Commission File Number: 841105-D

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TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS

                                                    The accompanying notes are an integral part of these unaudited consolidated interim financial statements.

                                                                The accompanying notes are an integral part of these unaudited consolidated interim financial statements.

The consolidated balance sheet at December 31, 2005 has been derived from audited consolidated financial statements at that date. The accompanying unaudited interim consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, and notes thereto.

Note 2: Management’s Use of Estimates

Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, income tax estimates, and the valuation of intangible assets.

Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The determination of the adequacy of the allowance and provisioning for estimated losses is evaluated regularly based on review of loans, with particular emphasis on non-performing and other loans that management believes warrant special consideration. The ongoing evaluation process includes a formal analysis, which considers among other factors: the character and size of the loan portfolio, business and economic conditions, real estate market conditions, collateral values, changes in product offerings or loan terms, changes in underwriting and/or collection policies, loan growth, previous charge-off experience, delinquency trends, nonperforming loan trends, the performance of individual loans in relation to contract terms, and estimated fair values of collateral.

While management uses available information to recognize losses on loans, changing economic conditions and the economic prospects of the borrowers may necessitate future additions or reductions to the allowance. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance, which also may necessitate future additions or reductions to the allowance, based on information available to them at the time of their examination.

Income Taxes: The Company estimates its income taxes for each period for which a statement of income is presented. The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. If current available information indicates that it is more likely than not that deferred tax assets will not be realized, a valuation allowance is established. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Significant management judgment is required in determining income tax expense, and deferred tax assets and liabilities. As of June 30, 2006 and December 31, 2005, there was no valuation allowance for deferred tax assets. Deferred tax assets are included in other assets on the consolidated balance sheet.

Goodwill and Identifiable Intangible Assets: In connection with acquisitions, the Company generally records as assets on its consolidated financial statements both goodwill and identifiable intangible assets, such as core deposit intangibles.

The Company evaluates whether the carrying value of its goodwill has become impaired, in which case the value is reduced through a charge to its earnings. Goodwill is evaluated for impairment at least annually, or upon a triggering event as defined by SFAS No. 142, using certain fair value techniques.

Any changes in the estimates used by the Company to determine the carrying value of its goodwill and identifiable intangible assets, or which otherwise adversely affect their value or estimated lives, would adversely affect the Company’s consolidated results of operations.

The following is a reconciliation of basic and diluted earnings per share for the three and six months ended June 30, 2006 and 2005:

(in thousands, except number of shares and per share data)

Note 4: Stock Based Compensation

On October 3, 2000, the shareholders of the Company approved the Bar Harbor Bankshares and Subsidiaries Incentive Stock Option Plan of 2000 ("ISOP") for its officers and employees, which provides for the issuance of up to 450,000 shares of common stock. At June 30, 2006, 78,948 shares are still available for future stock option grants. The purchase price of the stock covered by each option shall be its fair market value, which must be equal to at least 100% of the fair market value on the date such option is granted. Vesting terms range from five to seven years. No option shall be granted after October 3, 2010, ten years after the effective date of the ISOP.

Implementation of New Accounting Standards: In December 2004, the Financial Accounting Standards Board ("FASB") issued a revision of Statement of Financial Accounting Standards ("SFAS") No. 123. SFAS No. 123(R), "Share-Based Payment," makes significant changes to accounting for "payments" involving employee compensation and "shares" or securities in the form of stock options, restricted stock or other arrangements settled in the reporting entity’s securities. Most significant in the standard is the requirement that all stock options be measured at estimated fair value at the grant date and recorded as compensation expense over the requisite service period associated with the option, usually the vesting period. The revised standard was effective on January 1, 2006 for calendar-year public companies and is applied prospectively to stock options granted after the effective date and any unvested stock options at that date. The primary effect of the revised standard’s implementation on the Company is recognition of compensation expense associated with stock options.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123(R), using the modified-prospective-transition method. Under that transition method, compensation expense that the Company recognizes beginning in 2006 includes: (a) the compensation expense for all stock-based payments granted prior to, but not yet vested as of, January 1, 2006, based on the grant date fair value; and (b) the compensation expense for all share-based payments granted on or after January 1, 2006, based on the grant date fair value. Because the Company elected to use the modified-prospective-transition method, results for prior periods have not been restated. Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value recognition and measurement principles of APB Opinion 25, "Accounting for Stock Issued to Employees", and related interpretations ("intrinsic value method"). Under the provisions of the Company’s ISOP, the exercise price per share of each option granted cannot be less than the fair market value of the underlying common shares on the date of the grant. Accordingly, the Company previously did not recognize any stock-based employee compensation expense in net income prior to January 1, 2006.

Impact of the Adoption of SFAS No. 123(R): As a result of adopting SFAS 123(R), for the three and six months ended June 30, 2006, the Company recorded expenses of $36 and $71, respectively.

Comparable Disclosures: The following table illustrates the effect on the Company’s net income and earnings per share had the Company applied fair value recognition provisions of SFAS No. 123(R) to its stock-based employee compensation in 2005:

The fair value was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for stock option grants during the six months ended June 30, 2006 and 2005:

Expected market price volatility for the grants in the six months ended June 30, 2006, was determined by using the Company’s historical stock price volatility on a daily basis during the seven-year period ending June 30, 2006.

Stock Option Activity: The following table summarizes the Company’s stock option activity during the six months ended June 30, 2006:

The intrinsic value of the options exercised and cash received by the Company for options exercised during the six months ended June 30, 2006 was approximately $172 and $299, respectively.

As of June 30, 2006, there was approximately $427 of unrecognized compensation cost related to unvested stock option awards net of estimated forfeitures. This is expected to be recognized as expense over the next 7 years.

Stock Options Outstanding: The following table summarizes stock options outstanding by exercise price range at June 30, 2006:

The Company sponsors a limited post-retirement benefit program which funds medical coverage and life insurance benefits to a closed group of active and retired employees who meet minimum age and service requirements. It is the Company's policy to record the cost of post-retirement health care and life insurance plans based on actuarial estimates, which are dependent on claims and premiums paid. The cost of providing these benefits is accrued during the active service period of the employee.

The Company has non-qualified supplemental executive retirement plans for certain retired officers. These plans provide supplemental retirement benefits payable in installments over a period of years upon retirement or death. The Company recognized the net present value of payments associated with the agreements over the service periods of the participating officers. Interest costs continue to be recognized on the benefit obligations.

The Company also has supplemental executive retirement plans for certain executive officers. These plans provide a stream of future payments in accordance with individually defined vesting schedules upon retirement, termination, death, or in the event that the executive leaves the Company following a change of control event.

The following table summarizes the net periodic benefit costs for the three and six months ended June 30, 2006 and 2005:

The Company is expected to contribute $365 to the foregoing plans in 2006.

Note 6: Commitments and Contingent Liabilities

The Bank is a party to financial instruments in the normal course of business to meet financing needs of its customers. These financial instruments include commitments to extend credit, unused lines of credit, and standby letters of credit.

Commitments to originate loans, including unused lines of credit, are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank uses the same credit policy to make such commitments as it uses for on-balance-sheet items, such as loans. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the borrower.

The Bank guarantees the obligations or performance of customers by issuing standby letters of credit to third parties. These standby letters of credit are primarily issued in support of third-party debt or obligations. The risk involved in issuing standby letters of credit is essentially the same as the credit risk involved in extending loan facilities to customers, and they are subject to the same credit origination, portfolio maintenance and management procedures in effect to monitor other credit and off-balance sheet instruments. Exposure to credit loss in the event of non-performance by the counter-party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. Typically, these standby letters of credit have terms of five years or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements.

The following table summarizes the contractual amounts of commitments and contingent liabilities as of June 30, 2006 and December 31, 2005:

As of June 30, 2006, and December 31, 2005, the fair value of the standby letters of credit were not significant to the Company’s consolidated financial statements.

As part of its overall asset and liability management strategy, the Bank periodically uses derivative instruments to minimize significant unplanned fluctuations in earnings and cash flows caused by interest rate volatility. The Bank’s interest rate risk management strategy involves modifying the re-pricing characteristics of certain assets and liabilities so that changes in interest rates do not have a significant effect on net income.

The Company recognizes all of its derivative instruments on the consolidated balance sheet at fair value. On the date the derivative instrument is entered into, the Bank designates whether the derivative is part of a hedging relationship (i.e., cash flow or fair value hedge). The Bank formally documents relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking hedge transactions. The Bank also assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting the changes in cash flows or fair values of hedged items.

Changes in fair value of derivative instruments that are highly effective and qualify as a cash flow hedge are recorded in other comprehensive income or loss. Any ineffective portion is recorded in earnings. For fair value hedges that are highly effective, the gain or loss on the hedge and the loss or gain on the hedged item attributable to the hedged risk are both recognized in earnings, with the differences (if any) representing hedge ineffectiveness. The Bank discontinues hedge accounting when it is determined that the derivative is no longer highly effective in offsetting changes of the hedged risk on the hedged item, or management determines that the designation of the derivative as a hedging instrument is no longer appropriate.

At June 30, 2006 the Bank had four outstanding derivative instruments with notional principal amounts totaling $50,000. These derivative instruments were interest rate swap agreements and interest rate floor agreements, with notional principal amounts totaling $20,000 and $30,000, respectively. The details are summarized as follows:

The Bank is required to pay a counter-party monthly variable rate payments indexed to Prime, while receiving monthly fixed rate payments based upon interest rates of 6.04% and 6.25%, respectively, over the term of each agreement.

The interest rate swap agreements were designated as cash flow hedges in accordance with SFAS No. 133 Implementation Issue No. G25, "Cash Flow Hedges:   Using the First-Payments Received Technique in Hedging the Variable Interest Payments on a Group of Non-Benchmark-Rate-Based Loans".

At June 30, 2006, the fair market value of the interest rate swap agreements was an unrealized loss of $777 compared with $641 and $360 at December 31, and June 30, 2005, respectively. The fair market values of the interest rate swap agreements were included in other liabilities on the consolidated balance sheets.

At June 30, 2006, the net unrealized loss on the interest rate swap agreements included in accumulated other comprehensive income (loss), net of tax, amounted to $513, compared with $423 and $238 at December 31 and June 30, 2005, respectively. Also included in accumulated other comprehensive income (loss) at June 30, 2006, was a net deferred loss, net of tax, of $7 related to the de-designation and re-designation of these interest rate swap agreements as cash flow hedges in 2004.

During the three and six months ended June 30, 2006, the total net cash flows (paid to) received from counter-parties amounted to ($73) and ($126), compared with $22 and $45 during the same periods in 2005. The net cash flows (paid to) received from counter-parties were recorded in interest income.

Interest Rate Floor Agreements:

At June 30, 2006, and December 31, 2005, the unamortized premium net of the unrealized loss on the interest rate floor agreement amounted to $150 and $80, net of tax, respectively, and was recorded in accumulated other comprehensive loss on the consolidated balance sheet.

The following information addresses new or proposed accounting pronouncements that could have an impact on the Company’s financial condition, results of operations, earnings per share, or cash flows.

Accounting for Uncertainty in Income Taxes: In July 2006, the FASB issued Financial Accounting Standards Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes". FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes". FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken, or expected to be taken, in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 (January 1, 2007 for the Company). The Company is currently analyzing the effects of FIN 48.

Accounting for Servicing Rights of Financial Assets: In March 2006, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 156, "Accounting for Servicing of Financial Assets". This statement amends Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 requires companies to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract. The statement permits a company to choose either the amortized cost method or fair value measurement method for each class of separately recognized servicing assets. This statement is effective as of the beginning of a company's first fiscal year after September 15, 2006 (January 1, 2007 for the Company). The Company does not anticipate that the adoption of SFAS 156 will have a material impact on its financial condition or results of operations.

Unless otherwise noted, all dollars are expressed in thousands, except per share data.

Use of Non-GAAP Financial Measures: Certain information discussed below is presented on a fully taxable equivalent basis. Specifically, included in second quarter 2006 and 2005 net interest income was $475 and $385, respectively, of tax-exempt interest income from certain investment securities and loans. For the six months ended June 30, 2006 and 2005, the amount of tax-exempt income included in net interest income was $952 and $821, respectively. An amount equal to the tax benefit derived from this tax-exempt income has been added back to the interest income and net interest income totals discussed in this Management’s Discussion and Analysis, resulting in tax-equivalent adjustments of $184 and $151 in the second quarter of 2006 and 2005, respectively, and $371 and $353 in tax-equivalent adjustments for the six months ended June 30, 2006 and 2005, respectively. The analysis of net interest income tables included in this Form 10-Q provide a reconciliation of tax-equivalent financial information to the Company's consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles.

Management believes the disclosure of tax-equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in the Company's results of operations. Other financial institutions commonly present net interest income on a tax-equivalent basis. This adjustment is considered helpful in the comparison of one financial institution's net interest income to that of another institution, as each will have a different proportion of tax-exempt interest from their earning asset portfolios. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, other financial institutions generally use tax-equivalent net interest income to provide a better basis of comparison from institution to institution. The Company follows these practices.

FORWARD LOOKING STATEMENTS DISCLAIMER

Certain statements, as well as certain other discussions contained in this report on Form 10-Q, or incorporated herein by reference, contain statements which may be considered to be forward-looking within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. You can identify these forward-looking statements by the use of words like "strategy," "expects," "plans," "believes," "will," "estimates," "intends," "projects," "goals," "targets," and other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts.

Investors are cautioned that forward-looking statements are inherently uncertain. Forward-looking statements include, but are not limited to, those made in connection with estimates with respect to the future results of operation, financial condition, and the business of the Company which are subject to change based on the impact of various factors that could cause actual results to differ materially from those projected or suggested due to certain risks and uncertainties. Those factors include but are not limited to:

The forward-looking statements contained herein represent the Company's judgment as of the date of this report on Form 10-Q, and the Company cautions readers not to place undue reliance on such statements. The Company disclaims any obligation to publicly update or revise any forward-looking statement contained in the succeeding discussion, or elsewhere in this report on Form 10-Q, except to the extent required by federal securities laws.

Management’s discussion and analysis of the Company’s financial condition are based on the Consolidated Financial Statements, which are prepared in accordance with U.S. generally accepted accounting principles. The preparation of such 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, including those related to the allowance for loan losses, 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 the carrying values of assets that are not readily apparent from other sources. Actual results could differ from the amount derived from management’s estimates and assumptions under different assumptions or conditions.

The Company’s significant accounting policies are more fully enumerated in Note 1 to the Consolidated Financial Statements included in Item 8 of its December 31, 2005 report on Form 10-K. The reader of the financial statements should review these policies to gain a greater understanding of how the Company’s financial performance is reported. Management believes the following critical accounting policies represent the more significant estimates and assumptions used in the preparation of the Consolidated Financial Statements:

Allowance for Loan Losses - Management believes the allowance for loan losses ("allowance") is a significant accounting estimate used in the preparation of the Company’s consolidated financial statements. The allowance, which is established through a provision for loan loss expense, is based on management’s evaluation of the level of allowance required in relation to the estimated inherent risk of loss in the loan portfolio. Management regularly evaluates the allowance for loan losses for adequacy by taking into consideration factors such as previous loss experience, the size and composition of the portfolio, current economic and real estate market conditions and the performance of individual loans in relation to contract terms and estimated fair values of collateral. The use of different estimates or assumptions could produce different provisions for loan losses. A smaller provision for loan losses results in higher net income, and when a greater amount of provision for loan losses is necessary the result is lower net income. Refer to Part I, Item 2 below, Allowance for Loan Losses and Provision in this report on Form 10-Q, for further discussion and analysis concerning the allowance.

Income Taxes – The Company estimates its income taxes for each period for which a statement of income is presented. This involves estimating the Company’s actual current tax liability, 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 the Company’s consolidated balance sheets. The Company must also assess the likelihood that any deferred tax assets will be recovered from historical taxes paid and future taxable income and, to the extent that the 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 June 30, 2006 and December 31, 2005, there was no valuation allowance for deferred tax assets, which are included in other assets on the consolidated balance sheet.

Goodwill and Other Intangible Assets - The valuation techniques used by the Company to determine the carrying value of tangible and intangible assets acquired in acquisitions and the estimated lives of identifiable intangible assets involve estimates for discount rates, projected future cash flows and time period calculations, all of which are susceptible to change based upon changes in economic conditions and other factors.  Any changes in the estimates used by the Company to determine the carrying value of its goodwill and identifiable intangible assets, or which otherwise adversely affect their value or estimated lives, would adversely affect the Company's results of operations. Refer to Note 2 of the consolidated financial statements in Part I, Item 1 of this report on Form 10-Q for further details of the Company’s accounting policies and estimates covering goodwill and other intangible assets.

As more fully enumerated below, the decline in second quarter 2006 net income compared with the same quarter in 2005 was affected by a $521 thousand, or 100%, decline in realized gains on the sale of securities, substantially offset by a $415 thousand decline in non-interest expense.

In addition, the Federal Home Loan Bank of Boston (the "FHLB"), of which the Bank is a member and shareholder, did not declare a dividend on its stock during the second quarter of 2006. This action negatively impacted the Bank’s second quarter net interest income by approximately $168 thousand, based on historical dividend payout experience. Pursuant to the FHLB’s "Dividend Schedule Transition Plan," the FHLB reported to its members and shareholders that it anticipates its third quarter 2006 dividend will be "grossed up" to an equivalent accrual period matching the number of days in the second and third quarters. In this manner, the FHLB anticipates declaring the equivalent of four quarterly dividends in 2006.

The foregoing declines in second quarter 2006 net income compared with the same quarter in 2005 were offset in part by a $238 thousand or 17% decline in other operating expenses, a $211 thousand or 15% decline in salaries and employee benefits expense, and a $50 thousand or 14% increase in service charges on deposit accounts.

As more fully discussed below, the $296 thousand increase in net income for the six months ended June 30, 2006 compared with the same period in 2005 was principally attributed to a $313 thousand or 3% decline in non-interest expenses, a $150 thousand gain on the sale of Bank owned real estate, and a $104 thousand or 16% increase in service charges on deposit accounts.

The Company’s total assets surpassed $800 million during the second quarter. Total loans ended the second quarter at $544 million, representing increases of $29 million and $59 million compared with December 31 and June 30, 2005, or 6% and 12%, respectively. Commercial loans continued to drive the overall growth of the Bank’s loan portfolio, posting an increase of $39 million, or 20%, compared with June 30, 2005.

At June 30, 2006, retail deposits totaled $398 million, representing increases of $13 million and $34 million, or 3% and 9%, compared with December 31 and June 30, 2005, respectively.

The Company continued to exceed regulatory requirements for well-capitalized institutions, ending the second quarter with a Tier I Capital Ratio of 7.12%.

At June 30, 2006 the Company’s tangible book value per share of common stock outstanding amounted to $17.15, compared with $17.24 at the same date in 2005.

RESULTS OF OPERATIONS

Net interest income is the principal component of the Company's income stream and represents the difference or spread between interest generated from earning assets and the interest expense paid on deposits and borrowed funds. Net interest income is entirely generated by the Bank. Fluctuations in market interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income.

For the three months ended June 30, 2006, net interest income on a fully tax-equivalent basis amounted to $5,452, compared with $5,501 during the second quarter of 2005, representing a decline of $49, or 0.9%.

As previously discussed, the FHLB did not declare a dividend during the second quarter of 2006, which negatively impacted the Bank’s second quarter net interest income by approximately $168, or 5 basis points. As discussed below, the decline in second quarter 2006 net interest income was also attributed to a 56 basis point decline in the net interest margin compared with the same quarter in 2005.

For the six months ended June 30, 2006, net interest income on a fully tax-equivalent basis amounted to $11,126, compared with $11,014 during the same period in 2005, representing an increase of $112, or 1.0%. The increase in net interest income was principally attributed to average earning asset growth, as the net interest margin declined 47 basis points to 3.02% compared with the six months ended June 30, 2005. As is widely the situation throughout the banking industry, the decline in the net interest margin was largely attributed to the successive increases in short-term interest rates by the Board of Governors of the Federal Reserve System and an inverted U.S. Treasury yield curve, the impact of which has caused the Bank’s funding costs to increase at a faster pace than the yield on its earning asset portfolios.

Factors contributing to the changes in net interest income and the net interest margin are further enumerated in the following discussion and analysis.

Net Interest Income Analysis: The following tables summarize the Company’s average balance sheets and components of net interest income, including a reconciliation of tax equivalent adjustments, for the three and six months ended June 30, 2006 and 2005, respectively:

Net Interest Margin: The net interest margin, expressed on a tax-equivalent basis, represents the difference between interest and dividends earned on interest-earning assets and interest paid to depositors and other creditors, expressed as a percentage of average earning assets.

The net interest margin is determined by dividing tax-equivalent net interest income by average interest-earning assets. The interest rate spread represents the difference between the average tax-equivalent yield earned on interest earning-assets and the average rate paid on interest bearing liabilities. The net interest margin is generally higher than the interest rate spread due to the additional income earned on those assets funded by non-interest bearing liabilities, primarily demand deposits and shareholders’ equity.

For the three and six months ended June 30, 2006 the net interest margin amounted to 2.89% and 3.02%, compared with 3.45% and 3.49% during the same periods in 2005, representing declines of 56 and 47 basis points, respectively.

In June of 2004, the Board of Governors of the Federal Reserve System (the "Federal Reserve") began increasing short-term interest rates. Through June 30, 2006, the Federal Funds targeted rate had increased seventeen consecutive times for a total of 425 basis points, ending the second quarter of 2006 at 5.25%. However, during this same period of time, the benchmark 10-year U.S. Treasury note increased only 27 basis points, causing a dramatic 398 basis point flattening of the U.S. Treasury yield curve.

The Bank’s interest rate sensitivity position is more fully described below in Part I, Item 3 of this report on Form 10-Q, Quantitative and Qualitative Disclosures About Market Risk.

Interest Income: For the three months and six months ended June 30, 2006, total interest income, on a fully tax-equivalent basis, amounted to $11,508 and $22,389 compared with $9,096 and $17,839 during the same periods in 2005, representing increases of $2,412 and $4,550, or 26.5% and 25.5%, respectively.

Comparing the three and six months ended June 30, 2006 with the same periods in 2005, the weighted average yield on the Bank’s loan portfolio increased 46 and 47 basis points to 6.56% and 6.51% respectively, while the weighted average yield on the securities portfolio increased 64 and 51 basis points to 5.26% and 5.21%, respectively.

The increases in interest expense were principally attributed to increases in average interest bearing liabilities amounting to $115,460 and $103,016 or 20.5% and 18.5%, combined with 102 and 97 basis point increases in the weighted average cost of funds, when comparing the three and six-month periods ended June 30, 2006 with the same periods in 2005, respectively. The increase in the average cost of interest bearing funds was principally attributed to the increases in short-term market interest rates between periods and, to a lesser extent, a proportionately higher utilization of wholesale funding.

For the three and six months ended June 30, 2006, the weighted average cost of interest bearing liabilities amounted to 3.58% and 3.44%%, compared with 2.56% and 2.47% during the same periods in 2005, respectively. The weighted average cost of borrowed funds increased 76 and 72 basis points to 4.69% and 4.56%, respectively, while the weighted average cost of interest bearing deposits increased 116 and 113 basis points to 2.92% and 2.77%, respectively. The increase in the weighted average cost of interest bearing deposits outpaced the weighted average cost of borrowed funds, reflecting the longer maturities in the Bank’s borrowing base that were not as susceptible to movements in short-term market interest rates, combined with a higher utilization of brokered time deposits. In addition, given highly competitive pricing pressures and the need to strengthen customer relationships, during the three and six months ended June 30, 2006 the Bank more closely followed the market with respect to the upward re-pricing of maturity and non-maturity deposits, a trend that may continue in the future given the continuation of competitive market pressures.

Rate / Volume Analysis: The following tables set forth a summary analysis of the relative impact on net interest income of changes in the average volume of interest earning assets and interest bearing liabilities, and changes in average rates on such assets and liabilities. The income from tax-exempt assets has been adjusted to a fully tax equivalent basis, thereby allowing uniform comparisons to be made. Because of the numerous simultaneous volume and rate changes during the periods analyzed, it is not possible to precisely allocate changes to volume or rate. For presentation purposes, changes which are not solely due to volume changes or rate changes have been allocated to these categories in proportion to the relationships of the absolute dollar amounts of the change in each.