,837	47,455	6,382	1,571	4,673	138
Less Interest Expense:
Savings, Money Market & NOW
Accounts	3,940	2,616	1,324	(51)	1,403	(28)
Time Deposits	5,061	3,454	1,607	489	980	138
Other Short-term Borrowings	1,517	762	755	(116)	1,023	(152)
Long-term Debt	2,155	994	1,161	719	256	186
Securities sold under agreement to
repurchase	11	--	11	--	--	11
Junior Subordinated Debentures Issued to
Unconsolidated Subsidiary Trust	1,190	50	1,140	1,221	(3)	(78)
Total Interest Expense	13,874	7,876	5,998	2,262	3,659	77
Net Interest Income	$39,963	$39,579	$   384	$  (691)	$1,014	$   61
	2004 vs 2003
				Due to
			Increase			Volume/
(In thousands)	2004	2003	(Decrease)	Volume	Rate	Rate
Fully Taxable Equivalent Interest Income:
Loans	$32,747	$32,559	$   188	$2,743	$(2,356)	$(199)
Investments	14,693	12,901	1,792	2,847	(864)	(191)
Federal Funds Sold, Securities Sold under
Agreements to Repurchase and Interest
Bearing Deposits with Banks	15	120	(105)	(104)	(10)	9
Total Interest Income	47,455	45,580	1,875	5,486	(3,230)	(381)
Less Interest Expense:
Savings, Money Market & NOW
Accounts	2,616	2,918	(302)	178	(453)	(27)
Time Deposits	3,454	4,600	(1,146)	(88)	(1,079)	21
Other Short-term Borrowings	762	254	508	331	74	103
Long-term Debt	994	161	833	1,035	(27)	(175)
Junior Subordinated Debentures Issued to
Unconsolidated Subsidiary Trust	50	--	50	--	--	50
Total Interest Expense	7,876	7,933	(57)	1,456	(1,485)	(28)
Net Interest Income	$39,579	$37,647	$1,932	$4,030	$(1,745)	$(353)

<PAGE>  23

Provision for Loan Losses

The Allowance for Loan Losses ("Allowance") is reviewed by management at least quarterly and continues to be deemed adequate under current market conditions. At December 31, 2005 the Allowance stood at $7.08 million, 1.17% of total loans and 300% of nonperforming loans, compared to $7.51 million, 1.29% of total loans and 225% of nonperforming loans at December 31, 2004. Coverage of nonperforming loans increased significantly during 2005 due to nonperforming loan sales and paydowns on nonaccruing loans. Merchants recorded charge-offs of $693 thousand and recoveries of $264 thousand during 2005. There was no provision for loan losses during 2005 or 2004. Merchants expects that, as the loan portfolio continues to grow, additions to the Allowance in the form of provisions for loan losses will be necessary. For a more detailed discussion of Merchants' Allowance and nonperforming assets, see "Credit Quality and Allowance for Loan Losses."

NONINTEREST INCOME AND EXPENSES

Noninterest income

2005 compared to 2004

Total noninterest income was flat at $7.27 million for 2005 compared to $7.24 million for 2004. Losses on sales of investments totaled $32 thousand for 2005, compared to a gain of $49 thousand for 2004. The presentation of equity in losses of real estate limited partnerships has been reclassified during 2005 and this item is now a component of noninterest income instead of noninterest expense. Excluding gains and losses on sales of investments and equity in losses of real estate limited partnerships, total noninterest income increased $78 thousand year-over-year. The category Service Charges on Deposits decreased $381 thousand when comparing 2005 to 2004. This decrease is primarily a result of decreased monthly checking service charges; and an increase in the cost of internet banking, which is classified as an offset to service charge revenue. Increases in the earnings credit rate have allowed business customers to decrease the amount of hard dollar charges they incur each mon th, reducing the overall level of service charge revenue. At the same time, although Merchants continues to experience increases in overdraft service charge revenue, the rate of the increase has slowed as more customers use their debit cards for purchases. Electronic transactions are not approved unless there are sufficient funds in the customer's account to pay for the transaction.

Other noninterest income increased $354 thousand when comparing 2005 to 2004, primarily due to increases in net ATM and debit card income. Merchants' strong growth in transaction accounts and high retention rate of existing accounts has been a key contributor to these increases. These categories continued to increase during 2005 when compared to 2004, but at a slower pace. The average number of checks written on Merchants' transaction accounts has decreased to 7.4 per month, a 42% reduction from 1999 levels of 12.9 per month.

Merchants' equity in losses of real estate limited partnerships was slightly lower at $1.71 million for 2005 compared to $1.75 million for 2004. Merchants accounts for its investment in these partnerships using the equity method. Losses generated by the partnerships are recorded as a reduction in Merchants' investments in the Consolidated Balance Sheets and as a reduction of Noninterest Income in the Consolidated Statements of Income. Tax credits generated by the partnerships are recorded as a reduction in the income tax provision. Merchants finds these investments attractive because they provide a targeted internal rate of return of approximately 12%, and provide an opportunity to invest in affordable housing in the communities in which Merchants does business.

2004 compared to 2003

Total noninterest income decreased $714 thousand to $7.24 million from $7.96 million for 2004 compared to 2003. Net gains on sales of investments totaled $49 thousand for 2004 and $1.42 million for 2003. Merchants engaged a new investment advisory firm during 2003 to help it manage its investment portfolio. During 2003 some repositioning of the investment portfolio occurred resulting in larger than usual gains. Excluding gains (losses) on sales of investments, total noninterest income increased $657 thousand to $7.19 million for 2004 from $6.54 million for the prior year.

The category Service Charges on Deposits increased $384 thousand to $4.84 million for 2004 from $4.45 million for 2003. This increase is primarily a result of increases in net overdraft service charges, which increased $690 thousand to $3.62 million for 2004 from $2.93 million for 2003. The category Other noninterest income increased $262 thousand when comparing 2004 to 2003. This increase is due primarily to increases in net ATM and debit card revenue. Additionally, Merchants has had continued success in transitioning more of its customers' activity to electronic transactions, which has produced increased fee income levels and allowed for level staffing in its back office.

<PAGE>  24

Noninterest expense

2005 compared to 2004

Total noninterest expense increased $760 thousand, or 2.5%, to $31.55 million from $30.79 million for 2005, compared to 2004. Salaries and benefits expense increased less than 1% for all of 2005, compared to 2004. On July 1, 2005 Merchants transitioned its item processing function to an outside provider. Salary and benefits savings related to this change totaled approximately $185 thousand for 2005. Additionally, occupancy and equipment expenses decreased by 0.4% for all of 2005 compared to 2004 as the transition to an outside service provider for item processing reduced this line item by $197 thousand. Legal and professional fees increased $381 thousand when comparing 2005 to 2004, primarily a result of fees paid to the item processing service provider which totaled $347 thousand for 2005.

Merchants continued its incentive compensation program during 2005; the program was primarily focused on overall profitability for 2005, with a component focused on increased sales with a quality control component for the corporate banking department. Incentive compensation increased 29% during 2005 and averaged 8.7% of base salaries. This increase in incentive compensation was primarily a result of changes in the corporate banking department during 2005. These changes resulted in decreases in salary dollars which were offset by increases in incentive compensation. Overall compensation for this group was level with 2004.

Employee benefits were $206 thousand lower for 2005 than 2004. This decrease was primarily due to reduced pension expenses in 2005 resulting from strong returns on plan assets. Merchants' health and group insurance rate increases were mitigated by low claim levels during 2005, contributing to an overall small decrease in health and group insurance expense during the year. Merchants has transitioned to a high deductible, consumer driven health plan starting at the beginning of 2006 to help manage its future health care cost increases.

Other noninterest expenses increased $223 thousand, or 4.5%. There were a number of small increases that led to this overall increase in expense.

2004 compared to 2003

Noninterest expense increased $1.17 million to $30.79 million from $29.62 million for 2004 compared to 2003. Merchants' largest noninterest expense category is salaries and wages. This category increased $333 thousand to $11.90 million for 2004 from $11.57 million for 2003, a less than 3% increase. Merchants' average salary increases for 2004 were 5.52%. Incentive compensation increased 5.1% during 2004, and was just under 7% of salaries, consistent with 2003. The 2003 salaries and wages amount includes $266 thousand of dividends paid on shares of stock owned by certain trusts which invest deferred compensation in shares of Merchants' stock. The 2004 salaries and wages amount includes $209 thousand of dividends paid on these shares. Beginning in the fourth quarter of 2004 Merchants no longer expenses these dividends, but instead treats them like any other dividend on common stock, as a charge to retained earnings. This change in dividend treatment reflects Merchants' understan ding of current industry practices for these dividends, and also reflects clarified accounting literature related to dividend treatment on common stock held by these trusts. Shares held by these trusts are legally outstanding and are considered outstanding for earnings per share purposes. These shares are treated similar to treasury shares for financial reporting purposes. The regular fourth quarter 2004 dividend on these trust shares was $72 thousand; the one-time special dividend paid to these trusts was $1.22 million. These dividends were recorded as a retained earnings charge.

Employee benefit costs increased $257 thousand, or 7.2% to $3.83 million during 2004. The increase was primarily driven by increased costs of group health insurance. Merchants experienced a decrease in its pension plan expense during 2004 as a result of strong returns on plan assets. Occupancy and equipment expenses increased $730 thousand, or 13%, for 2004 compared to 2003, approximately $177 thousand of the year-to-date increase is attributable to Merchants' two de novo branches, and $290 thousand to Merchants' service center network server infrastructure and desktop computer upgrade completed during 2004. Legal and professional fees were $264 thousand, or 18% higher for 2004 compared to 2003. This increase is primarily a result of increases in investment advisory fees, and additional professional fees related to the service center network upgrade. Marketing expenses decreased to $1.38 million for 2004 from $1.53 million for 2003. This decrease is primarily a result of highe r expenses in 2003 related to the opening of two de novo branches and an aggressive 10 year mortgage campaign.

<PAGE>  25

Other noninterest expenses decreased $382 thousand, or 7.2% to $4.9 million during 2004. There were a number of small decreases that led to this overall decrease.
Income Taxes
Merchants recognized $1.70 million, $1.60 million and $1.32 million, respectively during 2005, 2004 and 2003 in low-income housing tax credits as a reduction in the provision for income taxes; this resulted in an effective tax rate of 24%, 25% and 27% for 2005, 2004 and 2003, respectively. As of December 31, 2005, Merchants has a net deferred tax asset of approximately $1.0 million arising from temporary differences between Merchants' book and tax reporting. This net deferred tax asset is included in Other Assets in the Consolidated Balance Sheets.
BALANCE SHEET ANALYSIS
Merchants' year-end total assets increased $42.83 million, or 4.1%, to $1.08 billion from $1.03 billion during 2005, while Merchants' average earning assets increased by $36.1 million, or 3.8%, to $990.5 million from $954.4 million.
Loans
Merchants experienced an increase in total loans during 2005 compared to 2004. The year end loan portfolio increased $21.6 million, or 3.7% to $605.9 million from $584.3 million at December 31, 2004. The composition of Merchants' loan portfolio is shown in the following table:
		As of December 31,
	Type of Loan	2005	2004	2003	2002	2001
		(In thousands)
	Commercial, Financial &
	Agricultural	$  71,912	$  82,644	$  84,698	$  93,856	$  84,555
	Real Estate - Residential	293,158	265,306	263,538	206,231	206,697
	Real Estate - Commercial	208,049	209,333	200,494	179,156	170,889
	Real Estate - Construction	25,942	19,354	12,536	9,154	7,731
	Installment	6,345	7,016	6,726	6,663	7,602
	All Other Loans	520	679	1,005	528	2,211
		$605,926	$584,332	$568,997	$495,588	$479,685
During 2005 most of the growth in Merchants' loan portfolio was in residential real estate and construction loans. Residential real estate loans increased $27.85 million, or 10.5% to $293.16 million during 2005 as borrowers sought to take advantage of continued low long-term rates. Construction loans increased $6.59 million, or 34%. Approximately $11 million of the construction loans outstanding at year end were related to housing that will be repaid with the sale of the related units. The balance of the construction loan category is comprised of land, residential and commercial construction loans that will be converted to permanent financing. The decrease in Commercial, Financial and Agricultural loans is the result of net new originations not being adequate to cover large payouts related to the sale of a business of $2.8 million, loan sales of $1.9 million and exiting a large $5.0 million relationship for quality purposes.
At December 31, 2005, Merchants serviced $7.91 million in residential mortgage loans for investors such as Federal government agencies (FNMA and FHLMC) and other financial investors. This servicing portfolio has decreased significantly as Merchants no longer sells its residential mortgages on the secondary market. Servicing revenue is not expected to be a significant revenue source in the future.
The following table presents the distribution of the varying contractual maturities or repricing opportunities of the loan portfolio at December 31, 2005.

<PAGE>  26

			Over One
		One Year	Through	Over Five
	Type of Loan	Or Less	5 Years	Years	Total
		(In thousands)
	Commercial Financial &
	Agricultural	$44,864	$18,473	$8,575	$71,912
	Real Estate - Residential	25,365	43,063	224,730	293,158
	Real Estate - Commercial	88,600	80,951	38,498	208,049
	Real Estate - Construction	24,482	1,063	397	25,942
	Installment	4,412	1,892	41	6,345
	All Other	520	--	--	520
		$188,243	$145,442	$272,241	$605,926
Loans maturing or repricing after one year which have predetermined interest rates totaled $401.66 million. Loans maturing or repricing after one year which have floating or adjustable interest rates totaled $16.02 million.
Investments
The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. The composition of Merchants' investment portfolio at carrying amounts, (excluding trading securities) is shown in the following table:

	As of December 31,
Type of Investment	2005	2004	2003	2002	2001
	(In thousands)
U.S. Treasury Obligations	$       198	$       199	$       198	$  23,311	$       454
U.S. Agency Obligations	14,819	21,356	28,083	63,128	41,809
Residential Real Estate
Mortgage-backed securities	141,088	125,939	101,895	122,513	133,489
Commercial Real Estate
Mortgage-backed securities	66,235	67,302	37,876	--	--
Collateralized Mortgage
Obligations	131,969	112,459	82,793	14,661	25,964
Corporate Bonds	23,346	32,262	40,302	27,565	7,647
Asset Backed Securities	12,805	17,030	48,435	18,191	2,061
	$390,460	$376,547	$339,582	$269,369	$211,424
Merchants continued to work with its investment advisory firm hired in early 2003. The firm is a registered investment advisor specializing in stable value and fixed income portfolios, and has a staff of investment professionals who research and track each bond. As of December 31, 2005 the firm had over $56 billion in assets under management. During the year, Merchants increased the investment portfolio (excluding trading securities) $13.91 million, or 3.7% to $390.46 million. At the same time Merchants increased its non-core funding sources $21.01 million to $125.76 million (excluding trust preferred securities). As mentioned in the earlier discussion on net interest income, this leverage has helped Merchants mitigate the effect of 2005's margin compression on its net interest income during the year.
Other Assets
Bank Premises and Equipment decreased to $12.14 million at year-end 2005 from $12.84 million at year-end 2004 as 2005 depreciation exceeded further investments in buildings and equipment. Investment in Real Estate Limited Partnerships increased to $9.36 million from $8.59 million during 2005. This increase represents continued investments by Merchants in affordable housing partnerships. These partnerships provide affordable housing in the communities in which Merchants does business, and provide Merchants with an acceptable level of return on its investment.

<PAGE>  27

Deposits

Merchants' year-end deposit balances increased $20.41 million, or 2.4%, to $854.58 million at year-end 2005 from $834.16 million at year-end 2004. The composition of Merchants' deposit balances is shown in the following table:

			As of December 31,
	Type of Deposit		2005	2004	2003		2002	2001
			(In thousands)
	Demand		$124,292	$119,089	$110,241		$102,554	$  92,065
	Free Checking for Life(R)		181,415	179,359	128,866		97,832	82,012
	Other Savings and NOW		50,196	58,918	85,197		90,844	93,014
	Money Market Accounts		248,344	282,212	285,824		278,754	275,923
	Time Deposits		250,329	194,586	197,955		185,290	168,798
			$854,576	$834,164	$808,083		$755,274	$711,812
Merchants continues to focus on gaining core banking relationships with households, small businesses, and corporate clients. By packing significant value into the transaction accounts and related services, Merchants attracts a customer base interested in low fees and convenient access across delivery channels. A leading brand in the marketplace, Free Checking for Life(R)was again promoted in 2005 via direct mail and other media. The account balances pay interest and require no minimum balance; the average cost of these funds at year-end was .32%. Though the number of accounts and households continued to rise in 2005, the free checking category grew only slightly in balances. The category has been subjected to commoditization in the marketplace, as both large and small competitors have entered the free checking arena. Merchants deviated from direct mail promotion of free checking in the second half of 2005 and focused marketing resources on a series of radio spots h ighlighting other programs and the value of banking with the company. Merchants introduced in late 2005 a packaged relationship program, FreedomLYNX(R) Banking, aimed at establishing stronger differentiation among free checking alternatives. FreedomLYNX(R) offers integrated accounts (including Free Checking for Life(R)and money market), free or low cost delivery options (including free debit card, free online banking with free bill pay, and free automated phone banking), and highly personalized service (including an assigned personal banker and a toll-free customer call center with live voice response). The program is packaged in a retail sales kit for ease of sales and service. Balances in Merchants' savings, NOW, and money market categories decreased $40.53 million during the year; those balances migrated to higher yielding time deposits, which increased $55.74 million during 2005. Merchants offers an attractive flexible certificate of deposit, TimeLYNX(R), that allows customers to earn market rates of interest while retaining much of the flexibility of a money market account (ability to deposit and withdraw funds from the account without penalty during the term). The blend of high value transaction products and options to move funds to higher yielding time instruments has allowed Merchants to grow deposits overall in a challenging interest rate environment.
During November 2004 Merchants consolidated several of its grandfathered product types into its current product offerings. Approximately $74 million was reclassified. Approximately $32 million was added to Free Checking for Life(R); $3 million of that came from demand deposit categories, $17 million from Other Savings and NOW accounts and $12 million from money market accounts.
Time Deposits $100 thousand and greater at December 31, 2005, had the following schedule of maturities:
		(In thousands)
		Three Months or Less				$  9,142
		Three to Six Months				8,572
		Six to Twelve Months				23,705
		One to Five Years				22,587
						$64,006
Other Liabilities
Other short-term borrowings ended the year at $50 million for 2005 compared to $55 million for 2004. This balance represents Merchants' use of short-term funding from the Federal Home Loan Bank of Boston ("FHLB") primarily to fund growth in the investment portfolio. Maturities were less than three months; interest rates on these borrowings ranged from 3.26% to 4.44%. Merchants' long-term debt position increased to $55.76 million at December 31, 2005 compared to $49.76 million at the end of 2004. The long term debt has maturities through 2010, and interest rates ranging from 1.68% to 4.92%. Merchants had additional borrowing capacity with the FHLB of approximately $81 million at December 31, 2005. Merchants also borrowed $20 million under a structured purchase agreement during December 2005. This borrowing is capped to protect against rising rates, and the cost of the funding will be reduced by the cash flows of an embedded floor if rates start to fall.

<PAGE>  28

On December 15, 2004 Merchants closed its private placement of an aggregate of $20 million of trust preferred securities. The placement occurred through a newly formed Delaware statutory trust affiliate of Merchants, MBVT Statutory Trust I (the "Trust") as part of a pooled trust preferred program. The Trust was formed for the sole purpose of issuing Capital Securities; these securities are non-voting. Merchants owns all of the common securities of the Trust. The proceeds from the sale of the Capital Securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust. Merchants' primary source of funds to pay interest on the debentures held by the Trust is current dividends from its principal subsidiary, Merchants Bank. Accordingly, Merchants' ability to service the debentures is dependent upon the continued ability of Merchants Bank to pa y dividends to Merchants.
These hybrid securities will qualify as regulatory capital for Merchants, up to certain regulatory limits. At the same time they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts quarterly at a fixed spread over three month LIBOR. The trust preferred securities mature on December 31, 2034, and are redeemable without penalty at Merchants' option, subject to prior approval by the Federal Reserve, beginning after five years from issuance. Merchants incurred $400 thousand in costs to issue the securities, and the costs are being amortized over five years using the straight-line method. The proceeds from the sale of the trust preferred securities were used for general corporate purposes, allowing Merchants to pay the special dividend declared on December 1, 2004 and at the same time continue to pursue alternative growt h opportunities.
CREDIT QUALITY AND ALLOWANCE FOR LOAN LOSSES
Stringent credit quality is a major strategic focus of Merchants. Merchants' low level of problem assets is evidence of the success of this effort. Although Merchants has been successful to date in minimizing its problem assets, there is no assurance that it will not have increased levels of problem assets in the future. Merchants generally places loans that become 90 or more days past due in nonaccrual status; if, in the opinion of management, the ultimate collectibility of principal and interest is assured, loans may continue to accrue interest and be left in this category. Included in this category are loans which have reached maturity and have not been renewed on a timely basis, for reasons other than financial capacity to pay.
The following table summarizes Merchants' nonperforming loans ("NPL") and nonperforming assets ("NPA") as of December 31, 2001, through December 31, 2005.
(In thousands)	2005	2004	2003	2002	2001
Nonaccrual Loans	$2,284	$3,233	$2,100	$1,925	$2,412
Loans Past Due 90 Days or
More and Still Accruing	--	20	26	46	--
Restructured Loans	80	83	86	1,728	198
Total Nonperforming Loans	2,364	3,336	2,212	3,699	2,610
Other Real Estate Owned	--	--	--	57	225
Total Nonperforming Assets	$2,364	$3,336	$2,212	$3,756	$2,835
NPL to Total Loans	0.39%	0.57%	0.39%	0.75%	0.54%
NPA to Total Loans plus OREO	0.39%	0.57%	0.39%	0.76%	0.59%
Excluded from the 2005 balances above are approximately $5.6 million of internally classified loans, compared to $6.3 million of internally classified loans at December 31, 2004. $1.1 million of these internally classified loans were sold during 2005 as part of management's efforts to improve credit quality. Other factors contributing to the net change in internally classified loan balances were loan payouts of $1.0 million, amortization of existing balances of $130 thousand, charge-offs of $27 thousand, and net downgrades into classified loans totaling $1.6 million. Overall economic conditions in Merchants' marketplace showed little change throughout the year.

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Management maintains an internal listing that includes all criticized and classified loans. The list is reviewed and updated monthly. The list make up is dynamic with individual loans migrating off and on the list. Some of these loans may migrate to non-performing status during the course of the next twelve months. Management believes that classified loans have well-defined weaknesses which, if left unattended, could lead to collection problems. The oversight process on these loans includes an active risk management approach. A management committee reviews the status of these loans each quarter and determines or confirms the appropriate risk rating and accrual status. The findings of this review process are instrumental in determining the adequacy of the allowance for loan losses.

Discussion of 2005 Events Affecting Nonperforming Assets

Historically, Merchants has worked closely with borrowers to collect obligations and when necessary pursued more vigorous collection efforts. Merchants' Credit Department and Commercial Loan Officers work together to address collection strategies for nonperforming assets. The following schedule shows the components of nonperforming assets as of the end of each of the previous five quarters:

(In thousands)		December 31, 2005	September 30, 2005	June 30, 2005	March 31, 2005	December 31, 2004
	Nonaccrual Loans	$2,284	$3,981	$3,416	$3,638	$3,233
	Loans Past Due 90 Days or
	More and still Accruing	--	--	100	--	20
	Restructured Loans	80	81	83	82	83
	Other Real Estate Owned	--	--	--	--	--
	Total	$2,364	$4,062	$3,597	$3,720	$3,336

Nonaccrual loans decreased to $2.28 million at December 31, 2005 from $3.23 million at December 31, 2004. During 2005 management identified $2.3 million in new nonperforming loans. Based on continued performance approximately $485 thousand in nonaccrual loans were returned to accrual status, principal payments of approximately $1.3 million were collected, approximately $250 thousand of nonaccrual loans were charged off and $1.1 million in nonaccrual loans were sold.

Policies and Procedures Related to the Accrual of Interest Income

Merchants recognizes income on earning assets on an accrual basis, which calls for the recognition of income as earned, rather than when it is collected. Merchants' policy is to classify a loan 90 days or more past due with respect to principal or interest as a nonaccruing loan, unless the ultimate collectibility of principal and interest is assured. Income accruals are suspended on all nonaccruing loans, and all previously accrued and uncollected interest is typically charged against current income. A loan remains in nonaccruing status until the factors which suggest doubtful collectibility no longer exist, the loan is liquidated, or when the loan is determined to be uncollectible, and is charged off against the allowance for loan losses. In those cases where a nonaccruing loan is secured by real estate, Merchants can, and may, initiate foreclosure proceedings. The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or t o give Merchants possession of the collateral in order to manage a future resale of the real estate. Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell. Any cost in excess of the estimated fair value on the transfer date is charged to the Allowance, while further declines in market values are recorded as OREO expense in the statement of income.

Loan Portfolio Monitoring

Merchants' Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within Merchants' portfolio, and sets loan authority limits for each lender. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or Merchants' President. All extensions of credit of $2.5 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants' Board of Directors.

The Directors' Loan Committee and the credit department regularly monitor Merchants' loan portfolio. The entire loan portfolio as well as individual loans is reviewed for loan performance, creditworthiness, and strength of

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documentation. Merchants monitors loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Merchants has hired external loan review firms to assist in monitoring both the commercial and residential loan portfolios. During 2005 the commercial loan review firm performed three comprehensive reviews of Merchants' loan portfolio, and reviewed approximately 75% (in dollar volume) of Merchants' commercial loan portfolio. Credit risk ratings are assigned to commercial loans at origination and are routinely reviewed by both management and the external loan review firms.
All loan officers are required to service their loan portfolios and account relationships. As necessary, loan officers or the credit department personnel take remedial actions to assure full and timely payment of loan balances.
Allowance for Loan Losses
The Allowance is based on Management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio, based on circumstances and conditions known at each reporting date. Merchants reviews the adequacy of the Allowance quarterly. Factors considered in evaluating the adequacy of the Allowance include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms and estimated fair values of properties that secure impaired loans.
The adequacy of the Allowance is determined using a consistent, systematic methodology, consisting of a review of the following key elements:
*	A specific reserve for loans identified as impaired;
*	A general reserve for the various loan portfolio classifications;
*	The unallocated allowance for loan losses
Impaired loans totaled $2.0 million and $3.8 million at December 31, 2005 and 2004, respectively. A loan is considered impaired, based on current information and events, if it is probable that Merchants will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Impairment on collateral-dependent loans, which comprise a significant majority of Merchants' loan portfolio, is measured based on the fair value of collateral. Unsecured loans are measured for impairment based on expected future cash flows, discounted at the historical effective interest rate. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable.
Merchants performs detailed and extensive reviews on these loans and on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. Through these reviews Merchants is able to determine if a loan requires a specific allocation of the Allowance or is permanently impaired and needs to be charged down. Loans are evaluated by looking at the fair market value of the collateral, if the loan is collateral dependent; or measuring the net present value of the expected future cash flows using the loan's original effective interest rate. If the loan is impaired further analysis is performed to determine if the impairment is permanent. If the impairment is deemed permanent the loan is charged down to its net realizable value through the Allowance.
The general Allowance is a percentage-based reflection of historical loss experience and assigns a required Allowance allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general Allowance employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. For pass rated loans, appropriate Allowance levels are estimated based on judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans. As of December 31, 2005, the Allowance related to pass rated loans was approximately $3.3 million. For loans rated special mention or substandard, the Allowance allocation is increased; as of December 31, 2005, the Allowance related to special mention or substandard loans was $1.1 million.

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The above evaluations combine the estimates of management and of external loan review sources. After the specific and general reserves previously identified a portion of the Allowance remains unallocated. The unallocated Allowance recognizes a measurement imprecision in the valuation and general components of the allowance and Management's evaluation of various other conditions not measurable in the specific and general components. The unallocated Allowance as of December 31, 2005 was $2.7 million, and was $2.0 million at December 31, 2004. The unallocated Allowance is intended to capture risks which are difficult to quantify using the formula-based loss components that determine allocations in Merchants' analysis. These risks include general economic and business conditions affecting Merchants' key lending areas, such as changes in interest rates and collateral valuation, credit quality trends, loan volumes and concentrations and specific industry conditions within portfolio segments. Additionally, general reserve factors used to calculate the reserve are based on historical charge off experience and are not necessarily indicative of future performance.

Losses are charged against the Allowance when management believes that the collectibility of principal is doubtful. To the extent management determines the level of anticipated losses in the portfolio has significantly increased or diminished, the Allowance is adjusted through current earnings. Overall, management believes that the Allowance is maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the Allowance.

The following table reflects Merchants' loan loss experience and activity in the Allowance for the past five years.

(In thousands)	2005	2004	2003		2002	2001
Average Loans Outstanding	$589,408	$581,259	$536,095		$479,253	$479,052
Allowance Beginning of Year	7,512	7,954	8,497		8,815	10,494
Charge-offs:
Commercial, Lease Financing
and all Other Loans	(336)	(56)	(722)		(311)	(611)
Real Estate - Mortgage	(339)	(703)	(343)		(7)	(48)
Installment & Credit Cards	(18)	(17)	(17)		--	(520)
Total Charge-offs	(693)	(776)	(1,082)		(318)	(1,179)
Recoveries:
Commercial, Lease Financing
and all Other Loans	144	34	397	��	755	333
Real Estate - Construction	--	--	--		3	--
Real Estate - Mortgage	115	297	140		187	104
Installment & Credit Cards	5	3	2		--	67
Total Recoveries	264	334	539		945	504
Net (Charge-offs) Recoveries	(429)	(442)	(543)		627	(675)
Provision for Loan Losses	--	--	--		(945)	(1,004)
Allowance End of Year	$    7,083	$    7,512	$    7,954		$    8,497	$    8,815
Allowance to Total Loans	1.17 %	1.29 %	1.40 %		1.71%	1.84 %
Net Loan (Charge-offs) Recoveries
to Average Loans	(0.07)%	(0.08)%	(0.10)%		0.13%	(0.14)%
As of December 31, 2005, Merchants' Allowance ratios were 300% of nonperforming loans and 1.17% of total loans. Although the Allowance has declined over the past five years both in size and as a percentage of the loan portfolio, management has not added to the Allowance for several reasons; most notable is the shift in the composition of the loan portfolio over the last five years, on a percentage basis, from higher risk commercial asset classes to less risky residential categories, as shown in the table on page 26. Additionally, Merchants' portfolio of non-performing assets has remained at consistently low levels over the last five years, and was .39% of total loans at December 31, 2005, the ratio of the allowance to non-performing assets at year-end was 300%.
Merchants will continue to take all appropriate measures to restore nonperforming assets to performing status or otherwise liquidate these assets in an orderly fashion so as to maximize their value to Merchants. There can be no

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assurances that Merchants will be able to complete the disposition of nonperforming assets without incurring further losses.

RELATED PARTY TRANSACTIONS

Merchants engages in banking transactions with certain of its directors and officers, and certain of their affiliates. During 2005 Merchants obtained legal services from a firm associated with one of its directors totaling $40 thousand; and project management services from a firm associated with one of its directors totaling $75 thousand.Merchants obtained insurance during 2005 through an insurance agency ("Agency") of which a director of Merchants Bank is president. In 2005, premiums paid to the Agency totaled $386 thousand. Merchants obtains these services on terms that are comparable to those that it would obtain from unaffiliated third parties.

At December 31, 2005, Merchants had loans outstanding to directors, executive officers, and associates of such persons totaling $3.42 million. It is the policy of Merchants to make these loans on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons. As of December 31, 2005, all loans to directors, officers, and certain of their affiliates, were performing in accordance with their contractual terms.

EFFECTS OF INFLATION

The financial nature of Merchants' consolidated balance sheet and statement of income is more clearly affected by changes in interest rates than by inflation, but inflation does affect Merchants because as prices increase the money supply tends to increase, the size of loans requested tends to increase, total company assets increase, and interest rates are affected by inflationary expectations. In addition, operating expenses tend to increase without a corresponding increase in productivity. There is no precise method, however, to measure the effects of inflation on Merchants' financial statements. Accordingly, any examination or analysis of the financial statements should take into consideration the possible effects of inflation.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued revised statement No. 123 ("FAS 123R"), "Share-Based Payment", which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of FAS 123R became effective for public companies for years beginning after July 1, 2005. Merchants adopted the provisions of FAS 123R using a modified prospective application. Under the modified prospective application, FAS 123R, which provides certain changes to the method for valuing stock-based compensation among other changes, will apply to new awards and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service has not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FAS 123. All options outstanding are fully ves ted as of December 31, 2005. Therefore adoption of FAS 123R will have no impact. Future grants will be accounted for according to the provisions of FAS 123R.

Liquidity and Capital Resource Management

General

Liquidity, as it pertains to banking, can be defined as the ability to meet cash commitments at all times in the most economical way to satisfy loan and deposit withdrawal demand, and to meet other business opportunities that require cash. Sources of liquidity for banks include short-term liquid assets, cash generated from loan repayments and amortization, borrowing, deposit generation and earnings. Merchants has a number of sources of liquid funds, including $28 million in available Federal Funds lines of credit with correspondent banks at year-end 2005; an overnight line of credit with the FHLB of $5 million; an estimated additional borrowing capacity with the FHLB of $81 million; and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties. Merchants' investment portfolio, which totaled $390 million at December 31, 2005, is actively managed by the Merchants' Asset Liability Committee ("ALC O") and is a strong source of cash flow for Merchants. The portfolio is fairly liquid, with a weighted average life of approximately 2.5 years, and is available to be used as a source of funds, if needed.

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Contractual Obligations
Merchants has certain long-term contractual obligations; including long-term debt agreements, operating leases for branch operations, and time deposits. The maturity schedules for these obligations are as follows:
			One Year	Three
		Less than	To Three	Years To		Over Five
(In thousands)		One Year	Years	Five Years		Years	Total
Debt Maturities		$  29,078	$24,592	$     273		$  1,821	$  55,764
Junior Subordinated Debentures		--	--	--		20,000	20,000
Operating Lease Payments		605	1,047	723		1,443	3,818
Time Deposits		167,689	71,248	11,343		49	250,329
		$197,372	$96,887	$12,339		$23,313	$329,911
Commitments and Off-Balance Sheet Risk
Merchants is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying Consolidated Balance Sheets.
Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. Merchants uses the same credit policies in making commitments as it does for on-balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2005, are as follows:
	(In thousands)				Contractual Amount
	Financial Instruments Whose Contract Amounts
	Represent Credit Risk:
	Commitments to Originate Loans				$  26,779
	Unused Lines of Credit				126,004
	Standby Letters of Credit				6,343
	Equity Commitments to Affordable Housing
	Limited Partnerships				1,455
Commitments to originate loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments to originate loans generally have expiration dates within 60 days of the commitment. Unused lines of credit have expiration dates ranging from one to two years from the date of the commitment. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. Merchants evaluates each customer's creditworthiness on a case-by-case basis. Upon extension of credit Merchants obtains an appropriate amount of real and/or personal property as collateral based on management's credit evaluation of the counterparty.
FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements No. 5, 57, and 107, and rescission of FASB Interpretation No. 34," requires certain disclosures and liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under s tandby letters of credit totaled approximately $6.3 million and $8.7 million at December 31, 2005 and 2004, respectively and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash

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requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants' standby letters of credit at December 31, 2005 and 2004 was insignificant.

Equity commitments to affordable housing partnerships represent funding commitments by Merchants to certain limited partnerships. These partnerships were created for the purpose of acquiring, constructing and/or redeveloping affordable housing projects. The funding of these commitments is generally contingent upon substantial completion of the project and none extend beyond the fifth anniversary of substantial completion.

Capital Resources

In general, capital growth is essential to support deposit and asset growth and to ensure the strength and safety of Merchants. Net income increased Merchants' capital by $11.9 million in 2005, $11.9 million in 2004 and $11.6 million in 2003. Payment of dividends decreased Merchants' capital by $6.8 million, $34.3 million and $6.2 million during 2005, 2004 and 2003, respectively. Merchants declared a special dividend of $4.50 per share on December 1, 2004. The total amount of the special dividend was $28.1 million, which is included in the $34.3 million discussed above. Merchants' Board of Directors determined that the lower tax rates on dividends provided an opportunity for Merchants to return capital to its shareholders in the form of a special dividend in a simple, fair and transparent process. In December 2004 Merchants, through a newly formed subsidiary business trust, privately placed $20 million in capital securities as part of pooled trust preferred program. These capi tal securities have certain features that make them an attractive funding vehicle. The securities qualify as regulatory capital under regulatory adequacy guidelines, and are included in capital in the table below. Merchants remained well capitalized under applicable regulatory guidelines after the payment of the special dividend both with and without the trust preferred securities.

Stock repurchases decreased Merchants' capital by $4.47 million during 2005, there were no stock repurchases during 2004. In addition changes in the market value of Merchants' available for sale investment portfolio decreased capital by $4.7 million in 2005. Merchants' pension plan was under funded by $3.08 million at December 31, 2005 which resulted in an after-tax charge of $2.00 million to equity for a minimum pension liability adjustment at December 31, 2005. The tax-effected adjustment was a $407 thousand increase in Accumulated Other Comprehensive Income at December 31, 2005.

Merchants is subject to various regulatory capital requirements administered by banking regulatory agencies. To be considered adequately capitalized under the regulatory framework for prompt corrective action, Merchants must maintain minimum levels of Tier-1 Leverage, Tier-1 Risk-Based and Total Risk-Based Capital. Merchants was considered well capitalized by the regulators at December 31, 2005. The ratios for Merchants are set forth below:

				Actual
		(In thousands)	Amount(1)	Percentage
		Tier 1 Leverage Capital	$90,454	8.54%
		Tier-1 Risk-Based Capital	90,454	13.31%
		Total Risk-Based Capital	97,537	14.36%
___________________
(1)	Capital amounts include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain regulatory limits.
In January 2001 Merchants' Board of Directors approved a stock repurchase program. The program has been extended until January 2006. Under the program, Merchants is authorized to repurchase up to 300 thousand shares of its common stock. As of December 31, 2005, Merchants had purchased 300 thousand shares of its common stock on the open market under the program at an average per share price of $23.44.
In October of 2005 Merchants' Board of Directors approved a new stock repurchase program, pursuant to which Merchants may repurchase 200 thousand shares of its stock from time to time through October 2006. The new program commenced when there were no shares remaining under the previous stock repurchase program.

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ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISK MANAGEMENT

General

Management and the Board of Directors of Merchants are committed to sound risk management practices throughout the organization. Merchants has developed and implemented a centralized risk management monitoring program. Risks associated with Merchants' business activities and products are identified and measured as to probability of occurrence and impact on Merchants (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides management with a comprehensive framework for monitoring Merchants' risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the FDICIA and the Sarbanes-Oxley Act of 2002.

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Merchants' primary market risk exposure is interest rate risk. An important component of Merchants' asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by Merchants' Board of Directors. The Investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment policy also establishes specific investment quality limits. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the ALCO. In this capacity the ALCO develops guidelines and strategies impacting Merchants' asset and liability management related activ ities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. As the portfolio has grown, the ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. Merchants continued to work to maximize net interest income while mitigating risk during 2005 through further repositioning of the investment portfolio, as well as carefully monitoring the overall duration and average life of the portfolio, as well as monitoring individual securities, among other strategies. Merchants has an outside investment advisory firm which helps it identify opportunities for increased yield, without significantly increasing risk, in the investment portfolio. The firm specializes in stable value and fixed income portfolios, and has a staff of investment professionals who research and track each bond. The ALCO has a weekly conference call with the investment advisor. Durin g these calls the ALCO and the investment advisor discuss trading activity from the previous week, and set strategy for the ensuing week. Additionally, any specific bonds or sectors that require additional attention are discussed on these calls. The investment advisory firm meets with the ALCO committee of Merchants' Board of Directors to perform a portfolio review on a quarterly basis. They report on the overall performance of the portfolio and perform modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios. The investment advisors also review and provide detail on individual holdings in the portfolio.

Interest Rate Risk

Interest rate risk is the exposure to a movement in interest rates, which, as described above, affects the Company's net interest income. Asset/liability management is governed by policies reviewed and approved annually by the Board of Directors. The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, meets frequently to review and develop asset/liability management strategies and tactics.

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of Merchants' assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure primarily by using on-balance sheet strategies, generally accomplished through the management of the duration, rate sensitivity and average lives of the Company's various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing of loans and deposits. The ALCO also considers the use of off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, to help minimize the Company's exposure to changes in interest rates. The ALCO uses an outside inve stment advisor to recommend investments and assist in transaction execution, and an outside ALCO consultant to perform rate shocks of its balance sheet and a variety of other analyses for the Committee. The ALCO is responsible for ensuring that the

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Board of Directors receives accurate information regarding Merchants' interest rate risk position at least quarterly. The investment advisor and ALCO consultant meet jointly with the ALCO and the Asset/Liability Committee of the Board of Directors on a quarterly basis to review the Bank's current position and to discuss future strategies. This review shows that Merchants' one year gap position has changed to a $137.2 million liability sensitive position, compared to a $29.2 million liability sensitive position at the end of 2004. This change is primarily a result of the migration of commercial and commercial real estate loans from variable rate to fixed rate as short term rates have moved up.
Merchants has established a target range for the change in net interest income, given a parallel 200 basis point change in interest rates, of zero to 7.5%. The net interest income simulation as of December 31st showed that the change in net interest income for the next 12 months from Merchants' expected or "most likely" forecast was as follows:
		Percent Change in
	Rate Change	Net Interest Income
	Up 200 basis points	(1.3%)
	Down 200 basis points	(0.2%)
The analysis shows additional margin compression in both the up and down 200 basis points scenarios. The ability to reduce funding costs is limited in the falling rate environment, while the approximately $174 million base of variable-rate prime based loans rapidly reset to lower yields. If rates fall further it will be difficult for Merchants to lower deposit rates enough to compensate for these anticipated decreases in loan rates. A steepening yield curve accompanied by rapidly falling short-term rates would create less exposure as compared to a parallel rate shift. In a rising rate scenario, net interest income trends slightly downward during most of the first two years as funding costs initially increase more quickly than asset yields. The model shows that after deposit costs begin to stabilize, margins begin to widen and net interest income increases. The degree to which this exposure materializes will depend, in part, on Merchants' ability to manage deposit and loan rate s as interest rates rise or fall.
The analysis discussed above includes no growth assumptions. The consultant also ran additional simulations, and modeled a down 200 basis points scenario with a steepening yield curve, a 400 basis point upward movement in rates and a simulation using Merchants' current growth assumptions. The steepening yield curve scenario mitigated some of the margin compression in the down 200 basis points scenario. Net interest income was higher than base in all scenarios in the growth model, demonstrating that Merchants can outgrow the potential margin compression. These types of dynamic analyses give the ALCO a more thorough understanding of how Merchants' balance sheet will perform in a variety of rate environments.
The preceding sensitivity analysis does not represent Merchants' forecast and should not be relied upon as being indicative of expected operating results. These estimates are based upon numerous assumptions including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, Merchants cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
The most significant factors affecting market risk exposure of net interest income during the year ended December 31, 2005 were (i) the shape and level of the U.S. Government securities and interest rate swap yield curve, (ii) changes in the size and composition of the investment portfolio, (iii) changes in the composition and size of the loan portfolio, and (iv) increases in deposit interest expense. During 2005 the yield curve flattened significantly as the federal funds rate increased approximately 200 basis points while rates on ten year treasuries increased by only 17 basis points.
As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off-balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that ALCO might take in responding to or anticipating changes in interest rates.

<PAGE>  37

The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest-bearing asset and liability on Merchants' balance sheet. The model uses contractual repricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposits such as Free Checking for LifeÒ accounts and Money Market accounts which are subject to repricing based on current market conditions. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model also assumes that the rate at which certain mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from the Office of Thrift Supervision Net Portfolio Value Model.

Merchants' interest rate sensitivity gap ("gap") is pictured below as of December 31, 2005. Interest rate gap analysis provides a static view of the maturity and repricing characteristics of Merchants' on and off-balance sheet positions. Gap is defined as the difference between assets and liabilities repricing or maturing within specified periods. An asset-sensitive position (positive gap) indicates that there are more rate-sensitive assets than rate-sensitive liabilities repricing or maturing within a specified time period, which would imply a favorable impact on net interest income during periods of rising interest rates. Conversely, a liability-sensitive position (negative gap) generally implies a favorable impact on net interest income during periods of falling interest rates. There are certain limitations inherent in a static gap analysis. These limitations include the fact that it is a static measurement and that it does not reflect the degrees to which interest earning assets and interest bearing deposits may respond non-proportionally to changes in market interest rates. Although the ALCO reviews all assumptions used in the model in detail, assets and liabilities do not always have clear repricing dates, and may reprice earlier or later than assumed in the model.

	Repricing Date
		One Day		Over Six		One Year
		To Six		Months To		To Five		Over Five
(In thousands)		Months		One Year		Years		Years		Total
Assets
Loans	$	243,491	$	42,497	$	230,559	$	82,296	$	598,843
U.S. Treasury & Agency Securities		3,001		--		12,175		--		15,176
Mortgage Backed Securities and
Collateralized Mortgage Obligations		38,549		34,450		167,047		46,624		286,670
Other Securities		5,460		5,663		63,649		13,842		88,614
Other Assets		--		--		--		85,933		85,933
Total Assets	$	290,501	$	82,610	$	473,430	$	228,695	$	1,075,236
Liabilities and Shareholders' Equity
Noninterest-bearing Deposits	$	--	$	--	$	--	$	124,292	$	124,292
Interest-bearing Deposits		327,192		86,162		316,930		--		730,284
Short-term Borrowings		52,988		--		--		--		52,988
Other Liabilities		--		--		--		4,892		4,892
Long-Term Debt		31,908		12,089		52,386		--		96,383
Shareholders' Equity		--		--		--		66,397		66,397
Total Liabilities and Shareholders'
Equity	$	412,088	$	98,251	$	369,316	$	195,581	$	1,075,236
Cumulative Gap	$	(121,587)	$	(137,228)	$	(33,114)	$	--	$	--
Gap as a % of Total Earning Assets		(12.27%)		(13.85%)		(3.34)%

Based on historical experience and Merchants' internal repricing policies, it is Merchants' practice to present repricing of statement savings, savings deposits, Free Checking for Life^(R) and NOW account balances in the "One Year to Five Years" category. Merchants' experience has shown that the rates on these deposits tend to be less rate-sensitive than other types of deposits.

Credit Risk

The Board of Directors reviews and approves Merchants' loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within Merchants' portfolio. Merchants' Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or president. All extensions of

<PAGE>  38

credit of $2.5 million or greater to any one borrower or related party interest, are reviewed and approved by the Loan Committee of Merchants' Board of Directors. Merchants' loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and with the assistance of an external loan review firm. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers or the loan workout function take remedial actions to assure full and timely payment of loan balances when necessary. Merchants' policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectibility of principal or interest becomes doubtful.

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ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Merchants Bancshares, Inc.
Consolidated Balance Sheets
			December 31,	December 31,
(In thousands except share data)			2005	2004
ASSETS
Cash and Due from Banks			$     45,214	$     40,325
Investments:
Securities available for sale			382,797	357,015
Securities held to maturity (fair value of $8,001 and $20,574)			7,663	19,532
Total investments			390,460	376,547
Loans			605,926	584,332
Less: Allowance for loan losses			7,083	7,512
Net loans			598,843	576,820
Federal Home Loan Bank stock			8,896	7,547
Bank premises and equipment, net			12,145	12,841
Investment in real estate limited partnerships			9,361	8,589
Other assets			10,317	9,736
Total assets			$1,075,236	$1,032,405
LIABILITIES
Deposits:
Demand deposits			$   124,292	$   119,089
Savings, NOW and money market accounts			479,955	520,489
Time deposits $100 thousand and greater			64,006	39,908
Other time deposits			186,323	154,678
Total deposits			854,576	834,164
Demand note due U.S. Treasury			2,988	2,374
Other short-term borrowings			50,000	55,000
Other liabilities			4,892	5,307
Long-term debt			55,764	49,757
Securities sold under agreement to repurchase			20,000	--
Junior subordinated debentures issued to unconsolidated subsidiary trust			20,619	20,619
Total liabilities			1,008,839	967,221
Commitments and contingencies (Note 15)
SHAREHOLDERS' EQUITY
Preferred stock Class A non-voting
Shares authorized - 200,000, none outstanding			--	--
Preferred stock Class B voting
Shares authorized - 1,500,000, none outstanding			--	--
Common stock, $.01 par value			67	67
Shares authorized		10,000,000
Issued	As of December 31, 2005	6,651,760
	As of December 31, 2004	6,651,760
Outstanding	As of December 31, 2005	5,976,287
	As of December 31, 2004	5,973,695
Capital in excess of par value			37,328	34,490
Retained earnings			43,965	38,893
Treasury stock, at cost			(13,733)	(11,065)
	As of December 31, 2005	675,473
	As of December 31, 2004	678,065
Deferred compensation arrangements			5,414	5,120
Accumulated other comprehensive loss			(6,644)	(2,321)
Total shareholders' equity			66,397	65,184
Total liabilities and shareholders' equity			$1,075,236	$1,032,405
See accompanying notes to consolidated financial statements

<PAGE>  40

Merchants Bancshares, Inc.
Consolidated Statements of Income
	Years Ended December 31,
(In thousands except share and per share data)	2005	2004		2003
INTEREST AND DIVIDEND INCOME:
Interest and Fees on Loans	$ 36,627	$ 32,725		$ 32,540
Interest and dividends on investments:
U.S. Treasury and agency obligations	6,979	6,746		7,812
Other	10,203	7,961		5,209
Total Interest and Dividend Income	53,809	47,432		45,561
INTEREST EXPENSE:
Savings, NOW and money market accounts	3,940	2,616		2,918
Time deposits $100 thousand and greater	1,136	862		1,354
Other time deposits	3,925	2,592		3,246
Other borrowed funds	1,528	762		254
Long-term debt	3,345	1,044		161
Total interest expense	13,874	7,876		7,933
Net interest income	39,935	39,556		37,628
Provision for loan losses	-	-	��	--
Net interest income after provision for loan losses	39,935	39,556		37,628
NONINTEREST INCOME:
Trust company income	1,652	1,547		1,406
Service charges on deposits	4,456	4,837		4,453
Net gains (losses) on sale of investment securities	(32)	49		1,420
Equity in losses of real estate limited partnerships	(1,712)	(1,745)		(1,615)
Other	2,907	2,553		2,291
Total noninterest income	7,271	7,241		7,955
NONINTEREST EXPENSES:
Salaries and wages	12,256	11,899		11,566
Employee benefits	3,622	3,828		3,571
Occupancy expense, net	3,104	3,106		2,785
Equipment expense	3,013	3,033		2,624
Legal and professional fees	2,112	1,731		1,467
Marketing	1,372	1,377		1,534
State franchise taxes	948	916		787
Other	5,126	4,903		5,285
Total noninterest expenses	31,553	30,793		29,619
Income before provision for income taxes	15,653	16,004		15,964
Provision for income taxes	3,751	4,071		4,372
NET INCOME	$ 11,902	$ 11,933		$ 11,592
Basic earnings per common share	$     1.88	$     1.91		$     1.87
Diluted earnings per common share	$     1.87	$     1.90		$     1.86
Weighted average common shares outstanding	6,318,524	6,225,417		6,183,919
Weighted average diluted shares outstanding	6,360,675	6,292,751		6,247,444
See accompanying notes to the consolidated financial statements.

<PAGE>  41

Merchants Bancshares, Inc.
Consolidated Statements of Comprehensive Income
	Years Ended December 31,
(In thousands)	2005		2004	2003
Net Income	$ 11,902		$ 11,933	$ 11,592
Change in net unrealized depreciation of securities
available for sale, net of taxes of $(2,553), $(619), and $(919)	(4,741)		(1,149)	(1,706)
Add: Reclassification adjustments for		��
securities (gains) losses included in net income,
net of taxes of $11, $(17), and $(497)	21		(32)	(923)
Minimum pension liability adjustment,
net of taxes of $219, $63 and $202	407		117	377
Comprehensive income before impact of transfers	7,589		10,869	9,340
Impact of transfer of securities from available for sale
to held to maturity, net of taxes of $(5), $13, and $(8)	(10)		24	(15)
Comprehensive income	$ 7,579		$ 10,893	$   9,325
See accompanying notes to the consolidated financial statements.

<PAGE>  42

Merchants Bancshares, Inc.
Consolidated Statements of Changes in Shareholders' Equity
For the Years Ended December 31, 2005, 2004, and 2003
						Accumulated
		Capital in			Deferred	Other
	Common	Excess of	Retained	Treasury	Compensation	Comprehensive
(In thousands except per share data)	Stock	Par Value	Earnings	Stock	Arrangements	(Loss) Income	Total
Balance at December 31, 2002	$67	$33,664	$ 55,827	$(10,980)	$3,194	$   986	$ 82,758
Net income	--	--	11,592	--	--	--	11,592
Dividends paid ($1.04 per share)	--	--	(6,165)	--	--	--	(6,165)
Purchase of treasury stock	--	--	--	(713)	--	--	(713)
Director's deferred compensation, net	--	--	--	59	105	--	164
Shares issued under stock plans, net	--	14	--	115	--	--	129
Dividend reinvestment plan	--	380	--	169	266	--	815
Accumulated other comprehensive income (loss)	--	--	--	--	--	(2,267)	(2,267)
Balance at December 31, 2003	$67	$34,058	$ 61,254	$(11,350)	$3,565	$(1,281)	$ 86,313
Net income	--	--	11,933	--	--	--	11,933
Dividends paid ($5.58 per share)	--	--	(34,294)	--	--	--	(34,294)
Director's deferred compensation, net	--	--	--	137	57	--	194
Shares issued under stock plans, net	--	26	--	76	--	--	102
Dividend reinvestment plan	--	406	--	72	1,498	--	1,976
Accumulated other comprehensive income (loss)	--	--	--	--	--	(1,040)	(1,040)
Balance at December 31, 2004	$67	$34,490	$ 38,893	$(11,065)	$5,120	$(2,321)	$ 65,184
Net income	--	--	11,902	--	--	--	11,902
Dividends paid ($1.08 per share)	--	--	(6,830)	--	--	--	(6,830)
Purchase of treasury stock	--	--	--	(4,474)	--	--	(4,474)
Sale of treasury stock	--	2,159	--	1,408	--	--	3,567
Director's deferred compensation, net	--	--	--	271	(37)	--	234
Shares issued under stock plans, net	--	368	--	(23)	--	--	345
Dividend reinvestment plan	--	311	--	150	331	--	792
Accumulated other comprehensive income (loss)	--	--	--	--	--	(4,323)	(4,323)
Balance at December 31, 2005	$67	$37,328	$ 43,965	$(13,733)	$5,414	$(6,644)	$ 66,397
See accompanying notes to consolidated financial statements.

<PAGE>  43

Merchants Bancshares, Inc.
Consolidated Statement of Cash Flows
For the Years Ended December 31,	2005	2004	2003
(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income	$   11,902	$   11,933	$   11,592
Adjustments to reconcile net income to net cash provided by
Operating activities:
Deferred tax expense	1,364	2,416	2,061
Depreciation and amortization	5,417	6,201	5,227
Net losses (gains) on sales of investment securities	32	(48)	(1,420)
Net gains on sales of loans	(74)	--	--
Net losses on disposition of premises and equipment	20	14	71
Net gains on sales of other real estate owned	--	(80)	(8)
Equity in losses of real estate limited partnerships	1,761	1,764	1,615
Changes in assets and liabilities:
Decrease (increase) in interest receivable	(129)	243	151
Decrease (increase) in other assets	159	(1,064)	(2,458)
(Increase) decrease in interest payable	417	44	(68)
(Decrease) increase in other liabilities	(205)	(5,609)	2,488
Net cash provided by operating activities	20,664	15,814	19,251
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities available for sale	18,636	66,107	100,390
Proceeds from maturities of investment securities available for sale	94,077	91,193	80,959
Proceeds from maturities of investment securities held to maturity	11,862	15,183	16,856
Purchases of investment securities available for sale	(148,662)	(214,879)	(274,077)
Loan originations in excess of principal payments	(24,995)	(18,884)	(76,528)
Purchases of Federal Home Loan Bank stock	(1,349)	(3,528)	(388)
Proceeds from sales of loans, net	3,060	3,107	2,576
Proceeds from sales of premises and equipment	272	--	--
Proceeds from sales of other real estate owned	--	80	65
Investments in real estate limited partnerships	(2,533)	(4,888)	(3,530)
Purchases of bank premises and equipment	(1,808)	(2,010)	(3,567)
Net cash used in investing activities	(51,440)	(68,519)	(157,244)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits	20,412	26,081	52,809
Net (decrease) increase in short-term borrowings	(4,386)	316	53,058
Proceeds from long-term debt	45,000	60,000	4,875
Proceeds from securities sold under agreement to repurchase	20,000	--	--
Proceeds from Issuance of Trust Preferred Securities	--	20,619	--
Principal payments on long-term debt	(38,993)	(16,862)	(634)
Cash dividends paid	(6,039)	(32,320)	(5,350)
Purchases of treasury stock	(4,474)	9	(713)
Sale of treasury stock	3,566	--	--
Increase in deferred compensation arrangements	234	194	164
Proceeds from exercise of stock options	345	102	129
Net cash provided by financing activities	35,665	58,139	104,338
Increase in cash and cash equivalents	4,889	5,434	(33,655)
Cash and cash equivalents beginning of year	40,325	34,891	68,546
Cash and cash equivalents end of period	$   45,214	$   40,325	$   34,891
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Total interest payments	$ 13,457	$7,832	$8,001
Total income tax payments	860	1,570	5,112
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING
AND FINANCING ACTIVITIES
Distribution of stock under deferred compensation arrangements	271	347	59
Distribution of treasury stock in lieu of cash dividend	792	759	815
See accompanying notes to consolidated financial statements.

<PAGE>  44

Merchants Bancshares, Inc.

Notes to Consolidated Financial Statements

December 31, 2005, 2004 and 2003

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. and its wholly owned subsidiaries Merchants Bank and Merchants Properties, Inc. as well as Merchants Bank's wholly owned subsidiary Merchants Trust Company (collectively "Merchants"). All material intercompany accounts and transactions are eliminated in consolidation. Merchants Bank and Merchants Trust Company offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 35 full-service banking locations throughout the state of Vermont.

Management's Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, and interest income recognition on loans. Operating results in the future may vary from the amounts derived from management's estimates and assumptions.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash on hand and amounts due from banks in the accompanying consolidated statements of cash flows.

Investment Securities

Merchants classifies certain of its investments in debt securities as held to maturity, which are carried at amortized cost if Merchants has the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held to maturity and equity securities that have readily determinable fair values are classified as available for sale securities or trading securities. Trading securities are investments purchased and held principally for the purpose of selling in the near term; available for sale securities are investments not classified as trading or held to maturity. Available for sale securities are carried at fair value which is measured at each reporting date. The resulting unrealized gain or loss is reflected in accumulated other comprehensive income (loss) net of the associated tax effects. Trading securities are also carried at fair value; gains and losses are recognized through the statements of income. Gains and losses on sales of investment securities are recognized through the statement of income using the specific identification method.

Transfers from securities available for sale to securities held to maturity are recorded at the securities' fair values on the date of the transfer. Any net unrealized gains or losses continue to be included in accumulated other comprehensive income (loss) and are reported as a separate component of shareholders' equity, on a net of tax basis. As long as the securities are carried in the held to maturity portfolio, such amounts are amortized (accreted) over the estimated remaining life of the transferred securities as an adjustment to yield in a manner consistent with the amortization of premiums and discounts. Net amortization (accretion) of such amounts totaled $(10) thousand and $24 thousand in 2005 and 2004, respectively.

Interest and dividend income, including amortization of premiums and discounts, is recorded in earnings for all categories of investment securities. Discounts and premiums related to debt securities are amortized using a method which approximates the level-yield method. The gain or loss recognized on the sale of an investment security is based upon the adjusted cost of the specific security.

Management reviews reductions in fair value below book value of investment securities to determine whether the impairment is other than temporary. If the impairment is determined to be other than temporary in nature, the carrying value of the security is written down to the appropriate level by a charge to earnings in the period of determination.

<PAGE>  45

Federal Home Loan Bank Stock

As a member of the Federal Home Loan Bank of Boston ("FHLB"), Merchants is required to hold stock in the FHLB. FHLB stock is carried at cost since there is no readily available market value. The stock cannot be sold, but can be redeemed by the FHLB at cost.

Loans

Loans are carried at the principal amounts outstanding net of the allowance for loan losses, and net of deferred loan costs and fees. Deferred loan costs and fees are amortized over the estimated lives of the loans using the interest method.

Allowance for Loan Losses

The Allowance for Loan Losses ("Allowance") is based on management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio. The Allowance is based on management's systematic periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions.

In addition, Federal regulatory agencies, as an integral part of their examination process, periodically review Merchants' Allowance and may require Merchants to recognize additions to the Allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

Factors considered in evaluating the adequacy of the Allowance include previous loss experience, the size and composition of the portfolio, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms, and estimated fair market values of collateral properties.

A loan is considered impaired, based on current information and events, if it is probable that Merchants will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Impairment on collateral-dependent loans, which comprise a significant majority of Merchants' loan portfolio, is measured based on the fair value of collateral. Unsecured loans are measured for impairment based on expected future cash flows, discounted at the historical effective interest rate. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable.

Income Recognition on Impaired and Nonaccrual Loans

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. If a loan or a portion of a loan is internally classified as doubtful or is partially charged-off, the loan is classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.

Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of the loans.

While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is uncertain, any payments received are generally applied to reduce the principal balance. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Interest collections in excess of that amount are recorded as recoveries to the Allowance until prior charge-offs have been fully recovered.

<PAGE>  46

Premises and Equipment

Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using straight-line and accelerated methods at rates that depreciate the original cost of the premises and equipment over their estimated useful lives. Expenditures for maintenance, repairs and renewals of minor items are generally charged to expense as incurred. When premises and equipment are replaced, retired, or deemed no longer useful they are written down to estimated selling price less costs to sell by a charge to current earnings.

Gains and Losses on Sales of Loans

Gains and losses on sales of loans are recognized based upon the difference between the selling price and the carrying amount of loans sold. Gains and losses are adjusted for servicing rights resulting from the sale of certain loans with servicing rights retained. Deferred loan costs and fees are recognized in income at the time such loans are sold.

Income Taxes

Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Low-income housing tax credits and historic rehabilitation credits are recognized as a reduction of income tax expense in the year in which they are earned.

Investments in Real Estate Limited Partnerships

Merchants has investments in various real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing. Merchants' ownership interest in these limited partnerships ranges from 3.3% to 99% as of December 31, 2005. Merchants accounts for its investments in limited partnerships, where Merchants neither actively participates nor has a controlling interest, under the equity method of accounting. Merchants consolidates the financial statements of the only limited partnership in which it is the general partner, actively involved in management, and has a controlling interest.

Management periodically reviews the results of operations of the various real estate limited partnerships to determine if the partnerships generate sufficient operating cash flow to fund their current obligations. In addition, management reviews the current value of the underlying property compared to the outstanding debt obligations. If it is determined that the investment suffers from a permanent impairment, the carrying value is written down to the estimated realizable value. The maximum exposure on these investments is the current carrying amount plus amounts obligated to be funded in the future.

Other Real Estate Owned

Collateral acquired through foreclosure is recorded at the lower of cost or fair value, less estimated costs to sell, at the time of acquisition. Subsequent decreases in the fair value of other real estate owned ("OREO") are reflected as a write-down and charged to expense. Net operating income or expense related to foreclosed property is included in noninterest expense in the accompanying consolidated statements of income.

Intangible Assets

Premiums paid for the purchase of core deposits are recorded as other assets and amortized using straight-line and accelerated methods over 7 to 15 years. As of December 31, 2005, such intangible assets totaled approximately $582 thousand and are included in other assets on the consolidated balance sheets. Amortization of such intangible assets amounted to $327 thousand, $327 thousand and $346 thousand in 2005, 2004, and 2003 respectively. Amortization for these intangibles for the five years subsequent to December 31, 2005 is: 2006 - $304 thousand; 2007 - $185 thousand; 2008 - $93 thousand; and zero thereafter.

Stock-Based Compensation

Merchants has granted stock options to certain key employees. The options granted vest after two years and are immediately exercisable upon vesting. Nonqualified stock options may be granted at any price determined by the Nominating and Governance Committee of Merchants' Board of Directors. All stock options have been granted at or above fair market value at the date of grant.

<PAGE>  47

Merchants accounts for its stock-based compensation plans in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Merchants has adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize the fair value of all stock-based awards measured on the date of the grant as expense over the vesting period. Merchants has also adopted SFAS No. 148 "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123," which, among other things, amends the disclosure requirements of SFAS No. 123. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and earnings per share disclosures for employee stock-based grants made in 1995 and future years as if the fair value based method defined in SFAS No. 123 had been applied. In Dec ember 2004, the FASB issued revised statement No. 123 ("FAS 123R"), "Share-Based Payment", which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of FAS 123R became effective for public companies for years beginning after July 1, 2005. Merchants adopted the provisions of FAS 123R using a modified prospective application. Under the modified prospective application, FAS 123R, which provides certain changes to the method for valuing stock-based compensation among other changes, will apply to new awards and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service has not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FAS 123. All options outstanding are fully vested as of December 31, 2005. Therefore adoption of FAS 123R will have no impact on current options. Future grants will be accounted for according to the provisions of FAS 123R.

The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model. No options have been granted since August 2001. Under SFAS No. 123, Merchants' net income and earnings per share for the years ended December 31, 2005, 2004 and 2003 would have been the same as the amounts reported in the accompanying consolidated financial statements. Pro forma compensation expense for options granted is reflected over the vesting period; therefore, future pro forma compensation expense may be greater if additional options are granted.

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions. Because Merchants' employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

Employee Benefit Costs

Prior to 1995 Merchants maintained a non-contributory pension plan covering substantially all employees that met eligibility requirements. The plan was curtailed in 1995. The cost of this plan, based on actuarial computations of current and future benefits, is charged to current operating expenses.

Earnings Per Share

Basic earnings per share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed in a manner similar to that of basic earnings per share except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares (such as stock options and unvested restricted stock awards) were issued during the period, computed using the treasury stock method.

Derivative Financial Instruments and Hedging Activities

Derivative instruments utilized by Merchants have included interest rate floor and swap agreements. Merchants is an end-user of derivative instruments and does not conduct trading activities for derivatives.

<PAGE>  48

Merchants follows the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Changes in the fair value of the derivative financial instruments are reported in either net income or as a component of other comprehensive income, depending on the use of the derivative and whether or not it qualifies for hedge accounting. As of December 31, 2005, there were no derivatives being used by Merchants.

Special hedge accounting treatment is permitted only if specific criteria are met, including a requirement that the hedging relationship be highly effective both at inception and on an ongoing basis. Accounting for hedges varies based on the type of hedge - fair value or cash flow. Results of effective hedges are recognized in current earnings for fair value hedges and in other comprehensive income for cash flow hedges. Ineffective portions of hedges are recognized immediately in earnings.

Segment Reporting

Merchants' operations are solely in the financial services industry and include providing to its customers traditional banking and other financial services. Merchants operates primarily in the state of Vermont. Management makes operating decisions and assesses performance based on an ongoing review of Merchants' consolidated financial results. Therefore, Merchants has a single operating segment for financial reporting purposes.

Reclassifications

Reclassifications are made to prior years' consolidated financial statements whenever necessary to conform to the current year's presentation.

(2) INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of December 31, 2005 and 2004. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2005 and 2004, are as follows:

<PAGE>  49

SECURITIES AVAILABLE FOR SALE:
			Gross		Gross
			Unrealized		Unrealized
	Amortized		Holding		Holding		Fair
(In thousands)	Cost		Gains		Losses		Value
2005
U.S. Treasury Obligations	$	200	$	--	$	2	$	198
U.S. Agency Obligations		14,976		1		158		14,819
Residential Real Estate
Mortgage-backed Securities		135,529		363		2,467		133,425
Commercial Real Estate
Mortgage-backed Securities		68,017		--		1,782		66,235
Collateralized Mortgage
Obligations		134,504		20		2,555		131,969
Corporate Bonds		23,697		8		359		23,346
Asset Backed Securities		12,982		33		210		12,805
	$	389,905	$	425	$	7,533	$	382,797
			Gross		Gross
			Unrealized		Unrealized
	Amortized		Holding		Holding		Fair
(In thousands)	Cost		Gains		Losses		Value
2004
U.S. Treasury Obligations	$	200	$	--	$	1	$	199
U.S. Agency Obligations		21,238		143		25		21,356
Residential Real Estate
Mortgage-backed Securities		105,511		1,363		467		106,407
Commercial Real Estate
Mortgage-backed Securities		67,747		239		684		67,302
Collateralized Mortgage
Obligations		113,225		127		893		112,459
Corporate Bonds		31,954		415		107		32,262
Asset Backed Securities		16,985		121		76		17,030
	$	356,860	$	2,408	$	2,253	$	357,015
SECURITIES HELD TO MATURITY:
			Gross		Gross
			Unrealized		Unrealized
	Amortized		Holding		Holding		Fair
(In thousands)	Cost		Gains		Losses		Value
2005
Residential Real Estate
Mortgage-backed Securities	$	7,663	$	338	$	--	$	8,001
		7,663		338		--		8,001
			Gross		Gross
			Unrealized		Unrealized
	Amortized		Holding		Holding		Fair
(In thousands)	Cost		Gains		Losses		Value
2004
Residential Real Estate
Mortgage-backed Securities	$	19,532	$	1,042	$	--	$	20,574
	$	19,532	$	1,042	$	--	$	20,574
There were no securities classified as trading at December 31, 2005 and 2004. There were trading losses of $23 thousand for the year ended December 31, 2004 which are included in other noninterest income in the accompanying consolidated statements of income.

<PAGE>  50

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2005, are as follows:

SECURITIES AVAILABLE FOR SALE:
			After One		After Five
	Within		But Within		But Within		After Ten
(In thousands)	One Year		Five Years		Ten Years		Years		Total
U.S. Treasury Obligations	$	--	$	198	$	--	$	--	$	198
U.S. Agency Obligations		3,002		11,817		--		--		14,819
Residential Real Estate
Mortgage-backed Securities		--		33,414		46,183		53,828		133,425
Commercial Real Estate
Mortgage-backed Securities		--		1,883		--		64,352		66,235
Collateralized Mortgage
Obligations		--		7,615		17,784		106,570		131,969
Corporate Bonds		2,020		17,870		3,456		--		23,346
Asset Backed Securities		--		4,485		--		8,320		12,805
	$	5,022	$	77,282	$	67,423	$	233,070	$	382,797
SECURITIES HELD TO MATURITY:
			After One		After Five
	Within		But Within		But Within		After Ten
(In thousands)	One Year		Five Years		Ten Years		Years		Total
Residential Real Estate
Mortgage-backed Securities	$	--	$	3,111	$	3,223	$	1,329	$	7,663

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of mortgage-backed securities and collateralized mortgage obligations are based on final contractual maturities.

Proceeds from sales of available for sale debt securities were $18.64 million, $66.11 million and $100.4 million during 2005, 2004 and 2003 respectively. Gross gains of $121 thousand, $1.00 million and $1.53 million; and gross losses of $153 thousand, $952 thousand and $114 thousand, were realized from sales of securities in 2005, 2004, and 2003 respectively.

Securities with a book value of $36.8 million and $10.7 million at December 31, 2005 and 2004 respectively, were pledged to secure U.S. Treasury borrowings, public deposits, securities sold under agreements to repurchase, and for other purposes required by law.

Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2005, were as follows:

<PAGE>  51

SECURITIES AVAILABLE FOR SALE:
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
(In thousands)	Value		Losses		Value		Losses		Value		Losses
U.S. Treasury Obligations	$	198	$	2		--		--	$	198	$	2
U.S. Agency Obligations		3,990		--		7,826		158		11,816		158
Residential Real Estate
Mortgage-backed Securities		48,413		672		59,987		1,795		108,400		2,467
Commercial Real Estate
Mortgage-backed Securities		19,354		1,110		45,244		672		64,598		1,782
Collateralized Mortgage
Obligations		41,964		633		79,913		1,922		121,877		2,555
Corporate Bonds		992		8		19,323		351		20,315		359
Asset Backed Securities		3,931		69		6,800		141		10,731		210
	$	118,842	$	2,494	$	219,093	$	5,039	$	337,935	$	7,533

There were no securities held to maturity with unrealized losses as of December 31, 2005.

U.S. Treasury and Agency securities: Unrealized losses on investments in U.S. Treasury and Agency securities were caused by interest rate fluctuations.

Residential Mortgage-backed securities: The unrealized losses on investments in mortgage-backed securities were caused by interest rate fluctuations. The cash flows of these securities are guaranteed by the Federal Home Loan Mortgage Corporation ("FHLMC") or Federal National Mortgage Association ("FNMA"). There are eighteen securities that have been in an unrealized loss position for 12 months or more. The percentage unrealized loss on these eighteen securities ranges from 2.20% to 4.97%, which Merchants considers minor.

Commercial Mortgage Backed Securities (CMBS): The unrealized losses in CMBS were caused by interest rate fluctuations. These bonds are backed by a variety of types of commercial real estate. Merchants looks at the overall structure of these bonds for, among other things, low historical default rates, low loan-to-value ratios, prepayment penalties and lock-outs, and good geographic and property type diversity as part of its pre-purchase evaluation. There are twenty-one securities that have been in an unrealized loss position for 12 months or more, the percentage unrealized loss on these bonds ranges from 1.22% to 5.37%, which Merchants considers minor.

Collateralized Mortgage Obligations (CMOs): The unrealized losses on investments in collateralized mortgage obligations were caused by interest rate fluctuations. There are twenty-nine securities that have been in an unrealized loss position for 12 months or more, nineteen of these bonds are guaranteed by FHLMC or FNMA. The individual unrealized losses on the twenty-nine bonds range from .39% to 5.00%, which Merchants considers minor.

Corporate bonds: The unrealized losses in investments in corporate bonds were caused by interest rate fluctuations. There were sixteen securities in this asset class with unrealized losses at December 31, 2005. Eight out of the sixteen bonds has been in an unrealized loss position for 12 months or more. The individual unrealized losses on these bonds range from .78% to 4.33%, which Merchants considers minor.

Asset Backed Securities (ABS): There were four bonds in this asset class that are in an unrealized loss position as of December 31, 2005, two have been in an unrealized loss position for 12 months or more. The average unrealized loss on the four bonds in this category is 1.93% and is primarily caused by interest rate fluctuations. The unrealized losses range from 1.51% to 3.54%, which Merchants considers minor.

Merchants has determined that because the decline in fair value for all classes of bonds is attributable to changes in interest rates and not credit quality, and because Merchants has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

<PAGE>  52

(3) LOANS
The composition of the loan portfolio at December 31, 2005 and 2004, is as follows:
		(In thousands)		2005		2004
		Commercial, Financial and Agricultural		$  71,912		$  82,644
		Real Estate - Residential		293,158		265,306
		Real Estate - Commercial		208,049		209,333
		Real Estate - Construction		25,942		19,354
		Installment Loans to individuals		6,345		7,016
		All Other Loans (including overdrafts)		520		679
		Total Loans		$605,926		$584,332
Merchants primarily originates residential real estate, commercial, commercial real estate, and installment loans, to customers throughout the state of Vermont. There are no known significant industry concentrations in the loan portfolio. Loans serviced for others at December 31, 2005 and 2004, amounted to approximately $17 million and $25 million, respectively.
A summary of changes in the allowance for loan losses for the years ended December 31, 2005, 2004 and 2003, is as follows:
	(In thousands)		2005		2004		2003
	Balance, Beginning of Year		$7,512		$7,954		$ 8,497
	Provision for Loan Losses		--		--		--
	Loans Charged Off		(693)		(776)		(1,082)
	Recoveries		264		334		539
	Balance, End of Year		$7,083		$7,512		$7,954
Total impaired loans were $2 million and $3.8 million at December 31, 2005 and 2004, respectively. The Allowance associated with such loans was zero and $72 thousand, respectively. Interest payments on impaired loans are generally recorded as principal reductions if the remaining loan balance is not expected to be paid in full. If full collection of the remaining loan balance is expected, interest income is recognized on a cash basis. Merchants recorded interest income on impaired loans of approximately $18 thousand, $50 thousand and $90 thousand during 2005, 2004 and 2003, respectively. The average balance of impaired loans was $3.3 million in 2005, $2.8 million in 2004 and $3.9 million in 2003.
Nonperforming loans at December 31, 2005 and 2004, are as follows:
		(In thousands)		2005		2004
		Nonaccrual Loans		$2,284		$3,233
		Loans Past Due 90 Days or More
		and Still Accruing Interest		--		20
		Restructured Loans		80		83
		Total Nonperforming Loans		$2,364		$3,336
The above disclosed restructured loans were performing in accordance with modified agreements with the borrowers at December 31, 2005 and 2004. Merchants had no Other Real Estate Owned at December 31, 2005 or 2004.
The amount of interest which was not earned, but which would have been earned had Merchants' nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $69 thousand, $97 thousand and $194 thousand in 2005, 2004 and 2003, respectively.

<PAGE>  53

An analysis of loans to directors, executive officers, and associates of such persons for the year ended December 31, 2005, is as follows:
	(In thousands)
	Balance, December 31, 2004	$3,716
	Additions	197
	Repayments	(490)
	Balance, December 31, 2005	$3,423
It is the policy of Merchants to make loans to directors, executive officers, and associates of such persons on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons.
(4) PREMISES AND EQUIPMENT
The components of premises and equipment included in the accompanying consolidated balance sheets are as follows:

			Estimated
	2005	2004	Useful Lives
	(In Thousands)		(In Years)
Land	$   757	$   762	N/A
Bank Premises	13,571	13,287	39
Leasehold Improvements	2,564	2,598	5 - 20
Furniture, Equipment, and Software	13,580	15,094	3 - 7
	30,472	31,741
Less: Accumulated Depreciation and Amortization	18,327	18,900
	$12,145	$12,841

Depreciation and amortization expense related to premises and equipment amounted to $2.2 million, $2.2 million and $1.8 million in 2005, 2004 and 2003, respectively.
Merchants leases certain properties for branch operations. Rent expense on these properties totaled $561 thousand, $572 thousand and $537 thousand for the years ended December 31, 2005, 2004 and 2003, respectively. Minimum lease payments on these properties subsequent to December 31, 2005 are as follows: 2006 - $605 thousand; 2007 - $562 thousand; 2008 - $485 thousand; 2009 - $378 thousand; 2010 - $345 thousand and $1.44 million thereafter.
(5) TIME DEPOSITS
Scheduled maturities of time deposits at December 31, 2005, were as follows:
	(In thousands)
	Mature in year ending December 31,
	2006	$167,689
	2007	58,184
	2008	13,064
	2009	7,072
	2010	4,271
	Thereafter	49
	Total time deposits	$250,329

<PAGE>  54

Time deposits greater than $100 thousand totaled $64.0 million and $39.9 million as of December 31, 2005 and 2004, respectively. Interest expense on time deposit greater than $100 thousand amounted to $1.1 million, $862 thousand and $1.4 million for the years ended December 31, 2005, 2004 and 2003, respectively.
(6) OTHER BORROWED FUNDS
Other borrowed funds consisted of the following at December 31, 2005 and 2004:
	(In thousands)	2005	2004
	Demand Note Due U.S. Treasury	$ 2,988	$ 2,374
	Federal Home Loan Bank Short-term Borrowings	50,000	55,000
		$52,988	$57,374
Maturities of short term borrowings are less than three months with interest rates at December 31, 2005, ranging from 3.26% to 4.44%.
As of December 31, 2005, Merchants could borrow up to approximately $33 million in overnight funds. $28 million of this $33 million are unsecured borrowing lines established with correspondent banks, the balance of $5 million is in the form of an overnight line of credit with the FHLB. Merchants has established both overnight and longer term lines of credit with the FHLB. The borrowings are secured by mortgage loans and FHLB stock held by Merchants. The total amount of assets pledged to the FHLB for both short and long-term borrowing arrangements totaled $247.35 million and $214.95 million at December 31, 2005 and 2004 respectively.
The following table provides certain information regarding other borrowed funds for the three years ended December 31, 2005, 2004 and 2003:

	Maximum				Weighted
	Month-End		Average		Average-Rate		Weighted
	Amount		Amount		During		Average Rate
(In thousands)	Outstanding		Outstanding		The Year		at Year End
2005
Federal Home Loan Bank
Short-term Borrowings	$	60,000	$	44,321		3.34%		4.02%
Demand Note Due U.S. Treasury		3,976		1,137		3.09%		3.95%
2004
Federal Home Loan Bank
Short-term Borrowings	$	86,000	$	52,649		1.43%		2.31%
Demand Note Due U.S. Treasury		2,491		743		1.05%		1.87%
2003
Federal Home Loan Bank
Short-term Borrowings	$	70,000	$	22,249		1.09%		1.13%
Demand Note Due U.S. Treasury		2,925		827		1.33%		0.73%
Federal Funds Purchased		--		30		1.28%		--

<PAGE>  55

(7) LONG-TERM DEBT
Long-term debt consisted of the following at December 31, 2005 and 2004:
	(In thousands)	2005	2004
	Amortizing Federal Home Loan Bank Notes,
	Rates ranging from 1.68% to 3.72%
	Payable February 2006 through March 2010	$53,749	$47,642
	1.50% Amortizing Federal Home Loan Bank Note,
	payable through October 2023	826	850
	Securities Sold Under Agreements to Repurchase,
	payable December 2008	20,000	--
	8.75% Mortgage Note, payable in Monthly
	Installments (Principal and Interest)
	through 2039	1,152	1,158
	Directors' Floating Growth (Savings) Program	37	107
		$75,764	$49,757
Securities sold under agreements to repurchase are collateralized by mortgage backed securities. The pledged assets had a market value of $26.42 million at December 31, 2005. The debt bears interest at LIBOR plus .45% and is capped when LIBOR reaches 5.25%, and interest cost will be reduced by the cash flows from an embedded floor struck if LIBOR falls below 4%.
The 8.75% Mortgage Note relates to an investment in an affordable housing project made through a consolidated limited partnership. The monthly installments are subsidized by the U.S. Department of Agriculture, which pays amounts annually so as to reduce the monthly principal and interest payments to an amount equivalent to a loan at a rate of 1%.
The Directors Floating Growth (Savings) program relates to a deferred compensation plan for directors. Until July 1, 1997, Directors of Merchants were entitled to defer a portion of their director's fees into this deferred plan. No additional compensation may be deferred into the Floating Growth (Savings) program. Benefits accrue based on a monthly allowance for interest at a rate that is fixed from time-to-time at the discretion of Merchants' Board of Directors. The benefits under the Floating Growth (Savings) program are generally payable annually starting in January of the year following a participant's 65th birthday or earlier death, and will be distributed to the participant (or upon the participant's death, to the participant's designated beneficiary) in accordance with the terms of the Floating Growth (Savings) plan. Final distributions under this plan were made in January 2006.
Maturities of long term debt subsequent to December 31, 2005, are as follows: 2006 - $29.08 million; 2007 - $7.95 million; 2008 - $16.64 million; 2009- $187 thousand; 2010 - $86 thousand and $1.82 million thereafter.
As of December 31, 2005, Merchants had an estimated additional borrowing capacity with the Federal Home Loan Bank of $81 million; and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties.
(8) TRUST PREFERRED SECURITIES
On December 15, 2004 Merchants closed its private placement of an aggregate of $20 million of trust preferred securities. The placement occurred through a newly formed Delaware statutory trust affiliate of Merchants, MBVT Statutory Trust I (the "Trust") as part of a pooled trust preferred program. The Trust was formed for the sole purpose of issuing capital securities, these securities are non-voting. Merchants owns all of the common securities of the trust. The proceeds from the sale of the capital securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust. Merchants' primary source of funds to pay interest on the debentures held by the Trust is current dividends from its principal subsidiary, Merchants Bank. Accordingly, Merchants' ability to service the debentures is dependent upon the continued ability of Merchants Bank to pa y dividends to Merchants.

<PAGE>  56

These hybrid securities will qualify as regulatory capital for Merchants, up to certain regulatory limits. At the same time they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities total $20.62 million, bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts quarterly at a fixed spread over three month LIBOR. The trust preferred securities mature on December 31, 2034, and are redeemable at Merchants' option, subject to prior approval by the Federal Reserve, beginning after five years from issuance. Merchants incurred $400 thousand in costs to issue the securities, which are being amortized over five years using the straight-line method. The proceeds from the sale of the trust preferred securities were used for general corporate purposes, and helped fund the special dividend declared on December 1, 2004.
(9) INCOME TAXES
The components of the provision for income taxes were as follows for the years ended December 31, 2005, 2004 and 2003:
		(In thousands)	2005	2004		2003
		Current	$2,387	$1,655		$2,311
		Deferred	1,364	2,416		2,061
			$3,751	$4,071		$4,372
Not included in the above table is the income tax impact associated with the unrealized gain or loss on securities available for sale and the income tax impact associated with the minimum pension liability adjustment, which are recorded directly in stockholders' equity.
The tax effects of temporary differences and tax credits that give rise to deferred tax assets and liabilities at December 31, 2005 and 2004, are presented below:
	(In thousands)				2005		2004
	Deferred Tax Assets:
	Allowance for Loan Losses				$ 2,479		$ 2,629
	Deferred Compensation				1,631		1,666
	Low income housing credit carryforward				1,286		582
	Core Deposit Intangible				378		396
	Deferred Gain on Sale of Interest Rate Swap				--		58
	Other				207		96
	Total Deferred Tax Assets				$ 5,981		$ 5,427
	Deferred Tax Liabilities
	Depreciation				(657)		(707)
	Accrued Liabilities				(724)		(496)
	Loan Market Adjustment				(3,513)		(1,979)
	Investments in Real Estate Limited Partnerships				(3,649)		(3,443)
	Total Deferred Tax Liabilities				(8,543)		(6,625)
	Net Deferred Tax Asset (Liability)				$(2,562)		$(1,198)
Low income housing tax credits are eligible for a 20 year carryforward.
In addition to the deferred tax assets and liabilities described above, Merchants had a deferred tax asset related to the net unrealized loss on securities available for sale of $2.49 million at December 31, 2005 and a deferred tax liability related to the net unrealized gain on securities available for sale of $54 thousand at December 31, 2004, respectively. Merchants also had a deferred tax asset of $1.08 million and $1.30 million at December 31, 2005 and 2004, respectively, related to the recognition of a minimum pension liability as of December 31, 2005.

<PAGE>  57

In assessing the realizability of Merchants' total deferred tax assets, management considers whether it is more likely than not that some portion or all of those assets will not be realized. Based upon management's consideration of historical and anticipated future pre-tax income, as well as the reversal period for the items giving rise to the deferred tax assets and liabilities, a valuation allowance for deferred tax assets was not considered necessary at December 31, 2005 and 2004. Merchants had a tax refund receivable at December 31, 2005 totaling approximately $1.59 million.
The following is a reconciliation of the federal income tax provision, calculated at the statutory rate of 35%, to the recorded provision for income taxes:
	(In thousands)	2005	2004	2003
	Applicable Statutory Federal Income Tax	$ 5,479	$ 5,601	$ 5,587
	(Reduction) Increase in Taxes Resulting From:
	Tax-exempt Income	(19)	(12)	(14)
	Housing Tax Credits	(1,700)	(1,600)	(1,320)
	Other, Net	(9)	82	119
	Provision for Income Taxes	$ 3,751	$ 4,071	$ 4,372

The State of Vermont assesses a franchise tax for banks in lieu of income tax. The franchise tax is assessed based on deposits and amounted to approximately $907 thousand, $870 thousand and $787 thousand in 2005, 2004 and 2003, respectively, which is included as non-interest expense in the accompanying consolidated statement of income.
(10) EMPLOYEE BENEFIT PLANS
Pension Plan
Prior to January 1995 Merchants maintained a noncontributory defined benefit plan covering all eligible employees. The plan was a final average pay plan with benefits based on the average salary rates over the five consecutive plan years out of the last ten consecutive plan years that produce the highest average. It was Merchants policy to fund the cost of benefits expected to accrue during the year plus amortization of any unfunded accrued liability that had accumulated prior to the valuation date based on IRS regulations for funding. During 1995 the plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.
The plan's obligations and funded status as of December 31, 2005 and 2004 measurement dates, were as follows:
	(In thousands)	2005	2004
	Change in Projected Benefit Obligation
	Benefit Obligation at Beginning of Year	$ 8,820	$ 8,640
	Interest Cost	448	507
	Actuarial (Gain) Loss	(710)	191
	Benefits Paid	(496)	(518)
	Projected Benefit Obligation at Year-end	$ 8,062	$ 8,820
	Change in Plan Assets
	Fair Value of Plan Assets at Beginning of Year	$ 7,039	$ 6,863
	Actual Return on Plan Assets	323	680
	Employer Contributions	150	14
	Benefits Paid	(496)	(518)
	Fair Value of Plan Assets at Year-end	$ 7,016	$ 7,039
	Funded Status of the Plan
	Funded Status	$(1,045)	$(1,781)
	Unrecognized Net Actuarial Loss	3,083	3,709
	Net Amount Recognized	$ 2,038	$ 1,928

<PAGE>  58

Amounts recognized in the consolidated balance sheets consist of:
	(In thousands)	2005	2004
	Minimum Pension Liability	$(1,045)	$(1,781)
	Accumulated Other Comprehensive Loss, Pre-tax	3,083	3,709
	Net Amount Recognized	$ 2,038	$ 1,928
The accumulated benefit obligation was equal to the projected benefit obligation at December 31, 2005 and 2004.
The following table summarizes the components of net periodic benefit cost for the years ended December 31, 2005, 2004, and 2003, respectively.

(In thousands)	2005	2004	2003
Interest Cost	$ 448	$ 507	$ 514
Expected Return on Plan Assets	(559)	(528)	(445)
Net Loss Amortization	150	221	261
Net Periodic Pension Cost	$   39	$ 200	$ 330

The following table summarizes the assumptions used to determine the benefit obligations at December 31, 2005 and 2004, and net periodic benefit costs for the years ended December 31, 2005 and 2004:
		2005	2004
	Benefit Obligations
	Discount Rate	5.65%	5.75%
	Net Periodic Benefit Cost
	Discount Rate	5.75%	6.00%
	Expected Long-term Return on Plan Assets	7.50%	8.00%

The expected long-term rate of return on plan assets reflects long-term earnings expectations on existing plan assets and those contributions expected to be received during the current plan year. In estimating that rate, appropriate consideration was given to historical returns earned by plan assets in the fund and the rates of return expected to be available for reinvestment. Rates of return were adjusted to reflect current capital market assumptions and changes in investment allocations, if any.

The following table sets forth the target asset allocation, and the asset allocation percentages as of December 31, 2005 and 2004, for Merchants' Pension Plan:

		Allocation	Allocation
	Target	Percentage	Percentage
	Allocation	12/31/2005	12/31/2004
Equity Securities	60-70%	63%	67%
Debt Securities	30-40%	33%	30%
Other/Cash	--	4%	3%
Total		100%	100%

Merchants' Pension Plan Investment Policy Statement sets forth the investment objectives and constraints of Merchants' Pension Plan (the "Plan"). The purpose of the policy is to assist the Retirement Plan Committee of Merchants in effectively supervising, monitoring and evaluating the investments of the Plan.

The investment objectives are to provide both income and capital appreciation and to assist with current and future spending needs of the Plan while at the same time minimizing the risks of investing. The investment target of the Plan is to achieve a total annual rate of return in excess of the change in the Consumer Price Index for the aggregate investments of the Plan evaluated over a period of five years. A certain amount of risk must be assumed to achieve

<PAGE>  59

the Plan's investment target rate of return. The Plan diversifies its assets to help to minimize the risks of investing. The Plan also uses a long time horizon to evaluate its returns. The Plan's asset allocation is based on this long-term perspective.

Specific guidelines regarding allocation of assets are as follows: equities shall be managed to a target of 65% of total investments and fixed income securities will be managed to a target of 35% of total investments, with a 5% tolerance either below or above, as measured on a quarterly basis. If the exposure for equities is less than 60% or greater than 70%, or the exposure for fixed income is less than 30% or greater than 40% at the end of any quarter, the assets will be rebalanced in order to restore the equity exposure.

Merchants' expected minimum required contribution to the Plan is expected to be in the range of zero to $2.3 million for 2006.

The following table summarizes the estimated future benefit payments expected to be paid under the Plan:

	Pension
(In thousands)	Benefits
2006	$   430
2007	431
2008	382
2009	400
2010	411
Years 2011 to 2015	2,420

The estimated future benefit payments expected to be paid under the Plan are based on the same assumptions used to measure Merchants' benefit obligation at December 31, 2005. No future service estimates were included due to the frozen status of the Plan.

401(k) Employee Stock Ownership Plan

Under the terms of Merchants' 401(k) Employee Stock Ownership Plan ("401(k)") eligible employees are entitled to contribute up to 75% of their compensation to the 401(k), and Merchants contributes a percentage of the amounts contributed by the employees as authorized by Merchants' Board of Directors. Merchants contributed approximately 109%, 110% and 111% of the amounts contributed by the employees (200% of up to 4.5% of individual employee compensation) in 2005, 2004 and 2003, respectively.

Summary of Expense

A summary of expense relating to Merchants' various employee benefit plans for each of the years in the three year period ended December 31, 2005, is as follows:

(In thousands)	2005	2004	2003
Pension Plan	$  39	$   200	$   330
401(k) Employee Stock Ownership Plan	914	865	795
Total	$953	$1,065	$1,125

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(11) STOCK-BASED COMPENSATION PLANS

Stock Option Plans

A summary of Merchants' stock option plans as of December 31, 2005, 2004 and 2003, and changes during the years then ended are as follows, with numbers of shares in thousands:

	2005		2004		2003
		Weighted		Weighted		Weighted
		Average		Average		Average
	Number	Exercise	Number	Exercise	Number	Exercise
	Of	Price	Of	Price	Of	Price
	Shares	Per Share	Shares	Per Share	Shares	Per Share
Options Outstanding, Beginning of Year	280	$17.78	299	$17.51	307	$17.45
Granted	--	--	--	--	--	--
Exercised	76	16.49	19	13.63	8	15.17
Expired	--	--	--	--	--	--
Options Outstanding, End of Year	204	$17.96	280	$17.78	299	$17.51
Options Exercisable	204	$17.96	280	$17.78	299	$17.51

As of December 31, 2005, there were options outstanding within the following ranges: 154 thousand at prices within the range of $15.00 to $20.00, and 50 thousand at prices within the range of $20.01 to $23.00. The weighted-average remaining contractual life of the outstanding options was 2.5 years as of December 31, 2005.

Deferred Compensation Plans

In December 1995 Merchants established several plans (the "Plans") and established certain trusts (the "Trusts") with Merchants Trust Company, to which it contributed an amount sufficient to cover Merchants' obligations to directors. The Plans used those payments, in part, to purchase newly issued common stock of Merchants at its then market price. The purchases have been accounted for as treasury stock transactions in Merchants' consolidated financial statements. The portions of the payments made to the Plans that were not invested in the common stock of Merchants were included as investments in the consolidated financial statements and were classified as trading. To the extent the obligations of Merchants under the Plans are based on investments by the Plans in other than shares of Merchants, the investments were revalued at each reporting date with a corresponding adjustment to compensation expense in the consolidated statement of income. The portion of the Plan that was no t held in shares of Merchants was paid out in December of 2004.

Restricted Stock Plans

Merchants has compensation plans for non-employee directors. Under the terms of these plans participating directors may elect to have all, or a specified percentage of their director's fees for a given year, paid in the form of cash or deferred in the form of restricted shares of Merchants' common stock. Directors who elect to have their compensation deferred are credited with a number of shares of Merchants common stock equal in value to the amount of fees deferred plus a risk premium of not more than 25% of the amount deferred. The participating director may not sell, transfer or otherwise dispose of these shares prior to distribution. With respect to shares of common stock issued or otherwise transferred to a participating director, the participating director will have the right to receive dividends or other distributions thereon. If a participating director resigns under certain circumstances, the director forfeits all of his or her restricted shares which are risk premium shares. During 2005, 9,262 shares of common stock of Merchants were distributed to a trust established under the terms of the Restricted Stock plans. The risk premium is reflected within a component of Stockholders' Equity labeled "Deferred Compensation Arrangements" and is recognized as an expense ratably over the five-year restriction period. Dividends paid on the restricted shares are taken as a charge to equity.

<PAGE>  61

(12) SHAREHOLDERS' EQUITY

Vermont state law requires Merchants to allocate a minimum of 10% of net income to surplus until such time as appropriated amounts equal 10% of deposits and other liabilities. Merchants' shareholders' equity included $17.1 million and $15.9 million of such appropriations as of December 31, 2005 and 2004, respectively. Vermont state law also restricts the payment of dividends under certain circumstances.

(13) EARNINGS PER SHARE

The following tables present reconciliations of the calculations of basic and diluted earnings per share for the years ended December 31, 2005, 2004 and 2003:

	Net			Per Share
2005	Income		Shares	Amount
	(In thousands except share and per share data)
Basic Earnings Per Share:
Income Available to Common Shareholders	$11,902	6,318,524		$1.88
Diluted Earnings Per Share:
Options issued to Executives	--	42,151		--
Income Available to Common Shareholders
Plus Assumed Conversions	$11,902	6,360,675		$1.87
	Net			Per Share
2004	Income		Shares	Amount
	(In thousands except share and per share data)
Basic Earnings Per Share:
Income Available to Common Shareholders	$11,933	6,225,417		$1.91
Diluted Earnings Per Share:
Options issued to Executives	--	67,334		--
Income Available to Common Shareholders
Plus Assumed Conversions	$11,933	6,292,751		$1.90
	Net			Per Share
2003	Income		Shares	Amount
	(In thousands except share and per share data)
Basic Earnings Per Share:
Income Available to Common Shareholders	$11,592	6,183,919		$1.87
Diluted Earnings Per Share:
Options issued to Executives	--	63,525		--
Income Available to Common Shareholders
Plus Assumed Conversions	$11,592	6,247,444		$1.86

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. The computation of diluted earnings per share excludes the effect of assuming the exercise of certain outstanding stock options because the effect would be anti-dilutive. As of December 31, 2005, 2004, and 2003, there were no such anti-dilutive options outstanding.

<PAGE>  62

(14) PARENT COMPANY
The Parent Company's investments in its subsidiaries are recorded using the equity method of accounting. Summarized financial information relative to the Parent Company only balance sheets at December 31, 2005 and 2004, and statements of income and cash flows for each of the years in the three year period ended December 31, 2005, are as follows:
Balance Sheets as of December 31,
(In thousands)	2005	2004
Assets:
Investment in and Advances to Subsidiaries*	$84,335	$82,619
Cash*	1,610	1,290
Other Assets	1,233	1,957
Total Assets	$87,178	$85,866
Liabilities and Shareholders' Equity:
Other Liabilities	$     162	$       63
Long Term Debt	20,619	20,619
Shareholders' Equity	66,397	65,184
Total Liabilities and Shareholders' Equity	$87,178	$85,866

Statements of Income for the Years Ended December 31,
(In thousands)	2005	2004	2003
Dividends from Merchants Bank*	$  6,831	$14,818	$  5,162
Equity in Undistributed Earnings of Subsidiaries	6,047	(2,755)	6,508
Other Expense, Net	(1,495)	(200)	(120)
Benefit from Income Taxes	519	70	42
Net Income	$11,902	$11,933	$11,592
Statements of Cash Flows for the Years Ended December 31,
(In thousands)	2005	2004	2003
Cash Flows from Operating Activities:
Net Income	$11,902	$11,933	$11,592
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
(Increase) Decrease in Other Assets	724	(1,949)	--
(Decrease) Increase in Other Liabilities	99	50	(114)
Equity in Undistributed Earnings of Subsidiaries	(6,047)	2,755	(6,508)
Net Cash Provided by Operating Activities	6,678	12,789	4,970
Cash Flows from Financing Activities:
Purchases of Treasury Stock	(4,474)	--	(713)
Sale of Treasury Stock	3,566	--	--
Investment in Unconsolidated Subsidiary	--	(619)	--
Proceeds from Exercise of Stock Options	345	102	129
Cash Dividends Paid	(6,039)	(32,320)	(5,350)
Junior Subordinated Debentures issued to Unconsolidated
Subsidiary trust	--	20,619	--
Other, Net	244	(10)	(99)
Net Cash Used in Financing Activities	(6,358)	(12,228)	(6,033)
Increase (Decrease) in Cash and Cash Equivalents	320	561	(1,063)
Cash and Cash Equivalents at Beginning of Year	1,290	729	1,792
Cash and Cash Equivalents at End of Year	$  1,610	$  1,290	$     729
* Account balances are partially or fully eliminated in consolidation.

<PAGE>  63

(15) COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

Merchants is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.

Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. Merchants uses the same credit policies in making commitments as it does for on-balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2005 and 2004 are as follows:

	Contractual
(In thousands)	Amount
2005
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Commitments to Originate Loans	$  26,779
Unused Lines of Credit	126,004
Standby Letters of Credit	6,343
Loans Sold with Recourse	759
Equity Commitments to Affordable Housing
Limited Partnerships	1,455
	Contractual
(In thousands)	Amount
2004
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Commitments to Originate Loans	$  28,155
Unused Lines of Credit	103,273
Standby Letters of Credit	8,746
Equity Commitments to Affordable Housing
Limited Partnerships	4,173

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 a portion of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. Merchants evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by Merchants upon extension of credit is based on management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is obtained as collateral.

FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34", requires certain disclosures and liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under st andby letters of credit totaled approximately $6.3 million and $8.7 million at December 31, 2005 and 2004, respectively, and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is

<PAGE>  64

evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants' standby letters of credit at December 31, 2005 and 2004 was insignificant.

Merchants may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at December 31, 2005 or 2004.

Interest Rate Cap and Floor Contracts

Interest rate caps allow the purchaser to "cap" the contractual rate associated with a liability; alternatively interest rate floors allow the purchaser to protect the rate of return on an asset. Merchants may use floor contracts to mitigate the effects on net interest income in the event interest rates on floating rate loans decline and may use cap contracts to mitigate the effects on net interest income should interest rates on floating rate deposits increase. As of December 31, 2005, there were no interest rate cap or floor contracts outstanding.

Interest Rate Swaps

An interest rate swap is an agreement whereby two parties agree to exchange periodic interest payments, most commonly one party agrees to pay the other party interest payments of a fixed rate; and the other party agrees to make interest payments at a rate that floats with a specified index. There is no exchange of the underlying principal amounts. Merchants uses swap agreements to mitigate the effect on net interest income should floating rates on loans decrease. Merchants is exposed to risk should the counterparty default in its responsibility to pay interest under the terms of the swap agreement, but minimizes this risk by performing normal credit reviews on the counterparties, limiting its exposure to any one counterparty, and by utilizing well known national investment firms as counterparties. Notional principal amounts are a measure of the volume of agreements transacted, but the level of credit risk is significantly less. Merchants entered into a $25 million, three year, interest rate swap early in the second quarter of 2002. Merchants received a fixed interest rate and paid prime under the agreement. Merchants terminated the swap and realized a $1.3 million gain during October 2002. The gain was accreted into income monthly through April 2005, using the effective yield method. There were no interest rate swap contracts outstanding as of December 31, 2005 or 2004.

Balances at the Federal Reserve Bank

At December 31, 2005 and 2004, amounts at the Federal Reserve Bank included $7.0 million and $7.8 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.

Legal Proceedings

Merchants and certain of its subsidiaries have been named as defendants in various legal proceedings arising from their normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, based upon the opinion of counsel on the outcome of such proceedings, any such liability will not have a material effect on the consolidated financial position of Merchants and its subsidiaries.

(16) FAIR VALUE OF FINANCIAL INSTRUMENTS

Investments

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents and the Federal Home Loan Bank stock approximate fair values. Fair value for investment securities is determined from quoted market prices, when available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.

<PAGE>  65

An analysis of the fair value of the investment securities as of December 31, 2005 and 2004, is as follows:

	2005		2004
	Carrying		Carrying
(In thousands)	Amount	Fair Value	Amount	Fair Value
Securities Available for Sale	$382,797	$382,797	$357,015	$357,015
Securities Held to Maturity	7,663	8,001	19,532	20,574
	$390,460	$390,798	$376,547	$377,589

Loans

The fair value of variable rate loans that reprice frequently and have no significant credit risk is based on carrying values. The fair value for other loans is estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

An analysis of the fair value of the loan portfolio as of December 31, 2005 and 2004, is as follows:

	2005		2004
	Carrying		Carrying
(In thousands)	Amount	Fair Value	Amount	Fair Value
Gross Loans	$605,926	$603,245	$584,332	$587,018
Allowance for Loan Losses	7,083	--	7,512	--
Net Loans	$598,843	$603,245	$576,820	$587,018

Deposits

The fair value of demand deposits approximates the amount reported in the consolidated balance sheets. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow which applies interest rates currently being offered for deposits of similar remaining maturities.

An analysis of the fair value of deposits as of December 31, 2005 and 2004 is as follows:

	2005		2004
	Carrying		Carrying
(In thousands)	Amount	Fair Value	Amount	Fair Value
Demand Deposits	$124,292	$124,292	$119,089	$119,089
Savings, NOW and Money Market	479,955	479,955	520,489	520,489
Time Deposits $100 thousand
and greater	64,006	62,963	39,908	39,486
Other Time Deposits	186,323	183,286	154,678	153,038
	$854,576	$850,496	$834,164	$832,102

Debt

The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity. An analysis of the fair value of the borrowings of Merchants as of December 31, 2005 and 2004 is as follows:

	2005		2004
	Carrying		Carrying
(In thousands)	Amount	Fair Value	Amount	Fair Value
Short-term Borrowings	$52,988	$52,988	$57,374	$57,315
Long-term Debt	55,764	55,198	49,757	49,322
Securities sold under agreement to
repurchase	20,000	20,044	--	--
Junior Subordinated Debentures issued
to Unconsolidated Subsidiary Trust	20,619	20,138	20,619	20,619

<PAGE>  66

Commitments to Extend Credit and Standby Letters of Credit

The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is $63 thousand and $87 thousand as of December 31, 2005 and 2004, respectively.

(17) REGULATORY CAPITAL REQUIREMENTS

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

Quantitative measures established by regulation to ensure capital adequacy require Merchants to maintain minimum ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2005, that Merchants met all capital adequacy requirements to which it is subject.

As of December 31, 2005, the most recent notification from the FDIC categorized Merchants Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed Merchants Bank's category. To be considered well capitalized under the regulatory framework for prompt corrective action, Merchants Bank must maintain minimum Tier 1 Leverage, Tier 1 Risk-Based, and Total Risk-Based Capital ratios as set forth in the table below.

						To Be Well-
						Capitalized Under
				For Capital		Prompt Corrective
		Actual		Adequacy Purposes		Action Provisions
	(In thousands)	Amount(1)	Percent	Amount	Percent	Amount	Percent
	As of December 31, 2005
	Merchants Bancshares, Inc.:
	Tier 1 Leverage Capital	$90,454	8.54%	$42,374	4.00%	N/A
	Tier 1 Risk-Based Capital	90,454	13.31%	27,174	4.00%	N/A
	Total Risk-Based Capital	97,537	14.36%	54,348	8.00%	N/A
	Merchants Bank:
	Tier 1 Leverage Capital	$88,187	8.30%	$42,513	4.00%	$53,141	5.00%
	Tier 1 Risk-Based Capital	88,187	12.93%	27,291	4.00%	40,396	6.00%
	Total Risk-Based Capital	95,270	13.96%	54,582	8.00%	68,227	10.00%
	As of December 31, 2004
	Merchants Bancshares, Inc.:
	Tier 1 Leverage Capital	$84,175	8.09%	$41,641	4.00%	N/A
	Tier 1 Risk-Based Capital	84,175	12.41%	27,139	4.00%	N/A
	Total Risk-Based Capital	91,687	13.51%	54,279	8.00%	N/A
	Merchants Bank:
	Tier 1 Leverage Capital	$81,329	7.79%	$41,768	4.00%	$52,210	5.00%
	Tier 1 Risk-Based Capital	81,329	11.95%	27,215	4.00%	40,822	6.00%
	Total Risk-Based Capital	88,841	13.06%	54,430	8.00%	68,037	10.00%
___________________
(1)	Capital amounts include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain regulatory limits.

<PAGE>  67

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

of Merchants Bancshares, Inc.:

We have audited the accompanying consolidated balance sheets of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders' equity, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 1, 2006, expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting.

/s/ KPMG

Albany, New York

March 1, 2006

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

of Merchants Bancshares, Inc.:

We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Merchants Bancshares, Inc. (the "Company") maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, o r disposition of the company's assets that could have a material effect on the financial statements.

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

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In our opinion, management's assessment that Merchants Bancshares, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders' equity, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 1, 2006 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG

Albany, New York

March 1, 2006

<PAGE>  70

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND

                  FINANCIAL DISCLOSURES

None.

ITEM 9A - CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures - The principal executive officer and principal financial officer of Merchants have evaluated the disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act as of December 31, 2005. Based on this evaluation, the principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in Merchants' filings and submissions with the Securities and Exchange Commission under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. In addition, Merchants has reviewed its internal controls and there have been no significant changes in its internal controls over financial reporting or in other factors during Merchants' most recent fiscal quarter that have or are likely to materially affect int ernal control over financial reporting.

Management's Report on Internal Control Over Financial Reporting -Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f) or 15d-15(f). Merchants' internal control system was designed to provide reasonable assurances to Merchants management and board of directors regarding the preparation and fair presentation of published financial statements. Under the supervision and with the participation of Merchants' management, including its principal executive officer and principal financial officer, an evaluation of the effectiveness of internal controls over financial reporting was conducted, based on the framework inInternal Control - Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the evaluation under the framework inInternal Control - Integrated Framework,management c oncluded that the internal controls over financial reporting were effective as of December 31, 2005. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2005 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included in Item 8 herein.

ITEM 9B - OTHER INFORMATION - All information required to be disclosed on Form 8-K during the fourth quarter of 2005 has been reported.

PART III

ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

ITEM 11 - EXECUTIVE COMPENSATION

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND

                  RELATED STOCKHOLDER MATTERS

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES

Reference is hereby made to pages 4-7, page 14, pages 11-12, pages 18-19, page 3, page 16 and page 20 of Merchants' Proxy Statement to Shareholders dated March 17, 2006, wherein pursuant to Regulation 14A information concerning the above subjects (Items 10 through 14) is incorporated by reference.

Pursuant to Rule 12b-23, definitive copies of the Proxy Statement will be filed within 120 days subsequent to the end of Merchants 2005 fiscal year.

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PART IV
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(1)	The following consolidated financial statements are included:
	Consolidated Balance Sheets, December 31, 2005, and December 31, 2004
	Consolidated Statements of Income for years ended December 31, 2005, 2004 and 2003
	Consolidated Statements of Comprehensive Income for the years ended December 31, 2005, 2004 and 2003
	Consolidated Statements of Changes in Shareholders' Equity for years ended December 31, 2005, 2004 and 2003
	Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003
	Notes to Consolidated Financial Statements
(2)	The following exhibits are either filed or attached as part of this report, or are incorporated herein by reference:
Exhibit		Description
3.1		Restated Certificate of Incorporation of Merchants (Incorporated by reference to Exhibit B to Pre-Effective Amendment No. 1 to Merchants Definitive Proxy Statement for the Annual Meeting of the Stockholders of the Company, filed on April 25, 1987)
3.2		Amended By-Laws of Merchants (Incorporated by reference to Exhibit C to Merchants' Definitive Proxy Statement for the Annual Meeting of the Stockholders of the Company, filed on April 25, 1987)
4		Instruments defining the rights of security holders, including indentures
4.1		Specimen of Merchants' Common Stock Certificate (Incorporated by Reference to Exhibit 4.1 to Merchants' 2001 Form 10-K filed on March 28, 2002)
4.2		Description of the Rights of holders of Merchants' Common Stock (appearing on pages 10 through 16 of Merchants' definitive Proxy Statement on Schedule 14A, effective as of April 25, 1987 for Merchants' Annual Meeting of Shareholders held June 2, 1987)
10.1		Merchants Bancshares, Inc. Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to Exhibit 4.1 to Merchants' Registration Statement on Form S-3 (Registration No. 333-20375) filed on January 22, 1997)
10.2		401(k) Employee Stock Ownership Plan of Merchants, dated January 1, 1990, as amended (Incorporated by reference to Merchants' Registration Statement on Form S-8 (Registration Number 33-3274) filed on November 16, 1989)
10.3		Amended and Restated Merchants Bank Pension Plan dated as of January 1, 1994 (Incorporated by Reference to Exhibit 10.6 to Post-Effective Amendment Number 1 to Merchants' Registration Statement on Form S-8 (Registration Number 333-18845) filed on December 26, 1996)
10.4		Form of Employment Agreement dated as of January 1, 2006, by and between Merchants and its subsidiaries and certain of its executive officers
10.5		Fixed/Floating Rate Junior Subordinated Deferrable Interest Debentures dated December 15, 2004; Merchants Bancshares, Inc. as Issuer, Wilmington Trust Company as Trustee (Incorporated by reference to Exhibit 10.5 to Merchants' 2004 Form 10-K filed on March 9, 2005)
10.5.1		MBVT Statutory Trust I Subscription Agreement dated December 15, 2004 (Incorporated by reference to Exhibit 10.5.1 to Merchants' 2004 Form 10-K filed on March 9, 2005)
10.5.2		Declaration of Trust dated December 15, 2004 between Merchants Bancshares, Inc. and Wilmington Trust Company (Incorporated by reference to Exhibit 10.5.2 to Merchants' 2004 Form 10-K filed on March 9, 2005)

<PAGE>  72

10.5.3	Guarantee Agreement between Merchants Bancshares, Inc. and Wilmington Trust Company dated December 15, 2004 (Incorporated by reference to Exhibit 10.5.3 to Merchants' 2004 Form 10-K filed on March 9, 2005)
10.5.4	Placement Agreement dated December 7, 2004 between Merchants Bancshares, Inc. and FTN Financial Capital Markets (Incorporated by reference to Exhibit 10.5.4 to Merchants' 2004 Form 10-K filed on March 9, 2005)
10.14	The Merchants Bank Amended and Restated Deferred Compensation Plan for Directors (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1997)
10.14.1	Trust under the Merchants Bank Amended and Restated Deferred Compensation Plan for Directors (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1997)
10.14.2	The Merchants Bancshares, Inc. Amended and Restated Deferred Compensation Plan for Directors (Incorporated by reference to Form S-8 filed on September 3, 1997)
10.15	Agreement among the Merchants Bank and Kathryn T. Boardman, Thomas R. Havers and Susan D. Struble dated as of December 20, 1995 (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1996)
10.15.1	Trust under the Agreement among the Merchants Bank and Kathryn T. Boardman, Thomas R. Havers and Susan D. Struble dated as of December 20, 1995 (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1996)
10.16	Agreement between the Merchants Bank and Dudley H. Davis dated December 20, 1995 (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1996)
10.16.1	Fixed Trust under Agreement between the Merchants Bank and Dudley H. Davis dated December 20, 1995 (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1996)
10.16.2	Variable Trust under Agreement between the Merchants Bank and Dudley H. Davis dated December 21, 1995 (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 1996)
11	Statement regarding computation of per share earnings.
14	Codes of Ethics (Incorporated by reference to the Registrant's Annual Report on Form 10-K for the Year Ended December 31, 2003)
21	Subsidiaries of Merchants
23	Consent of KPMG LLP
31.1	Certification of Chief Executive Officer of Merchants Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14
31.2	Certification of Chief Financial Officer of Merchants Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14
32.1	Certification of Chief Executive Officer of Merchants Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer of Merchants Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

<PAGE>  73

SIGNATURES
Pursuant to the requirement of Section 13 or 15 (d) of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on it's behalf by the undersigned, thereunto duly authorized.
Merchants Bancshares, Inc.
Date	February 16, 2006	By	/s/ Joseph L. Boutin
			Joseph L. Boutin, President & CEO
Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of MERCHANTS BANCSHARES, INC., and in the capacities and on the date as indicated.
By	/s/ Joseph L. Boutin			February 16, 2006
	Joseph L. Boutin, Director, President			Date
	& CEO of Merchants
By	/s/ Peter A. Bouyea			February 16, 2006
	Peter A. Bouyea, Director			Date
By	/s/ Charles A. Davis			February 16, 2006
	Charles A. Davis, Director			Date
By	/s/ Jeffrey L. Davis			February 16, 2006
	Jeffrey L. Davis, Director			Date
By	/s/ Michael G. Furlong			February 16, 2006
	Michael G. Furlong, Director			Date
By	/s/ John A. Kane			February 16, 2006
	John A. Kane, Director			Date
By	/s/ Lorilee A. Lawton			February 16, 2006
	Lorilee A. Lawton, Director			Date
By	/s/ Bruce M. Lisman			February 16, 2006
	Bruce M. Lisman, Director			Date
By	/s/ Raymond C. Pecor, Jr.			February 16, 2006
	Raymond C. Pecor, Jr. Director			Date
	Chairman of the Board of Directors
By	/s/ Patrick S. Robins			February 16, 2006
	Patrick S. Robins, Director			Date
By	/s/ Robert A. Skiff, Ph.D.			February 16, 2006
	Robert A. Skiff, Ph.D., Director			Date
By	/s/ Janet P. Spitler			February 16, 2006
	Janet P. Spitler, Treasurer & CFO of Merchants			Date

<PAGE>  74