UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

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 incorporation or organization)	(I.R.S. Employer Identification No.)
275 Kennedy Drive, South Burlington, VT	05403
(Address of principal executive offices)	(Zip Code)
802-658-3400
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    [ X ] Yes     [  ] No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  [X] Yes[  ] No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer [   ]Accelerated Filer [ X ]Nonaccelerated Filer [   ]  Smaller Reporting Company [  ]

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

[  ] Yes  [ X ] No

As of October 25, 2013, there were 6,313,319  shares of the registrant’s common stock, par value $0.01 per share, outstanding.

MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION		Page Reference
Item 1	Financial Statements
	Consolidated Balance Sheets (Unaudited)
	As of September 30, 2013 and December 31, 2012	3
	Consolidated Statements of Income (Unaudited)
	Three and nine months ended September 30, 2013 and 2012	4
	Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
	Three and nine months ended September 30, 2013 and 2012	5
	Consolidated Statements of Cash Flows (Unaudited)
	Nine months ended September 30, 2013 and 2012	6
	Notes to Interim Unaudited Consolidated Financial Statements	8
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3	Quantitative and Qualitative Disclosures about Market Risk	43
Item 4	Controls and Procedures	45
PART II - OTHER INFORMATION
Item 1	Legal Proceedings	46
Item 1A	Risk Factors	46
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	46
Item 3	Defaults Upon Senior Securities	46
Item 4	Mine Safety Disclosure	46
Item 5	Other Information	46
Item 6	Exhibits	46
	Signatures	47

2

ITEM 1 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(Unaudited)

	September 30,		December 31,
(In thousands except share and per share data)	2013		2012
ASSETS
Cash and due from banks	$	35,634	$	34,547
Interest earning deposits with banks and other short-term investments		21,648		42,681
Total cash and cash equivalents		57,282		77,228
Investments:
Securities available for sale, at fair value		269,676		508,681
Securities held to maturity (fair value of $134,118 and $454)		136,017		407
Total investments		405,693		509,088
Loans		1,165,501		1,082,923
Less: Allowance for loan losses		12,199		11,562
Net loans		1,153,302		1,071,361
Federal Home Loan Bank stock		7,496		8,145
Bank premises and equipment, net		16,457		16,077
Investment in real estate limited partnerships		4,748		5,423
Other assets		22,152		21,228
Total assets	$	1,667,130	$	1,708,550
LIABILITIES
Deposits:
Demand (noninterest bearing)	$	267,608	$	240,491
Savings, interest bearing checking and money market accounts		745,814		700,191
Time deposits $100 thousand and greater		121,912		123,371
Other time deposits		195,912		207,027
Total deposits		1,331,246		1,271,080
Short-term borrowings		8,200		0
Securities sold under agreements to repurchase		179,490		287,520
Other long-term debt		2,423		2,483
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		20,619
Other liabilities		8,229		8,627
Total liabilities		1,550,207		1,590,329
Commitments and contingencies (Note 8)
SHAREHOLDERS' EQUITY
Preferred stock
Class A non-voting shares authorized - 200,000, none outstanding		0		0
Class B voting shares authorized - 1,500,000, none outstanding		0		0
Common stock, $.01 par value		67		67
Authorized: 10,000,000 shares; Issued: 6,651,760 at September 30, 2013 and December 31, 2012
Outstanding: 6,311,332 at September 30, 2013 and 6,282,385 at December 31, 2012
Capital in excess of par value		36,908		36,742
Retained earnings		93,602		87,580
Treasury stock, at cost: 340,428 shares at September 30, 2013 and 369,375 shares at December 31, 2012		(14,081)		(14,786)
Deferred compensation arrangements: 314,953 shares at September 30, 2013 and 324,515 shares at December 31, 2012		6,329		6,403
Accumulated other comprehensive (loss) income		(5,902)		2,215
Total shareholders' equity		116,923		118,221
Total liabilities and shareholders' equity	$	1,667,130	$	1,708,550
See accompanying notes to unaudited consolidated financial statements

3

Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands except per share data)	2013		2012		2013		2012
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	11,070	$	11,278	$	32,864	$	33,860
Investment income:
Interest and dividends on investment securities		2,301		2,942		7,649		9,005
Interest on interest earning deposits with banks and other short-term investments		13		9		38		29
Total interest and dividend income		13,384		14,229		40,551		42,894
INTEREST EXPENSE
Savings, interest bearing checking and money market accounts		416		176		758		603
Time deposits $100 thousand and greater		193		271		605		852
Other time deposits		339		413		1,059		1,293
Securities sold under agreement to repurchase and other short-term debt		83		341		817		1,454
Long-term debt		201		364		602		1,253
Total interest expense		1,232		1,565		3,841		5,455
Net interest income		12,152		12,664		36,710		37,439
Provision for credit losses		400		250		800		700
Net interest income after provision for credit losses		11,752		12,414		35,910		36,739
NONINTEREST INCOME
Net gains (losses) on investment securities		1		(26)		(12)		422
Trust division income		759		670		2,278		2,000
Service charges on deposits		995		1,033		2,972		3,001
Net debit card income		720		686		2,114		2,102
Gain on sale of other assets		0		749		0		1,083
Other		311		352		846		1,020
Total noninterest income		2,786		3,464		8,198		9,628
NONINTEREST EXPENSE
Compensation and benefits		4,754		4,809		14,059		14,756
Occupancy expense		1,021		946		3,085		2,843
Equipment expense		889		891		2,768		2,684
Legal and professional fees		695		677		2,001		1,954
Marketing		393		360		1,158		1,264
Equity in losses of real estate limited partnerships		271		370		811		1,189
State franchise  taxes		363		321		1,082		965
FDIC insurance		215		217		655		644
Prepayment penalty on long-term debt		0		677		0		1,363
Other Real Estate Owned ("OREO") expenses		17		65		84		129
Other		1,282		1,381		4,063		4,311
Total noninterest expense		9,900		10,714		29,766		32,102
Income before provision for income taxes		4,638		5,164		14,342		14,265
Provision for income taxes		964		1,159		3,034		2,911
NET INCOME	$	3,674	$	4,005	$	11,308	$	11,354
Basic earnings per common share	$	0.58	$	0.64	$	1.80	$	1.82
Diluted earnings per common share	$	0.58	$	0.64	$	1.79	$	1.81
See accompanying notes to consolidated financial statements

4

Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income (Loss)

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2013		2012		2013		2012
Net income	$	3,674	$	4,005	$	11,308	$	11,354
Other comprehensive (loss) income,  net of tax:
Change in net unrealized (loss) gain on securities available for sale, net of taxes of $1,453, $564, $(2,929) and $682		2,698		1,047		(5,440)		1,266
Unrealized holding losses arising during the period for securities transferred from availableforsale to heldtomaturity, net of taxes of $(1,701), $0, $(1,701) and $0		(3,159)		0		(3,159)		0
Accretion of unrealized holding losses of securities transferred from availableforsale to heldtomaturity, net of taxes of $70, $0, $70 and $0		129		0		129		0
Reclassification adjustments for net securities losses (gains) included in net income, net of taxes of $0, $9, $4 and $(148)		0		17		8		(274)
Change in net unrealized loss on interest rate swaps, net of taxes of $3, $19, $93 and $63		6		35		172		117
Pension liability adjustment, net of taxes of $30, $29, $93 and $86		57		53		173		159
Other comprehensive (loss) income		(269)		1,152		(8,117)		1,268
Comprehensive (loss) income	$	3,405	$	5,157	$	3,191	$	12,622
See accompanying notes to consolidated financial statements

5

Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
(In thousands)	2013		2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	11,308	$	11,354
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		800		700
Depreciation and amortization		1,526		1,464
Amortization of investment security premiums and accretion of discounts, net		974		1,794
Stock based compensation		141		127
Net losses (gains) on sales of investment securities		12		(422)
Net gains on sale of premises, equipment and other assets		82		(1,083)
Gains on sale of other real estate owned		0		(7)
Equity in losses of real estate limited partnerships, net		811		1,189
Changes in assets and liabilities:
Net change in interest receivable		819		545
Net change in other assets		2,872		(870)
Net change in interest payable		(18)		2,345
Net change in other liabilities		(156)		(12,440)
Net cash provided by operating activities		19,171		4,696
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities available for sale		53,215		64,336
Proceeds from maturities of investment securities available for sale		87,877		146,762
Proceeds from maturities of investment securities held to maturity		4,073		115
Proceeds from redemption of Federal Home Loan Bank stock		649		485
Purchases of investment securities available for sale		(55,774)		(225,450)
Loan originations in excess of principal payments		(85,240)		(45,366)
Proceeds from sales of loans, net		2,378		0
Proceeds from sale of other assets		0		334
Proceeds from sale of premises and equipment		64		788
Proceeds from sales of other real estate owned		140		505
Real estate limited partnership investments		(102)		(1,299)
Purchases of bank premises and equipment		(2,052)		(2,522)
Net cash provided by (used in) investing activities		5,228		(61,312)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits		60,166		75,083
Net increase in short-term borrowings		8,200		55,600
Net decrease in securities sold under agreement to repurchase, short-term		(108,030)		(34,531)
Principal payments on long-term debt		(60)		(20,059)
Cash dividends paid		(4,827)		(4,730)
Sale of treasury stock		12		15
Increase in deferred compensation arrangements		186		160
Proceeds from exercise of stock options, net of withholding taxes		0		278
Tax benefit from exercise of stock options		8		20
Net cash (used in) provided by financing activities		(44,345)		71,836
(Decrease) increase in cash and cash equivalents		(19,946)		15,220
Cash and cash equivalents beginning of period		77,228		37,812
Cash and cash equivalents end of period	$	57,282	$	53,032
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total interest payments	$	3,859	$	3,110
Total income tax payments		0		4,350
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Distribution of stock under deferred compensation arrangements	$	450	$	391
Distribution of treasury stock in lieu of cash dividend under dividend reinvestment plan		460		518
Non-cash exercise of stock options		181		129
Transfer of loans to other real estate owned		163		140
Transfer of securities from available for sale to held to maturity		144,428		0
Decrease in payable for investments purchased		0		(9,461)
See accompanying notes to consolidated financial statements

6

7

Notes To Interim Unaudited Consolidated Financial Statements

For additional information, see the Merchants Bancshares, Inc. (“Merchants,” “we,” “us,” “our”) Annual Report on Form 10-K for the fiscal year ended December 31, 2012, filed with the Securities and Exchange Commission (the “SEC”) on March 6, 2013.

NOTE 1: FINANCIAL STATEMENT PRESENTATION

Principles of Consolidation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of our interim consolidated financial statements as of September  30, 2013 and December 31, 2012 and for the three and nine months ended September  30, 2013 and 2012 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I.  Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.

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 us 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, interest income recognition on loans and investments and analysis of other-than-temporary impairment of investment securities. Operating results in the future may vary from the amounts derived from our estimates and assumptions.

NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-02, “Comprehensive Income (Topic 220) – Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The objective of this update is to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. The amendments in this update apply to all entities that issue financial statements that are presented in conformity with U.S. GAAP and that report items of other comprehensive income. Public companies are required to comply with these amendments for all reporting periods presented, including interim periods. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012.  Adoption of this update did not have a material impact on our financial condition or results of operations.

In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210) – Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The main objective in developing this update is to address implementation issues about the scope of ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” The amendments clarify that the scope of ASU 2011-11 applies only to derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in the ASC or otherwise subject to a master netting arrangement or similar agreement.  ASU 2011-11 requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial statements. This includes the effect or potential effect of rights of offset associated with an entity’s recognized assets and liabilities that are subject to the ASU. Consistent with ASU 2011-11, an entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented. The effective date is the same as the effective date of ASU 2011-11. Adoption of the update did not have a material impact on our financial condition or results of operations.

8

NOTE 3: INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of September 30, 2013 and December 31, 2012. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of September 30, 2013 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	100	$	0	$	0	$	100
U.S. Agency Obligations		8,463		0		609		7,854
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		102,822		3,350		930		105,242
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		18,533		0		534		17,999
Agency Collateralized Mortgage Obligations ("CMOs")		98,570		593		812		98,351
Collateralized Loan Obligations ("CLOs")		39,877		0		143		39,734
Asset Backed Securities ("ABSs")		357		39		0		396
Total Available for Sale	$	268,722	$	3,982	$	3,028	$	269,676
Held to Maturity:
U.S. Agency Obligations	$	15,826	$	0	$	268	$	15,558
U.S. Government Sponsored Enterprises ("U.S. GSEs")		9,428		0		575		8,853
Federal Home Loan Bank ("FHLB") Obligations		4,675		0		46		4,629
Agency CMOs		96,852		12		988		95,876
Agency MBSs		9,236		27		61		9,202
Total Held to Maturity	$	136,017	$	39	$	1,938	$	134,118

The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2012 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	100	$	0	$	0	$	100
U.S. Agency Obligations		10,956		0		59		10,897
U.S. GSEs		58,731		723		88		59,366
FHLB Obligations		24,546		39		0		24,585
Agency MBSs		142,441		6,326		0		148,767
Agency CMBSs		5,087		0		58		5,029
Agency CMOs		227,815		2,922		338		230,399
Non-agency CMOs		4,589		6		2		4,593
CLOs		24,748		0		221		24,527
ABSs		357		61		0		418
Total Available for Sale	$	499,370	$	10,077	$	766	$	508,681
Held to Maturity:
Agency MBSs	$	407	$	47	$	0	$	454
Total Held to Maturity	$	407	$	47	$	0	$	454

9

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of September 30, 2013, are as follows:

			After One		After Five
	Within		But Within		But Within		After Ten
(In thousands)	One Year		Five Years		Ten Years		Years		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	100	$	0	$	0	$	0	$	100
U.S. Agency Obligations		0		0		0		7,854		7,854
Agency MBSs		201		4,553		16,619		83,869		105,242
Agency CMBSs		0		0		13,453		4,546		17,999
Agency CMOs		0		0		3,317		95,034		98,351
CLOs		0		0		29,766		9,968		39,734
ABSs		0		0		0		396		396
Total Available for Sale	$	301	$	4,553	$	63,155	$	201,667	$	269,676
Held to Maturity (at amortized cost):
U.S. Agency Obligations	$	0	$	0	$	0	$	15,826	$	15,826
U.S. GSEs		0		0		9,428		0		9,428
FHLB Obligations		0		0		4,675		0		4,675
Agency CMOs		0		0		0		96,852		96,852
Agency MBSs		12		27		0		9,197		9,236
Total Held to Maturity	$	12	$	27	$	14,103	$	121,875	$	136,017

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2012, are as follows:

			After One		After Five
	Within		But Within		But Within		After Ten
(In thousands)	One Year		Five Years		Ten Years		Years		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	0	$	100	$	0	$	0	$	100
U.S. Agency Obligations		0		0		0		10,897		10,897
U.S. GSEs		0		10,025		49,341		0		59,366
FHLB Obligations		0		0		24,585		0		24,585
Agency MBSs		316		3,387		22,854		122,210		148,767
Agency CMBSs		0		0		5,029		0		5,029
Agency CMOs		0		0		4,139		226,260		230,399
Non-agency CMOs		0		0		0		4,593		4,593
CLOs		0		0		24,527		0		24,527
ABSs		0		0		0		418		418
Total Available for Sale	$	316	$	13,512	$	130,475	$	364,378	$	508,681
Held to Maturity (at amortized cost):
Agency MBSs	$	11	$	73	$	0	$	323	$	407
Total Held to Maturity	$	11	$	73	$	0	$	323	$	407

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of Agency MBSs and Agency CMOs in the tables above are based on final contractual maturities.

10

The following table presents the proceeds, gross gains and gross losses on available for sale securities for the three and nine months ended September 30, 2013 and 2012.

	Three Months Ended September 30,				Nine Months Ended September 30,
(In thousands)	2013		2012		2013		2012
Proceeds	$	2,001	$	22,672	$	53,215	$	64,336
Gross gains		1		36		548		530
Gross losses		0		(62)		(560)		(108)
Net gains (losses)	$	1	$	(26)	$	(12)	$	422

Securities with a carrying amount of $264.35 million and $349.52 million at September 30, 2013 and December 31, 2012, 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 available for sale 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 September 30, 2013, were as follows:

	Less Than 12 Months				12 Months or More				Total
(In thousands)	Fair Value		Loss		Fair Value		Loss			Fair Value	Loss
U.S. Agency Obligations	$	7,854	$	609	$	0	$	0	$	7,854	$	609
Agency MBSs		36,587		930		0		0		36,587		930
Agency CMBSs		13,037		427		4,962		107		17,999		534
Agency CMOs		27,682		635		3,800		177		31,482		812
CLOs		39,734		143		0		0		39,734		143
Total	$	124,894	$	2,744	$	8,762	$	284	$	133,656	$	3,028

Gross unrealized losses on investment securities held to maturity 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 over our entire holding period, at September 30, 2013, were as follows:

	Less Than 12 Months				12 Months or More				Total
(In thousands)	Fair Value		Loss		Fair Value		Loss			Fair Value	Loss
U.S. Agency Obligations	$	15,559	$	268	$	0	$	0	$	15,559	$	268
U.S. GSEs		8,853		575		0		0		8,853		575
FHLB Obligations		4,629		46		0		0		4,629		46
Agency CMOs		82,408		927		4,460		61		86,868		988
Agency MBSs		8,883		61		0		0		8,883		61
Total	$	120,332	$	1,877	$	4,460	$	61	$	124,792	$	1,938

Gross unrealized losses on investment securities available for sale 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 over our entire holding period, at December 31, 2012, were as follows:

	Less Than 12 Months				12 Months or More				Total
(In thousands)	Fair Value		Loss		Fair Value		Loss		Fair Value		Loss
U.S. Agency Obligations	$	10,897	$	59	$	0	$	0	$	10,897	$	59
U.S. GSEs		9,882		88		0		0		9,882		88
Agency CMBSs		5,029		58		0		0		5,029		58
Agency CMOs		39,047		338		0		0		39,047		338
Non-agency CMOs		0		0		3,041		2		3,041		2
CLOs		24,527		221		0		0		24,527		221
Total	$	89,382	$	764	$	3,041	$	2	$	92,423	$	766

There were no securities classified as held to maturityas of December 31, 2012 with unrealized losses. There were no securities classified as trading at September 30, 2013 and December 31, 2012.

11

Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair value. These discrepancies generally occur because of changes in interest rates since the time of purchase, or because the credit quality of the issuer has deteriorated. We perform a quarterly analysis of each security in our portfolio to determine if impairment exists, and if it does, whether that impairment is other-than-temporary.

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities.  Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA. CLOs are floating rate securities that consist of pools of commercial loans structured to provide very strong over collateralization and subordination.  All of our CLOs are the senior AAA tranche and are the first bond to get paid down. Non-Agency CMOs are tracked individually with updates on the performance of the underlying collateral and stress testing performed and reviewed monthly. Additionally, we monitor individual bonds that experience greater levels prepayment or market volatility.

We use an external pricing service to obtain fair market values for our investment portfolio. We have obtained and reviewed the service provider’s pricing and reference data document. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information. Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. In addition, model processes, such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios. We periodically test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and by obtaining prices on bonds from an alternative pricing source.

We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity.

During the third quarter of 2013, we transferred securities with a total amortized cost of $144.43 million with a corresponding fair value of $139.57 million from availableforsale to heldtomaturity.  The net unrealized loss, net of taxes, on these securities at the dates of the transfers were $3.16 million.  The unrealized holding loss at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and is amortized over the remaining lives of the securities as an adjustment of the yield.  The amortization of the unamortized holding loss reported in accumulated other comprehensive income will offset the effect on interest income of the discount for the transferred securities.  The remaining unamortized balance of the losses for the securities transferred from availableforsale to heldtomaturity was $3.03 million at September 30, 2013.

As a member of the FHLB system, we are required to invest in stock of the Federal Home Loan Bank of Boston (“FHLBB”) in an amount determined based on our borrowings from the FHLBB. At September 30, 2013, our investment in FHLBB stock totaled $7.50 million. We received and recorded dividend income totaling $7 thousand and $20 thousand during the three and nine months ended September 30, 2013, respectively, compared to $11 thousand and $36 thousand during the three and nine months ended September 30, 2012, respectively.

NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at September 30, 2013 and December 31, 2012 was as follows:

(In thousands)	September 30, 2013		December 31, 2012
Commercial, financial and agricultural	$	163,138	$	165,023
Municipal loans		96,491		84,689
Real estate loans – residential		493,667		460,395
Real estate loans – commercial		373,085		357,178
Real estate loans – construction		32,768		10,561
Installment loans		5,898		4,701
All other loans		454		376
Total loans	$	1,165,501	$	1,082,923

We primarily originate residential real estate, commercial, commercial real estate, municipal obligations and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. Total loans in the table above included $561 thousand and $250 thousand of net deferred loan origination cost at September 30, 2013 and December 31, 2012, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $454 thousand and $376 thousand at September 30, 2013 and December 31, 2012, respectively. Ending loan balances in the table above at September 30, 2013

12

and December 31, 2012 reflect the reclassification of $35.07 millionand $29.56 million, respectively, in non-owner occupied residential real estate loans from the residential real estate category to the commercial real estate category.  This presentation more accurately presents the risk profile of these loans.

Allowance for Credit Losses

We have divided the loan portfolio into portfolio segments, each with different risk characteristics and methodologies for assessing risk. Each portfolio segment is broken down into class segments where appropriate. Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan and lease losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment. A description of the segments follows:

Commercial, financial and agricultural: We offer a variety of loan options to meet the specific needs of commercial customers including term loans and lines of credit. Such loans are made available to businesses for working capital such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment, receivables, inventory or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans by the nature of the underlying collateral, and the collateral value may change daily. To reduce the risk, management generally employs enhanced monitoring requirements, obtains personal guarantees and, where appropriate, may also attempt to secure real estate as collateral.

Municipal: Municipal loans primarily consist of term and time loans issued on a tax-exempt and taxable basis which are general obligations of the municipality. These loans are viewed as lower risk as municipalities can utilize taxing power to meet financial obligations.

Real Estate – Residential: Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences. We originate adjustable-rate and fixed-rate, one-tofour-family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are collateralized by owner-occupied properties located in our market area. Loans on one-tofour-family residential real estate are generally originated in amounts of no more than 80% of the purchase price or appraised value (whichever is lower). Hazard insurance is required.  Mortgage title insurance is also required for all first mortgages and for second mortgages in excess of $100,000.

Real Estate – Commercial: We offer commercial real estate loans to finance real estate purchases and refinancing of existing commercial properties. These commercial real estate loans are generally secured by first liens on the real estate, which may include both owner occupied and non owner occupied facilities. The types of facilities financed include apartments, hotels, warehouses, retail facilities, manufacturing facilities and office buildings. Our underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower’s underlying cash flows.

Real Estate – Construction: We offer construction loans for the construction, expansion and improvement of residential and commercial properties which are secured by the real estate being developed. A review of all plans and budgets is performed prior to approval, third party progress documents are required during construction, and an independent approval process for all draw and release requests is maintained to ensure that funding is prudently administered and that funds are sufficient to complete the project.

Installment: We offer traditional direct consumer installment loans for various personal needs, including vehicle and boat financing. The vast majority of these loans are secured by a lien on the purchased vehicle and are underwritten using credit scores and income verification. We do not provide any indirect consumer lending activities.

For purposes of evaluating the adequacy of the allowance for credit losses, we consider a number of significant factors that affect the collectability of the portfolio. For individually evaluated loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans, estimates of our exposure to credit loss reflect a current assessment of a number of factors, which could affect collectability. These factors include: past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in our market; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. Past loss experience is based on net loan losses as a percentage of portfolio balances, using a five year weighted average. An external loan review firm and various regulatory agencies periodically review our allowance for credit losses.

After a thorough consideration of the factors discussed above, any required additions to the allowance for credit losses are made periodically by charges to the provision for credit losses. These charges are necessary to maintain the allowance for credit losses at a level which Management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While Management uses available information to recognize losses on loans, additions may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above.

13

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the three months ended September 30, 2013:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	3,274	$	400	$	3,385	$	5,018	$	551	$	21	$	9	$	12,658
Charge-offs		0		0		(49)		0		0		(9)		(27)		(85)
Recoveries		13		0		0		0		1		0		4		18
Provision (credit)		137		346		(192)		100		(19)		6		22		400
Ending balance	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the nine months ended September 30, 2013:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	3,447	$	522	$	3,421	$	4,660	$	234	$	17	$	11	$	12,312
Charge-offs		0		0		(152)		(1)		0		(9)		(75)		(237)
Recoveries		62		0		4		40		2		0		8		116
Provision (credit)		(85)		224		(129)		419		297		10		64		800
Ending balance	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment  for the three months ended September 30, 2012:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	3,102	$	410	$	3,357	$	4,676	$	233	$	21	$	18	$	11,817
Charge-offs		0		0		0		0		0		0		0		0
Recoveries		3		0		1		1		8		0		0		13
Provision (credit)		136		31		75		13		(10)		(2)		7		250
Ending balance	$	3,241	$	441	$	3,433	$	4,690	$	231	$	19	$	25	$	12,080

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment  for the nine months ended September 30, 2012:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	2,905	$	309	$	3,017	$	4,605	$	477	$	23	$	17	$	11,353
Charge-offs		(9)		0		(20)		0		0		0		0		(29)
Recoveries		21		0		13		1		21		0		0		56
Provision (credit)		324		132		423		84		(267)		(4)		8		700
Ending balance	$	3,241	$	441	$	3,433	$	4,690	$	231	$	19	$	25	$	12,080

14

The allowance for credit losses consists of the allowance for loan losses and the reserve for undisbursed lines of credit. The reserve for undisbursed lines of credit is included in other liabilities on the balance sheet. The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at September 30, 2013:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	253	$	0	$	129	$	56	$	0	$	0	$	0	$	438
Ending balance collectively evaluated for impairment		3,171		746		3,015		5,062		533		18		8		12,553
Totals	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991
Financing receivables:
Ending balance individually evaluated for impairment	$	1,275	$	0	$	1,135	$	274	$	0	$	0	$	0	$	2,684
Ending balance collectively evaluated for impairment		161,863		96,491		492,532		372,811		32,768		5,898		454		1,162,817
Totals	$	163,138	$	96,491	$	493,667	$	373,085	$	32,768	$	5,898	$	454	$	1,165,501
Components:
Allowance for loan losses	$	2,810	$	731	$	3,057	$	5,075	$	500	$	18	$	8	$	12,199
Reserve for undisbursed lines of credit		614		15		87		43		33		0		0		792
Total allowance for credit losses	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at December 31, 2012:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	149	$	0	$	361	$	59	$	0	$	0	$	0	$	569
Ending balance collectively evaluated for impairment		3,298		522		3,060		4,601		234		17		11		11,743
Totals	$	3,447	$	522	$	3,421	$	4,660	$	234	$	17	$	11	$	12,312
Financing receivables:
Ending balance individually evaluated for impairment	$	233	$	0	$	2,317	$	472	$	0	$	0	$	0	$	3,022
Ending balance collectively evaluated for impairment		164,790		84,689		458,078		356,706		10,561		4,701		376		1,079,901
Totals	$	165,023	$	84,689	$	460,395	$	357,178	$	10,561	$	4,701	$	376	$	1,082,923
Components:
Allowance for loan losses	$	2,915	$	494	$	3,333	$	4,605	$	187	$	17	$	11	$	11,562
Reserve for undisbursed lines of credit		532		28		88		55		47		0		0		750
Total allowance for credit losses	$	3,447	$	522	$	3,421	$	4,660	$	234	$	17	$	11	$	12,312

15

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of September 30, 2013:

	30-59 Days		60-89 Days		90 Days or More		Total Past						Greater Than 90 Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	133	$	65	$	8	$	206	$	162,932	$	163,138	$	0
Municipal		0		0		0		0		96,491		96,491		0
Real estate-residential:
First mortgage		9		436		702		1,147		457,430		458,577		0
Second mortgage		65		0		199		264		34,826		35,090		83
Real estate-commercial:
Owner occupied		158		0		107		265		217,091		217,356		0
Non-owner occupied		0		0		0		0		155,729		155,729		0
Real estate-construction:
Residential		0		0		0		0		2,223		2,223		0
Commercial		0		0		0		0		30,545		30,545		0
Installment		0		0		0		0		5,898		5,898		0
Other		0		0		0		0		454		454		0
Total	$	365	$	501	$	1,016	$	1,882	$	1,163,619	$	1,165,501	$	83

Out of the total past due loans above $1.01 million are non-accruing or restructured.

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of December 31, 2012:

	30-59 Days		60-89 Days		90 Days or More		Total Past						Greater Than 90 Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	0	$	0	$	0	$	0	$	165,023	$	165,023	$	0
Municipal		0		0		0		0		84,689		84,689		0
Real estate-residential:
First mortgage		92		43		950		1,085		420,400		421,485		0
Second mortgage		0		0		716		716		38,194		38,910		0
Real estate-commercial:
Owner occupied		0		0		295		295		222,013		222,308		0
Non-owner occupied		0		0		0		0		134,870		134,870		0
Real estate-construction:
Residential		0		0		0		0		1,559		1,559		0
Commercial		0		0		0		0		9,002		9,002		0
Installment		0		0		0		0		4,701		4,701		0
Other		0		0		0		0		376		376		0
Total	$	92	$	43	$	1,961	$	2,096	$	1,080,827	$	1,082,923	$	0

All of the total past due loans in the aging table above consist of non-accruing and restructured loans. There were no past due performing loans at December 31, 2012.

16

Impaired loans by class at September 30, 2013 are as follows:

(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial, financial and agricultural	$	275	$	1,152	$	0
Real estate – residential:
First mortgage		499		920		0
Second mortgage		199		235		0
Real estate – commercial:
Owner occupied		107		242		0
Non-owner occupied		0		70		0
Installment		0		53		0
With related allowance recorded
Commercial, financial and agricultural		1,000		1,000		253
Real estate – residential:
First mortgage		384		393		96
Second mortgage		53		53		33
Real estate – commercial:
Owner occupied		167		176		56
Installment		0		0		0
Total
Commercial, financial and agricultural		1,275		2,152		253
Real estate – residential		1,135		1,601		129
Real estate – commercial		274		488		56
Installment		0		53		0
Total	$	2,684	$	4,294	$	438

Impaired loans by class at December 31, 2012 are as follows:

(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial, financial and agricultural	$	7	$	970	$	0
Real estate – residential:
First mortgage		853		1,174		0
Second mortgage		16		52		0
Real estate – commercial:
Owner occupied		295		487		0
Non-owner occupied		0		70		0
Installment		0		45		0
With related allowance recorded
Commercial, financial and agricultural		226		228		149
Real estate – residential:
First mortgage		748		766		173
Second mortgage		700		700		188
Real estate – commercial:
Owner occupied		177		179		59
Total
Commercial, financial and agricultural		233		1,198		149
Real estate – residential		2,317		2,692		361
Real estate – commercial		472		736		59
Installment		0		45		0
Total	$	3,022	$	4,671	$	569

17

Average recorded investment and interest income recognized on our impaired loans for the three and nine months ended September 30, 2013 are as follows:

	Three Months				Nine Months
(In thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	272	$	15	$	223	$	42
Real estate – residential:
First mortgage		463		24		622		68
Second mortgage		188		1		133		2
Real estate – commercial:
Owner occupied		107		0		83		15
Non-owner occupied		0		0		0		0
Installment		0		0		1		0
With related allowance recorded
Commercial, financial and agricultural		333		0		342		0
Real estate – residential:
First mortgage		399		0		523		0
Second mortgage		18		0		317		0
Real estate – commercial:
Owner occupied		168		0		171		0
Installment		6		0		6		0
Total
Commercial, financial and agricultural		605		15		565		42
Real estate – residential		1,068		25		1,595		70
Real estate – commercial		275		0		254		15
Installment		6		0		7		0
Total	$	1,954	$	40	$	2,421	$	127

There was no interest recognized on a cash basis for the periods in the table above.

18

Average recorded investment and interest income recognized on our impaired loans for the three and nine months ended September 30, 2012 are as follows:

	Three Months				Nine Months
(In thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	24	$	0	$	49	$	1
Real estate – residential:
First mortgage		888		27		818		47
Second mortgage		331		7		325		34
Real estate – commercial:
Owner occupied		350		2		405		5
Non-owner occupied		0		0		0		0
Installment		2		0		1		0
With related allowance recorded
Commercial, financial and agricultural		13		0		23		0
Real estate – residential:
First mortgage		580		0		662		0
Second mortgage		481		0		194		0
Real estate – commercial:
Owner occupied		231		0		113		0
Total
Commercial, financial and agricultural		37		0		72		1
Real estate – residential		2,280		34		1,999		81
Real estate – commercial		581		2		518		5
Installment		2		0		1		0
Total	$	2,900	$	36	$	2,590	$	87

There was no interest recognized on a cash basis for the periods in the table above.

Nonperforming loans at September 30, 2013 and December 31, 2012 are as follows:

(In thousands)	September 30, 2013		December 31, 2012
Nonaccrual  loans	$	2,236	$	2,355
Loans greater than 90 days and accruing		83		0
Troubled debt restructurings ("TDRs")		365		557
Total nonperforming loans	$	2,684	$	2,912

Of the total TDRs in the table above, $242 thousand at September 30, 2013 and $374 thousand at December 31, 2012, are nonaccruing. All TDRs at September 30, 2013 were restructured prior to January 1, 2013. We have reviewed all restructurings that occurred on or after January 1, 2013 for identification as TDRs. We did not identify as a  TDR any loan for which the allowance for credit losses had been measured under a general allowance for credit losses methodology. Seven of the TDRs at September 30, 2013 were residential real estate and one was commercial real estate. At September 30, 2013, there were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring. We had no commitments to lend additional funds to borrowers whose loans were in nonaccrual status or to borrowers whose loans were 90 days past due and still accruing at September 30, 2013. Interest income on restructured loans during the three and nine months ended September 30, 2013 and 2012 was insignificant.

Our OREO balance at September 30, 2013 was $23 thousand. We had no OREO at December 31, 2012.

19

Nonaccrual loans by class as of September 30, 2013 and December 31, 2012 are as follows:

(In thousands)	September 30, 2013		December 31, 2012
Commercial, financial and agricultural	$	1,266	$	225
Real estate - residential:
First mortgage		686		1,119
Second mortgage		177		716
Real estate - commercial:
Owner occupied		107		295
Non owner occupied		0		0
Installment		0		0
Total nonaccruing non-TDR loans	$	2,236	$	2,355
Nonaccruing TDR’s
Commercial, financial and agricultural		1		8
Real estate – residential:
First mortgage		74		189
Real estate - commercial:
Owner occupied		167		177
Total nonaccrual loans including TDRs	$	2,478	$	2,729

Commercial Grading System

We use risk rating definitions for our commercial loan portfolios and certain residential loans which are generally consistent with regulatory and banking industry norms. Loans are assigned a credit quality grade which is based upon management’s on-going assessment of risk based upon an evaluation of the quantitative and qualitative aspects of each credit. This assessment is a dynamic process and risk ratings are adjusted as each borrower’s financial situation changes. This process is designed to provide timely recognition of a borrower’s financial condition and appropriately focus management resources.

Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. Pass rated commercial loan relationships with a total exposure of $1 million or greater are subject to a formal annual review process; additionally, management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.

Loans rated Pass-Watch require more than usual attention and monitoring by the account officer, though not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, marginally adequate cash flow and/or collateral coverage or early-stage declining trends in operations or financial condition.

Loans rated Special Mention possess potential weakness that may expose the bank to some risk of loss in the future. These loans require more frequent monitoring and formal reporting to Management.

Substandard loans reflect well-defined weaknesses in the current repayment capacity, collateral or net worth of the borrower with the possibility of some loss to the bank if these weaknesses are not corrected. Action plans are required for these loans to address the inherent weakness in the credit and are formally reviewed.

Residential  real estate and consumer loans

We do not use a grading system for our performing residential real estate and consumer loans. Credit quality for these loans is based on performance and payment status.

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Below is a summary of loans by credit quality indicator as of September 30, 2013:

	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	235	$	143,379	$	10,875	$	1,010	$	7,639	$	163,138
Municipal		37		70,951		23,740		1,763		0		96,491
Real estate – residential:
First mortgage		455,233		2,787		0		66		491		458,577
Second mortgage		35,080		0		0		0		10		35,090
Real estate – commercial:
Owner occupied		144		181,775		20,852		3,833		10,752		217,356
Non-owner occupied		153		134,616		11,817		300		8,843		155,729
Real estate – construction:
Residential		691		103		1,429		0		0		2,223
Commercial		751		29,301		493		0		0		30,545
Installment		5,898		0		0		0		0		5,898
All other loans		454		0		0		0		0		454
Total	$	498,676	$	562,912	$	69,206	$	6,972	$	27,735	$	1,165,501

Below is a summary of loans by credit quality indicator as of December 31, 2012:

	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	85	$	138,307	$	18,738	$	5,704	$	2,189	$	165,023
Municipal		5		77,242		7,442		0		0		84,689
Real estate – residential:
First mortgage		418,802		1,718		32		71		862		421,485
Second mortgage		37,200		1,000		0		0		710		38,910
Real estate – commercial:
Owner occupied		86		188,330		16,718		3,546		13,628		222,308
Non-owner occupied		40		120,521		11,454		736		2,119		134,870
Real estate – construction:
Residential		41		0		1,518		0		0		1,559
Commercial		598		7,882		522		0		0		9,002
Installment		4,701		0		0		0		0		4,701
All other loans		376		0		0		0		0		376
Total	$	461,934	$	535,000	$	56,424	$	10,057	$	19,508	$	1,082,923

The amount of interest which was not earned, but which would have been earned had our nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $32 thousand and $108 thousand for the three and nine months ended September 30, 2013 and was approximately $38 thousand and $107 thousand for the three and nine months ended September 30, 2012, respectively.

NOTE 5: EMPLOYEE BENEFIT PLANS

Pension Plan

Prior to January 1995, we maintained a noncontributory defined benefit plan covering all eligible employees. Our pension plan (the “Pension 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 our 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 Pension Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.

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The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized for the three and nine months ended September 30, 2013 and 2012, respectively:

	Three Months Ended September 30,				Nine Months Ended September 30,
(In thousands)		2013		2012		2013		2012
Interest cost	$	105	$	119	$	314	$	358
Expected return on plan assets		(247)		(150)		(741)		(450)
Service costs		10		12		40		36
Net loss amortization		87		82		266		245
Net periodic pension cost	$	(45)	$	63	$	(121)	$	189

We have no minimum required contribution for 2013.

Our Pension Investment Policy Statement sets for the investment objectives and constraints of the Pension Plan. The purpose of the policy is to assist and our Retirement Plan Committee in effectively supervising, monitoring, and evaluating the Pension Plan.

NOTE 6: EARNINGS PER SHARE

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the three and nine months ended September 30, 2013 and 2012:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands except per share data)	2013		2012		2013		2012
Net income	$	3,674	$	4,005	$	11,308	$	11,354
Weighted average common shares outstanding		6,309		6,269		6,298		6,252
Dilutive effect of common stock equivalents		15		11		13		12
Weighted average common and common equivalent
shares outstanding		6,324		6,280		6,311		6,264
Basic earnings per common share	$	0.58	$	0.64	$	1.80	$	1.82
Diluted earnings per common share	$	0.58	$	0.64	$	1.79	$	1.81

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and nine months ended September 30, 2013 and 2012. 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. There were no anti-dilutive options outstanding for the three and nine months ended September 30, 2013 or 2012.

NOTE 7: STOCK REPURCHASE PROGRAM

We extended our stock buyback programthrough January 2014. Under the program,which was originally adopted in January 2007,  we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption. We did not repurchase any of our shares during 2012 or during the firstnine months of 2013, and do not expect to repurchase shares in the near future.

NOTE 8: COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

We are 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.

Disclosures are required regarding liability-recognition for the fair value at issuance of certain guarantees. We do not issue any guarantees that would require liability-recognition or disclosure, other than our standby letters of credit. We have 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 standby letters of credit totaled approximately $5.08 million and $4.48 million at September 30, 2013 and December 31, 2012, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have

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terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Our 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.

We may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at September 30, 2013 or December 31, 2012.

Legal Proceedings

We have been named as defendants in various legal proceedings arising from our 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 input from counsel on the outcome of such proceedings, any such liability will not have a material effect on our financial condition and results of operations.

NOTE 9: FAIR VALUE OF FINANCIAL INSTRUMENTS

We record certain assets and liabilities at fair value.  Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While Management believes our valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.  A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

Ø Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Ø Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability.

Ø Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

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Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at September 30, 2013 measured at fair value on a recurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	0	$	100	$	0
U.S. Agency Obligations		7,854		0		7,854		0
Agency MBSs		105,242		0		105,242		0
Agency CMBSs		17,999		0		17,999		0
Agency CMOs		98,351		0		98,351		0
CLOs		39,734		0		39,734		0
ABSs		396		0		396		0
Interest rate swap agreements		518		0		518		0
Total assets	$	270,194	$	0	$	270,194	$	0
Liabilities
Interest rate swap agreements		1,310		0		1,310		0
Total liabilities	$	1,310	$	0	$	1,310	$	0

The table below presents the balance of financial assets and liabilities at December 31, 2012 measured at fair value on a recurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	0	$	100	$	0
U.S. Agency Obligations		10,897		0		10,897		0
U.S. GSEs		59,366		0		59,366		0
FHLB Obligations		24,585		0		24,585		0
Agency MBSs		148,767		0		148,767		0
Agency CMBSs		5,029		0		5,029		0
Agency CMOs		230,399		0		230,399		0
Non-Agency CMOs		4,593		0		4,593		0
CLOs		24,527		0		24,527		0
ABSs		418		0		418		0
Interest rate swap agreements		552		0		552		0
Total assets	$	509,233	$	0	$	509,233	$	0
Liabilities
Interest rate swap agreements		1,610		0		1,610		0
Total liabilities	$	1,610	$	0	$	1,610	$	0

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. More information regarding our investment securities can be found in Footnote 3 to these consolidated financial statements.

The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor.  The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts.  The variable

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cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

There were no transfers between Level 1 and Level 2 for the three or nine months ended September 30, 2013 or September 30, 2012.  There were no Level 3 assets measured at fair value on a recurring basis during the three or nine months ended September 30, 2013.

Financial instruments on a non-recurring basis

Certain assets are also measured at fair value on a non-recurring basis. These other financial assets include impaired loans and OREO.

The table below presents the balance of financial assets by class at September 30, 2013 measured at fair value on a nonrecurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
OREO	$	23	$	0	$	0	$	23
Commercial, financial and agricultural		747		0		0		747
Real estate-residential:
First mortgage		288		0		0		288
Second mortgage		20		0		0		20
Real estate-commercial:
Owner occupied		111		0		0		111
Total	$	1,189	$	0	$	0	$	1,189

The table below presents the balance of financial assets by class at December 31, 2012 measured at fair value on a nonrecurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Commercial, financial and agricultural	$	79	$	0	$	0	$	79
Real estate-residential:
First mortgage		593		0		0		593
Second mortgage		512		0		0		512
Real estate-commercial:
Owner occupied		415		0		0		415
Total	$	1,599	$	0	$	0	$	1,599

The related allowance associated with impaired loans measured at fair value did not result in material provisions for loan losses in any period presented.  Valuation allowances recorded on OREO were not material for any periods presented.

We use the fair value of underlying collateral to estimate the specific reserves for collateral dependent impaired loans. Collateral may be real estate and/or business assets including equipment, inventory and accounts receivable. Real estate values are determined based on appraisals by qualified licensed appraisers we have hired. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Management’s ongoing review of appraisal information may result in additional discounts or adjustments to valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale. Other business assets are valued using a variety of approaches including appraisals, depreciated book value, purchase price and independent confirmation of accounts receivable. Property acquired is carried at the lower of cost or the estimated fair value of the property, determined by an independent appraisal, and is adjusted for estimated disposal costs. Certain inputs used in appraisals, and possible subsequent adjustments, are not always observable, and therefore, collateral dependent impaired loans and OREO are categorized as Level 3 within the fair value hierarchy.

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The table below presents the valuation methodology and unobservable inputs for Level 3 assets by class measured at fair value on a non-recurring basis at September 30, 2013:

					Range of
(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Inputs
OREO	$	23	Appraisal of collateral	Appraisal adjustments	0%-40%
Commercial, financial and agricultural		747	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-residential:
First mortgage		288	Appraisal of collateral	Appraisal adjustments	0%-40%
Second mortgage		20	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-commercial:
Owner occupied		111	Appraisal of collateral	Appraisal adjustments	0%-40%
Total	$	1,189

The table below presents the valuation methodology and unobservable inputs for Level 3 assets by class measured at fair value on a non-recurring basis at December 31, 2012:

					Range of
(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Inputs
Commercial, financial and agricultural	$	79	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-residential:
First mortgage		593	Appraisal of collateral	Appraisal adjustments	0%-40%
Second mortgage		512	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-commercial:
Owner occupied		415	Appraisal of collateral	Appraisal adjustments	0%-40%
Total	$	1,599

Changes to our assumptions about unobservable inputs will impact our estimate of fair value.  Discounts to appraised values reflect the age of the appraisal and estimated costs of disposition.

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

The fair value of Merchants’ financial instruments as of September 30, 2013 are summarized in the table below:

	Carrying
(In thousands)	Amount		Fair Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	57,282	$	57,282	$	57,282	$	0	$	0
Securities available for sale		269,676		269,676		0		269,676		0
Securities held to maturity		136,017		134,118		0		134,118		0
FHLB stock		7,496		7,496		0		7,496		0
Loans, net of allowance for loan losses		1,153,302		1,161,169		0		0		1,161,169
Interest rate swap agreements		518		518		0		518		0
Accrued interest receivable		3,549		3,549		0		959		2,590
Total assets	$	1,627,840	$	1,633,808	$	57,282	$	412,767	$	1,163,759
Deposits	$	1,331,246	$	1,332,660	$	1,013,422	$	319,238	$	0
Short-term borrowings		8,200		8,200		0		8,200		0
Securities sold under agreement to repurchase		179,490		179,472		0		179,472		0
Other long-term debt		2,423		2,326		0		2,326		0
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,409		0		14,409		0
Interest rate swap agreements		1,310		1,310		0		1,310		0
Accrued interest payable		208		208		14		194		0
Total liabilities	$	1,543,496	$	1,538,585	$	1,013,436	$	525,149	$	0

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The fair value of Merchants’ financial instruments as of December 31, 2012 are summarized in the table below:

	Carrying
(In thousands)	Amount		Fair Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	77,228	$	77,228	$	77,228	$	0	$	0
Securities available for sale		508,681		508,681		0		508,681		0
Securities held to maturity		407		454		0		454		0
FHLB stock		8,145		8,145		0		8,145		0
Loans, net of allowance for loan losses		1,071,361		1,096,188		0		0		1,096,188
Interest rate swap agreements		552		552		0		552		0
Accrued interest receivable		4,368		4,368		0		1,366		3,002
Total assets	$	1,670,742	$	1,695,616	$	77,228	$	519,198	$	1,099,190
Deposits	$	1,271,080	$	1,273,573	$	940,682	$	332,891	$	0
Securities sold under agreement to repurchase		287,520		287,837		0		287,837		0
Other long-term debt		2,483		2,502		0		2,502		0
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		15,177		0		15,177		0
Interest rate swap agreements		1,610		1,610		0		1,610		0
Accrued interest payable		195		195		0		195		0
Total liabilities	$	1,583,507	$	1,580,894	$	940,682	$	640,212	$	0

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, FHLBB stock, accrued interest receivable and accrued interest payable approximate fair value.

The methodologies for other financial assets and financial liabilities are discussed below.

Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value estimates, methods and assumptions set forth below for our financial instruments, including those financial instruments carried at cost, are made solely to comply with disclosures required by generally accepted accounting principles in the United States and do not always incorporate the exit-price concept of fair value proscribed by ASC 820-10 and should be read in conjunction with the financial statements and associated footnotes.

Deposits - The fair value of deposits with no stated maturity, which includes demand, savings, interest bearing checking and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. 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 method which applies interest rates currently being offered for deposits of similar remaining maturities.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity.

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 approximately $50 thousand at September 30, 2013 and $45 thousand as of December 31, 2012, respectively.

Limitations‑ Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments.  Because no market exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.

These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument.  These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange, nor are they intended to represent the fair value of us as a whole.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.  The fair value estimates presented herein are based on pertinent information available to Management as of the respective balance sheet date.  Although we are not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since

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the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures.  Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

NOTE 10: COMPREHENSIVE INCOME

The accumulated balances for each classification of other comprehensive income are as follows:

(In thousands)	Unrealized Gains (Losses) on Securities Available For Sale		Unrealized Gains (Losses) on Securities Transferred From Available For Sale to Held To Maturity		Pension and Postretirement Benefit Plans		Interest Rate Swaps		Accumulated Other Comprehensive Income (Loss)
Balance December 31, 2012	$	6,033	$	0	$	(3,130)	$	(688)	$	2,215
Other comprehensive income before reclassifications		(1,285)		0		0		48		(1,237)
Reclassification adjustments for (gains) losses reclassified into income		0		0		60		0		60
Net current period other comprehensive (loss) income		(1,285)		0		60		48		(1,177)
Balance March 31, 2013	$	4,748	$	0	$	(3,070)	$	(640)	$	1,038
Other comprehensive income before reclassifications		(6,853)		0		0		118		(6,735)
Reclassification adjustments for (gains) losses reclassified into income		8		0		56		0		64
Net current period other comprehensive (loss) income		(6,845)		0		56		118		(6,671)
Balance June 30, 2013	$	(2,097)	$	0	$	(3,014)	$	(522)	$	(5,633)
Other comprehensive income before reclassifications		(461)		0		0		6		(455)
Transfer of securities from availableforsale to heldtomaturity		3,159		(3,159)		0		0		0
Accretion of unrealized losses of securities transferred from availableforsale to heldtomaturity recognized in other comprehensive income		0		129		0		0		129
Reclassification adjustments for (gains) losses reclassified into income		0		0		57		0		57
Net current period other comprehensive (loss) income		2,698		(3,030)		57		6		(269)
Balance September 30, 2013	$	601	$	(3,030)	$	(2,957)	$	(516)	$	(5,902)

All amounts in the table above are net of tax. Amounts in parentheses indicate debits.

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Details of the reclassification adjustments in the above table for the three and nine months ended September 30, 2013 are presented below:

	Three Months		Nine Months
Details about Accumulated Other Comprehensive Income Components (In thousands)	Amount Reclassified from Accumulated Other Comprehensive Income		Amount Reclassified from Accumulated Other Comprehensive Income		Affected Line Item in the Statement Where Net Income is Presented
Unrealized (gains) losses securities
	$	1	$	12	Net losses (gains) on investment securities
		1		12	Total before tax
		(1)		(4)	Provision for income taxes
	$	0	$	8	Net of tax
Pension and postretirement benefit plans
		87		266	Compensation and benefits
		87		266	Total before tax
		(30)		(93)	Provision for income taxes
	$	57	$	173	Net of tax
Total reclassification adjustments	$	57	$	181

NOTE 11: DERIVATIVE FINANCIAL INSTRUMENTS

At September 30, 2013 and December 31, 2012, we hadan interest rate swap with a notional amount of $10 million that was designated as  a cash flow hedge. The swap was used to convert a portion of the floating rate interest on our trust preferred issuance to a fixed rate of interest. Each quarter we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item. There was no ineffective portion recognized in earnings during the three or nine months ended September 30, 2013 or 2012. The fair value of $(793) thousand and $(1.06) million was reflected in other comprehensive income in the accompanying consolidated balance sheets at September 30, 2013 and December 31, 2012, respectively.

We entered into interest rate swaps during 2013 with a notional amount of $36.46 million with certain of our commercial customers.  In order to minimize our risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps with our counterparty totaling $36.46 million (pay fixed/receive floating swaps). Hedge accounting has not been applied for these derivatives.  Because the terms of the swaps with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations. The fair values of $516 thousand and $502 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at September 30, 2013.

During 2013, we entered into interest rate swaps with notional amounts totaling $8.80 million that were designated as fair value hedges of certain fixed rate loans with municipalities. The amounts recognized in earnings and other assets for the ineffective portion of the interest swaps was immaterial.

We assessed our counterparty risk at September 30, 2013 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Footnote 9 to these consolidated financial statements.

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

FORWARD-LOOKING STATEMENTS

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements 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, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe our future plans, strategies and expectations, can generally be identified by the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions. Forward-looking statements are based on the current assumptions and beliefs of Management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among others, continued weakness in general, national, regional or local economic conditions, which could impact the performance of our investment portfolio, quality of credits or the overall demand for services; changes in loan default and charge-off rates which could affect the allowance for credit losses; volatility in the equity and financial markets; reductions in deposit levels which could necessitate increased and/or higher cost borrowing to fund loans and investments; declines in mortgage loan refinancing, equity loan and line of credit activity which could reduce net interest and noninterest income; changes in the domestic interest rate environment and inflation; changes in the carrying value of investment securities and other assets; further actions by the U.S. government and Treasury Department that could have a negative impact on our investment portfolio and earnings; misalignment of our interest-bearing assets and liabilities; increases in loan repayment rates affecting interest income; changing business, banking, or regulatory conditions or policies, or new legislation affecting the financial services industry, that could lead to changes in the competitive balance among financial institutions, restrictions on bank activities, changes in costs (including deposit insurance premiums), increased regulatory scrutiny, or changes in the secondary market for bank loans and other products; and changes in accounting rules, federal and state laws,IRS regulations, and other regulations and policies governing financial holding companies and their subsidiaries which may impact our ability to take appropriate action to protect our financial interests in certain loan situations.

Investors should not place undue reliance on our forward-looking statements, and 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, which are included in more detail in our Annual Report on Form 10-K, as updated by our Quarterly Reports on Form 10-Q, and other filings submitted to the Securities and Exchange Commission. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statements are made.

USE OF NON-GAAP FINANCIAL MEASURES

Certain information in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income is tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of taxable 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 our results of operations. Other financial institutions commonly present net interest income on a taxable equivalent basis. This adjustment is considered helpful in the comparison of one financial institution’s net interest income to that of another, as each will have a different proportion of taxable exempt interest from its earning assets. 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 taxable equivalent net interest income to provide a better basis of comparison from institution to institution. We follow these practices. A reconciliation of taxable equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled “Distribution of Assets, Liabilities and Shareholders Equity; Interest Rates and Net Interest Margin.” A 35.0% tax rate was used in both 2013 and 2012. An additional non-GAAP financial measure we use is the tangible capital ratio. Because we have no intangible assets, our tangible shareholder’s equity is the same as our shareholder’s equity.

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GENERAL

The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three and nine months ended September 30, 2013 and 2012 should be read in conjunction with the consolidated financial statements and Notes thereto and selected statistical information appearing elsewhere in this Quarterly Report on Form 10-Q. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank.

RESULTS OF OPERATIONS

Overview

We realized net income of  $3.67 million and $11.31 million for the three and nine months ended September  30, 2013, respectively, compared to $4.00 million and $11.35 million for the three and nine months ended September 30, 2012, respectively. Basic earnings per share were $0.58 and $1.80 for the three and nine months ended September 30, 2013, respectively, and $0.64 and $1.82 for the three and nine months ended September 30, 2012, respectively. Diluted earnings per share were $0.58 and $1.79 for the three and nine months ended September 30, 2013, respectively, and $0.64 and $1.81 for the three and nine months ended September 30, 2012, respectively.

We declared and distributed total dividends of $0.28 and $0.84 per share during the three and nine months ended September 30, 2013 and 2012, respectively.  On October17, 2013, we declared a dividend of $0.28 per share, which will be paid on November 14, 2013, to shareholders of record as of October 31, 2013.  Total assets were $1.67 billion at September 30, 2013.  Total shareholders’ equity was $116.92 million at September  30, 2013.

Our return on average equity was 12.89% and  12.94% for the three and nine months ended September  30, 2013, respectively, compared to 13.95% and 13.47% for the three and nine months ended September 30, 2012, respectively.Our return on average assets was 0.88% and 0.90% for the three and nine months ended September 30, 2013, respectively, compared to 0.97% and 0.92% for the three and nine months ended September 30, 2012, respectively. Our capital ratios remain strong, with a Tier 1 leverage ratio of 8.41%, a total risk-based capital ratio of 16.13% and a tangible capital ratio of 7.01%.

Ø Net interest income  - Our taxable equivalent net interest income was $12.71 million and $38.24 million for the three and nine months ended September 30, 2013, respectively, compared to $13.15 million and $38.97 million for the same periods in 2012.  Our taxable equivalent net interest margin decreased by 15 basis points to 3.14% and 13 basis points to 3.17% for the three and nine months ended September 30, 2013, from 3.29% and 3.30% for the same periods in 2012.

Ø Provision for Credit Losses –The provision for credit losses was $400 thousand and $800 thousand for the quarter and nine months ended September 30, 2013, respectively, compared to $250 thousand and $700 thousand for the same periods in 2012.  The increase in the provision was primarily a result of continued loan growth.

Ø Loans - We achieved another record high in our loan portfolio for the fifth quarter in a row. Ending loan balances at September 30, 2013 were $1.17 billion, an increase of $61.49 millionfrom balances at June 30, 2013 and an increase of $82.58 million from December 31, 2012. 

Ø Investments - Our investment portfolio totaled $405.69 million at September  30, 2013, a decrease of $103.40 million from the December 31, 2012 ending balance of $509.09 million.  

Ø Deposits –Deposit balances at September 30, 2013 were $1.33 billion, an increase of $60.17 million from December 31, 2012 balances of $1.27 billion.

Ø Shareholders’ equity - Shareholder’s equity ended the quarter at $116.92 million, and our book value per share was $18.53 at September 30, 2013.  During the third quarter we moved securities with a September 30, 2013 carrying value of $136.02 million from the Available for Sale (“AFS”) category to the Held to Maturity (“HTM”) category. We selected securities that had the most price volatility in a rising rate environment to move to the HTM category.  We recorded an after tax charge to Accumulated Other Comprehensive Income of $3.16 million as a result of the transfer.  This change will protect our tangible capital from further price deterioration on that portion of our investment portfolio.

Net Interest Income

As shown on the  tables on pages  32 and 33our taxable equivalent net interest income was $12.71 million and $38.24 million for the three and nine months ended September 30, 2013, respectively, compared to $13.15 million and $38.97 million for the same periods in 2012.  Our taxable equivalent net interest margin was 3.14% and 3.17% compared to 3.29% and 3.30% for the three and nine months ended September 30, 2013 and 2012, respectively. Though margin compression has slowed, it continues to be a challenge. Most of the margin compression is concentrated in our loan yields, which decreased 30 basis points and 12 basis points since December 31, 2012 and June 30, 2013, respectively.  One of the factors influencing our loan yields is an increase in variable rate loans.  Average variable rate loans for the third quarter were $304.06 million, an increase of $42.12 million from the fourth quarter of 2012.  These loans have a lower current yield than fixed rate loans, but will have higher yields when rates start to rise.  They also help the overall position of our largely fixed rate balance sheet.  We are encouraged by the fact that we are starting to see new fixed rate loans come on at rates at

31

or near portfolio averages which will help to reduce margin compression. Our average cost of interest bearing liabilities declined five basis points since December 31, 2012 and two basis points since June 30, 2013. 

The following tables present an analysis of net interest income and illustrate interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a fully taxable-equivalentbasis, using a 35% rate.  Nonaccrual loans are included in the average loan balance outstanding.

	Three Months Ended
	September 30, 2013			September 30, 2012
		Interest			Interest
	Average	Income/	Average	Average	Income/	Average
(In thousands, fully taxable equivalent)	Balance	Expense	Rate	Balance	Expense	Rate
ASSETS:
Loans, including fees on loans	$    1,154,967	$     11,631	4.00%	$  1,064,507	$    11,763	4.40%
Investments	427,414	2,301	2.14%	507,833	2,942	2.30%
Interest-earning deposits with banks and other short-term investments	21,700	13	0.24%	16,241	9	0.22%
Total interest earning assets	1,604,081	$     13,945	3.45%	1,588,581	$    14,714	3.68%
Allowance for loan losses	(11,946)			(11,309)
Cash and due from banks	27,913			25,793
Bank premises and equipment, net	16,392			14,952
Other assets	25,077			31,440
Total assets	$    1,661,517			$  1,649,457
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$       772,234	$          416	0.21%	$     677,321	$         176	0.10%
Time deposits	318,795	532	0.66%	341,231	684	0.80%
Total interest bearing deposits	1,091,029	948	0.34%	1,018,552	860	0.34%
Short-term borrowings	26,451	21	0.32%	60,141	39	0.26%
Securities sold under agreements to repurchase, short-term	145,962	62	0.17%	196,117	302	0.61%
Other long-term debt	2,430	12	2.04%	9,032	57	2.50%
Junior subordinated debentures issued to unconsolidated subsidiary trust	20,619	189	3.69%	20,619	307	6.01%
Total borrowed funds	195,462	284	0.58%	285,909	705	0.98%
Total interest bearing liabilities	1,286,491	$       1,232	0.38%	1,304,461	$      1,565	0.48%
Noninterest bearing deposits	252,795			220,646
Other liabilities	8,150			9,466
Shareholders' equity	114,081			114,884
Total liabilities and shareholders' equity	$    1,661,517			$  1,649,457
Net interest earning assets	$       317,590			$     284,120
Net interest income (fully taxable equivalent)		$     12,713			$    13,149
Tax equivalent adjustment		(561)			(485)
Net interest income		$     12,152			$    12,664
Net interest rate spread			3.07%			3.20%
Net interest margin			3.14%			3.29%

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	Nine Months Ended
	September 30, 2013			September 30, 2012
		Interest			Interest
	Average	Income/	Average	Average	Income/	Average
(In thousands, fully taxable equivalent)	Balance	Expense	Rate	Balance	Expense	Rate
ASSETS:
Loans, including fees on loans	$    1,121,404	$     34,392	4.10%	$  1,051,886	$    35,391	4.49%
Investments	470,911	7,649	2.17%	506,256	9,005	2.38%
Interest-earning deposits with banks and other short-term investments	21,265	38	0.24%	18,454	29	0.21%
Total interest earning assets	1,613,580	$     42,079	3.49%	1,576,596	$    44,425	3.76%
Allowance for loan losses	(11,827)			(11,061)
Cash and due from banks	26,232			24,037
Bank premises and equipment, net	16,368			14,549
Other assets	30,373			32,762
Total assets	$    1,674,726			$  1,636,883
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$       727,042	$          758	0.14%	$     660,386	$         603	0.12%
Time deposits	325,718	1,664	0.68%	346,347	2,145	0.83%
Total interest bearing deposits	1,052,760	2,422	0.31%	1,006,733	2,748	0.36%
Short-term borrowings	23,009	51	0.29%	39,614	77	0.26%
Securities sold under agreements to repurchase, short-term	212,755	766	0.48%	223,540	1,377	0.82%
Other long-term debt	2,450	37	2.03%	17,420	350	2.68%
Junior subordinated debentures issued to unconsolidated subsidiary trust	20,619	565	3.77%	20,619	903	5.93%
Total borrowed funds	258,833	1,419	0.73%	301,193	2,707	1.20%
Total interest bearing liabilities	1,311,593	$       3,841	0.39%	1,307,926	$      5,455	0.56%
Noninterest bearing deposits	238,655			207,097
Other liabilities	7,952			9,514
Shareholders' equity	116,526			112,346
Total liabilities and shareholders' equity	$    1,674,726			$  1,636,883
Net interest earning assets	$       301,987			$     268,670
Net interest income (fully taxable equivalent)		$     38,238			$    38,970
Tax equivalent adjustment		(1,528)			(1,531)
Net interest income		$     36,710			$    37,439
Net interest rate spread			3.10%			3.20%
Net interest margin			3.17%			3.30%

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The following tables present 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).

Analysis of Changes in Fully Taxable Equivalent Net Interest Income

	Three Months Ended
	September 30,		Increase	Due to
(In thousands)	2013	2012	(Decrease)	Volume	Rate
Fully taxable equivalent interest income:
Loans	$         11,631	$         11,763	$          (132)	$          979	$         (1,111)
Investments	2,301	2,942	(641)	(442)	(199)
Interest earning deposits with banks and other short-term investments	13	9	4	3	1
Total interest income	13,945	14,714	(769)	540	(1,309)
Less interest expense:
Savings, interest bearing checking and money market accounts	416	176	240	22	218
Time deposits	532	684	(152)	(42)	(110)
FHLB and other short-term borrowings	21	39	(18)	(19)	1
Securities sold under agreements to repurchase, short-term	62	302	(240)	(63)	(177)
Other long-term debt	12	57	(45)	(36)	(9)
Junior subordinated debentures issued to unconsolidated subsidiary trust	189	307	(118)	-	(118)
Total interest expense	1,232	1,565	(333)	(138)	(195)
Net interest income	$         12,713	$         13,149	$          (436)	$          678	$         (1,114)
	Nine Months Ended
	September 30,		Increase	Due to
(In thousands)	2013	2012	(Decrease)	Volume	Rate
Fully taxable equivalent interest income:
Loans	$         34,392	$         35,391	$          (999)	$       2,219	$         (3,218)
Investments	7,649	9,005	(1,356)	(601)	(755)
Interest earning deposits with banks and other short-term investments	38	29	9	3	6
Total interest income	42,079	44,425	(2,346)	1,621	(3,967)
Less interest expense:
Savings, interest bearing checking and money market accounts	758	603	155	60	95
Time deposits	1,664	2,145	(481)	(121)	(360)
FHLB and other short-term borrowings	51	77	(26)	(35)	9
Securities sold under agreements to repurchase, short-term	766	1,377	(611)	(64)	(547)
Other long-term debt	37	350	(313)	(244)	(69)
Junior subordinated debentures issued to unconsolidated subsidiary trust	565	903	(338)	-	(338)
Total interest expense	3,841	5,455	(1,614)	(404)	(1,210)
Net interest income	$         38,238	$         38,970	$          (732)	$       2,025	$         (2,757)

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Provision for Credit Losses

The allowance for loan losses at September 30, 2013 was $12.20 million, or 1.05% of total loans and 455% of non-performing loans compared to the December 31, 2012 balance of $11.56 million, or 1.07% of total loans and 397% of non-performing loans. We recorded a $400 thousand and $800 thousand provision for credit losses during the three and nine months ended September 30, 2013, respectively, compared to $250 thousand and $700 thousand for the same periods in 2012, respectively.Our continued loan growth was the primary factor for the provision to date in 2013. Credit quality continues to be very healthy, we are a top performer in this measure. Performing loans past due 30-89 days were 0.01% of total loans at September 30, 2013 and December 31, 2012.  Nonperforming loansas a percent of total loans were 0.23% at September 30, 2013 compared to 0.27% at December 31, 2012.  Accruing substandard loans increased to 2.21% of total loans at September 30, 2013 compared to 1.60% at December 31, 2012.  Net charge-offs year to date for 2013 total $121 thousand. Our other real estate owned (“OREO”) balance was $23 thousand at September 30, 2013 and was zero at December 31, 2012.  All of these factors are taken into consideration during Management’s quarterly review of the Allowance. For a more detailed discussion of our Allowance and nonperforming assets, see “Credit Quality and Allowance for Credit Losses” beginning on page 37.

NONINTEREST INCOME AND EXPENSES

Noninterest income

Total noninterest income decreased $678 thousand to $2.79 million for the third quarter of 2013 compared to the third quarter of 2012 and decreased $1.43 million for the first nine months of 2013 compared to the same period in 2012. Excluding net gains on investment securities and gains on sales of other assets, total noninterest income increased $44 thousand for the third quarter of 2013 compared to the third quarter of 2012, and increased $87 thousand for the first nine months of 2013 compared to the same period in 2012.  Increases in cash management fees and other service charge income more than offset continued reductions in overdraft fees. Trust division income increased $89 thousand and $278 thousand for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012.

Noninterest expense

Total noninterest expense decreased $814 thousand to $9.90 million for the third quarter of 2013 compared to the same period in 2012 and decreased $2.34 million to $29.77 million for the first nine months of 2013 compared to the same periods in 2012.  Excluding a $677 thousand and $1.36 million prepayment penalty incurred during the three and nine months ended September 30, 2012, respectively, noninterest expense decreased $137 thousand and $973 thousand for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. Total compensation and benefits decreased $55 thousand for the third quarter of 2013 compared to the same period in 2012, and decreased $697 thousand for the first nine months of 2013 compared to the same period in 2012. Strong growth and performance ahead of plan triggered an increase to our incentive accrual of $175 thousand during the third quarter of 2013.  This increase was offset by reductions in the cost of our self-funded health insurance during 2013 as a result of positive claims experience. Additionally, the overfunded status of our pension plan is producing income for us in 2013 instead of expense. The timing of investments in low income housing partnerships and their associated tax credits led to a reduction in expenses related to real estate limited partnerships to $271 thousand and $811 thousand for the three and nine months ended September 30, 2013 compared to $370 thousand and $1.19 million for the same periods in 2012.

Income Taxes

Our effective tax rate for 2013 was negatively impacted by the timing of investments in low income housing partnerships discussed above, which produced a lower level of tax credits for us in 2013 compared to 2012. Our effective tax rate was positively impacted by the donation of our branch building in North Bennington, Vermont, to a non-profit organization during the second quarter of 2013. This donation, along with the tax credits from housing partnership investments,yielded an effective tax rate of 21% for the first nine months of 2013 compared to 20% for the first nine months of 2012.

BALANCE SHEET ANALYSIS

Loans

Quarterly average loan balances for the third quarter were $1.15 billion, an increase of $81 million over average loan balances for the fourth quarter of 2012; this represents an average annualized growth rate of 10.0%.  Ending loan balances at September 30, 2013, June 30, 2013 and December 31, 2012 reflect the reclassification of $35.07 million, $34.63 million, and $29.56 million, respectively, in non-owner occupied residential real estate loans from the residential real estate category to the commercial real estate category.  This presentation more accurately presents the risk profile of these loans.

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The composition of our loan portfolio is shown in the following table as of the dates indicated:

(In thousands)	September 30, 2013	June 30, 2013	December  31, 2012
Commercial, financial & agricultural	$ 163,138	$ 169,215	$ 165,023
Municipal	96,491	45,319	84,689
Real estate – residential	493,667	485,764	460,395
Real estate – commercial	373,085	365,693	357,178
Real estate – construction	32,768	31,813	10,561
Installment	5,898	5,667	4,701
All other loans	454	544	376
	$ 1,165,501	$ 1,104,015	$ 1,082,923

Growth in our commercial real estate and construction loan categories has been driven by new customer acquisition and expansion of existing relationships.  Growth in our residential real estate portfolio continues to be driven by increased mortgage refinance volume due to the low interest rate environment. Mortgage application volumes decreased during the quarter and are expected to continue decreasing if rates are stable or increase.

Investments

The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. The average investment portfolio for the third quarter of 2013 was $419.92 million, a reduction of $90.64 million from the fourth quarter of 2012.  The ending balance in the investment portfolio was $405.69 million at September 30, 2013, compared to $428.39 million at June 30, 2013 and $509.09 million at December 31, 2012. We are intentionally allowing the investment portfolio to run off and using the amortization to fund our loan growth.  This will help us control overall asset growth and strengthen our capital ratios and returns. During the third quarter we transferred securities with a book value of $139.57 million from the Available for Sale (“AFS”) category to the Held to Maturity (“HTM”) category. We recorded an after tax charge to Accumulated Other Comprehensive Income of $3.16 million as a result of the transfer.  This change will protect our tangible capital from further price deterioration on that portion of our investment portfolio.

The composition of our investment portfolio as of September 30, 2013, including both available for sale and heldtomaturity securities, consisted of the following:

(In thousands)	Amortized Cost	Fair Value
Available for Sale:
U.S. Treasury Obligations	$ 100	$ 100
U.S. Agency Obligations	8,463	7,854
Residential Real Estate Mortgage-backed  Securities (“Agency MBSs”)	102,822	105,242
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")	18,533	17,999
Agency Collateralized Mortgage Obligations (“Agency CMOs”)	98,570	98,351
Collateralized Loan Obligations ("CLOs")	39,877	39,734
Asset Backed Securities (“ABSs”)	357	396
Total available for sale	268,722	269,676
Held to maturity:
U.S. Agency Obligations	15,826	15,558
U.S. Government Sponsored Enterprises ("U.S. GSEs")	9,428	8,853
Federal Home Loan Bank (“FHLB”) Obligations	4,675	4,629
Agency CMOs	96,852	95,876
Agency MBSs	9,236	9,202
Total held to maturity	136,017	134,118
Total Securities	$ 404,739	$ 403,794

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities.  Agency CMBSs consist of bonds backed by commercial real estate which are guaranteed by FNMA. CLOs are floating rate securities that consist of pools of commercial loans structured to provide very strong over collateralization and subordination.  All of our CLOs are the senior AAA tranche and are the first bond to get paid down.

We use an external pricing service to obtain fair market values for our investment portfolio.   We have obtained and reviewed the

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service provider’s pricing and reference data document. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information.  Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations.  In addition, model processes, such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios.  We periodically test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and byobtaining prices on bonds from an alternative pricing source.

We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity. 

As a member of the Federal Home Loan Bank system, we are required to invest in stock of the FHLBB in an amount determined based on our borrowings from the FHLBB.  At September 30, 2013, our investment in FHLBB stock totaled $7.50 million.  Dividend income on FHLBB stock of $7 thousand and $20 thousand was recorded during the three and nine months ended September 30, 2013, respectively, compared to $11 thousand and $36 thousand during the three and nine months ended September 30, 2012, respectively. The FHLBB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, we have concluded that our investment in FHLBB stock is not impaired.  We will continue to monitor our investment in FHLBB stock. 

Deposits

Total deposits at September 30, 2013 were $1.33 billion compared to $1.27 billion at December 31, 2012, a $60.17 million, or annualized 6.3%, increase. Growth during 2013 has been concentrated in our transaction account categories, with continued reductions in time deposit balances. Securities sold under agreement to repurchase, which represent collateralized customer accounts, declined to $179.49 million at September 30, 2013 from $287.52 million at December 31, 2012 as a result of seasonal municipal cash flows combined with migration to other deposit products. Short-term wholesale borrowings increased to $8.20 million at September 30, 2013 from zero at December 31, 2012.

CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

The United States economy continues to show slight improvement into 2013; however, high unemployment and foreclosure rates continue in certain parts of the country.  Although Vermont, our primary market, has not been immune to this economic turmoil, the state has one of the lowest foreclosure rates in the country, home price depreciation has been muted, and the unemployment rate is lower than the national average.

Credit quality

Credit quality is a major strategic focus and strength of our company.  Although we actively manage current nonperforming and classified loans, there is no assurance that we will not have increased levels of problem assets in the future.  The make up of the nonperforming pool is dynamic with accounts moving in and out of this category over time.

The following table summarizes our nonperforming loans and nonperforming assets as of the dates indicated:

(In thousands)	September 30, 2013	June 30, 2013	December 31, 2012	September 30, 2012
Nonaccrual loans	$ 2,236	$ 1,116	$ 2,355	$ 2,180
Loans past due 90 days or more and still accruing	83	75	0	0
Troubled debt restructurings (“TDR”)	365	409	557	560
Total nonperforming loans (“NPL”)	2,684	1,600	2,912	2,740
OREO	23	140	0	0
Total nonperforming assets (“NPA”)	$ 2,707	$ 1,740	$ 2,912	$ 2,740

Non-performing loans at September 30, 2013 were $2.68 million, 0.23% of total loans. Of the $2.68 million in nonperforming loans in the table above, $1.55 million are commercial and commercial real estate loans and $1.13 million are residential mortgages and home equity loans.

TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. At September 30, 2013, $242 thousand of TDRs were in nonaccrual status and $123 thousand were accruing interest.

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Excluded from the nonperforming balances discussed above are our loans that are 30 to 89 days past due, which are not necessarily considered classified or impaired.  Accruing loans 30 to 89 days past due as a percentage of total loans as of the periods indicated are presented in the following table:

Period Ended	30-89 Days
September  30, 2013	0.01%
June  30, 2013	0.00%
December 31, 2012	0.01%
September 30, 2012	0.01%

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. If a loan or a portion of a loan is internally classified as impaired or is partially charged-off, the loan is generally 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. Income accruals are suspended on all nonaccruing loans, and all previously accrued and uncollected interest is charged against current income. 

Loans may be returned to accrual status when 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 and all principal and interest amounts contractually due, including arrearages, are reasonably assured of repayment within an acceptable period of time.

While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is uncertain, any payments received are generally applied to reduce the principal balance. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has 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 a reduction of principal.

A loan remains in nonaccruing status until the factors which suggest doubtful collectability 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, we 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 to give us 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 and is actively marketed.  Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense in the consolidated statement of income. Impaired loans, which primarily consist of non-accruing loans and TDRs, totaled $2.68 million and $3.02 million at September 30, 2013 and December 31, 2012, respectively.  At September 30, 2013, $1.60 million of impaired loans had specific reserve allocations totaling $438 thousand. 

Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss.  These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled comprehensive reviews of the borrowers’ financial condition, payment performance, accrual status and collateral.  These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation, and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our loan loss reserve.

Substandard loans at September 30, 2013 totaled $27.74 million, of which $25.70 million continue to accrue interest.  Accruing substandard loans at September 30, 2013 reflect a $1.73 million increase in balances since June 30, 2013 and a$8.34 million increasesince December 31, 2012. At September 30, 2013, accruing substandard loans related to owner-occupied commercial real estate totaled $15.68 million, investor commercial real estate loans totaled $1.91 million, residential mortgage loans totaled $9 thousand, non-owner occupied residential property commercial real estate loans totaled $505 thousand, multifamily real estate loans totaled $1.22 million, and $6.37 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Seven borrowers in a variety of industries account for 78% of the total accruing substandard loans, and approximately $526 thousand of the total accruing substandard loans carry some form of government guarantee.

To date, with very few exceptions, all payments due from accruing substandard borrowers have been made as agreed and Management’s ongoing evaluation of these borrowers’ financial condition and collateral indicates a reasonable certainty that these exposures are adequately secured. 

Management monitors asset quality closely and continuously performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports.  In addition to frequent financial analysis and review of well-rated and adversely graded loans, Management incorporates active monitoring of key credit and non-credit risks for each customer, assessing risk through the daily reviews of overdrafts, delinquencies and usage of electronic banking products and tracking for timely receipt of all required financial statements.

Allowance for Credit Losses

The allowance for credit losses is made up of two components: the allowance for loan losses (“ALL”) and the reserve for undisbursed lines.  The ALL is based on Management's estimate of the amount required to reflect the known and inherent risks in the loan

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portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the ALL quarterly. Factors considered in evaluating the adequacy of the ALL 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 contractual terms and estimated fair values of properties that secure impaired loans.

The adequacy of the ALL is determined using a consistent, systematic methodology, consisting of a review of both specific reserves for loans identified as impaired and general reserves for the various loan portfolio classifications.  When a loan is impaired, we determine its impairment loss by comparing the excess, if any, of the loan’s carrying amount over (1) the present value of expected future cash flows discounted at the loan’s original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan.  When a loan is deemed to have an impairment loss, the loan is either charged down to its estimated net realizable value, or a specific reserve is established as part of the overall allowance for loan losses if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan.

The general allowance for loan losses is a percentage-based reflection of historical loss experience and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. Appropriate reserve levels are estimated based on Management’s judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans.

Losses are charged against the ALL when Management believes that the collectability of principal is doubtful. To the extent Management determines the level of anticipated losses in the portfolio increased or diminished, the ALL is adjusted through current earnings. Overall, Management believes that the ALL 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 ALL.

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The following table reflects our loan loss experience and activity in the Allowance for Credit Losses for the periods indicated:

(In thousands)	Nine Months Ended September 30, 2013	Six Months Ended June  30, 2013	Twelve Months Ended December 31, 2012	Nine Months Ended September 30, 2012
Average loans during the period	$ 1,121,404	$ 1,104,344	$ 1,057,446	$ 1,051,886
Allowance beginning of year	12,312	12,312	11,353	11,353
Charge-offs:
Commercial, financial & agricultural	0	0	(9)	(9)
Real estate – residential	(152)	(103)	(20)	(20)
Real estate – commercial	(1)	(1)	(32)	0
Other	(84)	(48)	0	0
Total charge-offs	(237)	(152)	(61)	(29)
Recoveries:
Commercial, financial & agricultural	62	49	30	21
Real estate – residential	4	4	14	13
Real estate – commercial	40	40	1	1
Real estate – construction	2	1	25	21
Other	8	4	0	0
Total recoveries	116	98	70	56
Net  recoveries (charge-offs)	(121)	(54)	9	27
Provision for credit losses	800	400	950	700
Allowance end of period	$ 12,991	$ 12,658	$ 12,312	$ 12,080
Components:
Allowance for loan losses	$ 12,199	$ 11,890	$ 11,562	$ 11,444
Reserve for undisbursed lines of credit	792	768	750	636
Allowance for credit losses	$ 12,991	$ 12,658	$ 12,312	$ 12,080

The following table reflects our nonperforming asset and coverage ratios as of the dates indicated:

	September 30, 2013	June 30, 2013	December 31, 2012	September 30, 2012
NPL to total loans	0.23%	0.14%	0.27%	0.26%
NPA to total assets	0.16%	0.11%	0.17%	0.16%
Allowance for loan losses to total loans	1.05%	1.08%	1.07%	1.07%
Allowance for loan losses to NPL	455%	743%	397%	418%

We 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. There can be no assurances that we will be able to complete the disposition of nonperforming assets without incurring further losses.

Loan Portfolio Monitoring

Our Board of Directors grants each loan officer the authority to originate loans on our behalf, 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 our 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 our Senior Lender, the Senior Credit Officer, and/or our President. With the exception of certain municipal loans, all extensions of credit of $4.0 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors. Short-term Revenue Anticipation and Tax Anticipation extensions of credit of $8.0 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.

The Loan Committee and the credit department regularly monitor our loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. We monitor loan concentrations by individual borrowers, industries and loan types. As part of the annual

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credit policy review process, targets are set by loan type for the total portfolio. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are routinely reviewed by lenders and Management on a periodic basis according to total exposure and risk rating. These internal reviews assess the adequacy of all aspects of credit administration, additionally, we maintain an on-going active monitoring process of loan performance during the year.  We have also hired external loan review firms to assist in monitoring the commercial, municipal and residential loan portfolios. The commercial loan review firm reviews at a minimum 60% in dollar volume of our commercial loan portfolio each year. These comprehensive reviews assessed the accuracy of our risk rating system as well as the effectiveness of credit administration in managing overall credit risks.

All loan officers are required to service their loan portfolios and account relationships. Loan officers, a commercial workout officer, or collection personnel take remedial actions to assure full and timely payment of loan balances as necessary, with the supervision of the Senior Lender and the Senior Credit Officer.

Liquidity and Capital Resource Management

General

Liquid assets are maintained at levels considered adequate to meet our liquidity needs.  Liquidity is adjusted as appropriate to meet asset and liability management objectives. Liquidity is monitored by the Asset and Liability Committee (“ALCO”) of Merchants Bank’s Board of Directors, based upon Merchants Bank’s policies. Our primary sources of liquidity are deposits, amortization and prepayment of loans, maturities of investment securities and other short-term investments, periodic principal repayments on mortgage-backed and other amortizing securities, advances from the FHLBB, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan and investment prepayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competition. Interest rates on deposits are priced to maintain a desired level of total deposits.

As of September  30, 2013, we could borrow up to $45 million in overnight funds through unsecured borrowing lines established with correspondent banks.  We have established both overnight and longer term lines of credit with the FHLBB.  FHLBB borrowings are secured by residential mortgage loans. The total amount of loans pledged to the FHLBB for both short- and long-term borrowing arrangements totaled $382.12 million at September  30, 2013. We have additional borrowing capacity with the FHLBB of $244.60 million as of September  30, 2013.  We have also established a borrowing facility with the Board of Governors of the Federal Reserve System (“FRB”) which will enable us to borrow at the discount window. Additionally, we have the ability to borrow through the use of repurchase agreements, collateralized by Agency MBSs and Agency CMOs, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, has a cost basis of $404.74 million at September 30, 2013, of which $264.35 million was pledged.  The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position.  Any excess funds are either left on deposit at the FRB, or are in a fully insured account with one of our correspondent banks.

The following table presents information regarding our short-term borrowings as of the dates indicated:

	Three Months Ended September 30, 2013	Nine Months Ended September 30, 2013
FHLBB and other short-term borrowings
Amount outstanding at end of period	$ 8,200	$ 8,200
Maximum during the period amount outstanding	62,600	72,500
Average amount outstanding	26,451	23,009
Weighted average-rate during the period	0.32%	0.29%
Weighted average rate at period end	0.31%	0.31%
Securities sold under agreement to repurchase, short-term
Amount outstanding at end of period	$ 179,490	$ 179,490
Maximum during the period amount outstanding	190,023	287,520
Average amount outstanding	145,962	212,755
Weighted average-rate during the period	0.17%	0.48%
Weighted average rate at period end	0.18%	0.18%

Commitments and Off-Balance Sheet Risk

We are a party to financial instruments with off‑balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Contingent obligations under standby letters of credit totaled approximately $5.08 million and $4.48 million at September 30, 2013 and December 31, 2012, respectively, and represent the maximum potential future payments we 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. The fair value of our standby letters of credit at September 30, 2013 and 2012 was insignificant.

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Capital Resources

We are 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 our financial statements. Under capital adequacy guidelines, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. It is the policy of the FRB 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. We are also subject to the regulatory framework for prompt corrective action that requires it to meet specific capital guidelines to be considered well capitalized. Our 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 us 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 September 30, 2013, that Merchants met all capital adequacy requirements to which it is subject.

As of September 30, 2013, 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 of September 30, 2013 we exceeded all current applicable regulatory capital requirements. We continue to be considered well capitalized under current applicable regulations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) required the federal banking agencies to establish minimum leverage and risk-based capital requirements for insured banks and their holding companies.  The federal banking agencies issued a joint final rule, or the “Final Capital Rule,” that implements the Basel III capital standards and establishes the minimum capital levels required under the Dodd-Frank Act.  We must comply with the Final Capital Rule by January 1, 2015.  The Final Capital Rule establishes a minimum common equity Tier I capital ratio of 6.5% of risk-weighted assets for a “well capitalized” institution and increases the minimum Tier I capital ratio for a “well capitalized” institution from 6% to 8%. Additionally, the Final Capital Rule requires an institution to maintain a 2.5% common equity Tier I capital conservation buffer over the 6.5% minimum risk-based capital requirement to avoid restrictions on the ability to pay dividends, discretionary bonuses, and engage in share repurchases.  The Final Capital Rule permanently grandfathers trust preferred securities issued before May 19, 2010, subject to a limit of 25% of Tier I capital.  As of September 30, 2013, our capital ratios exceed all Basel III minimums, including the capital conservation buffer.

The following table represents our actual capital ratios and capital adequacy requirements as of September 30, 2013.

									To Be Well-
									Capitalized Under
					For Capital				Prompt Corrective
	Actual				Adequacy Purposes				Action Provisions
(In thousands)	Amount		Percent		Amount		Percent		Amount		Percent
Merchants Bancshares, Inc.:
Tier 1 Leverage Capital	$	139,795	8.42	%	$	66,373	4.00	%		N/A	N/A
Tier 1 Risk-Based Capital		139,795	14.88	%		37,577	4.00	%		N/A	N/A
Total Risk-Based Capital		151,562	16.13	%		75,153	8.00	%		N/A	N/A
Tangible Capital		116,923	7.01	%		N/A	N/A			N/A	N/A
Merchants Bank:
Tier 1 Leverage Capital	$	136,933	8.23	%	$	66,572	4.00	%	$	83,215	5.00	%
Tier 1 Risk-Based Capital		136,933	14.48	%		37,824	4.00	%		56,736	6.00	%
Total Risk-Based Capital		148,767	15.73	%		75,648	8.00	%		94,560	10.00	%
Tangible Capital		134,576	8.05	%		N/A	N/A			N/A	N/A

Capital amounts for Merchants Bancshares, Inc. include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain regulatory limits.

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ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

General

Our Management and Board of Directors are committed to sound risk management practices throughout the organization. We have developed and implemented a centralized risk management monitoring program. Risks associated with our business activities and products are identified and measured as to probability of occurrence and impact on us (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 our risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Corporation Improvement Act and the Sarbanes-Oxley Act of 2002.

Liquidity Risk

Our liquidity is measured by our ability to raise cash when needed at a reasonable cost.  We must be capable of meeting expected and unexpected obligations to customers at any time.  Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds that can be accessed quickly in time of need.  As discussed previously under “Liquidity and Capital Resources,” we have several sources of readily available funds, including the ability to borrow using our investment portfolio as collateral. We also monitor our liquidity on a quarterly basis in compliance with our Liquidity Contingency Plan.

Market Risk – Interest Rate 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. Our primary market risk exposure is interest rate risk. An important component of our 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 our Bank’s Board of Directors. Our investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. Our investment policy also establishes specific investment quality limits. Our Bank’s Board of Directors has established a Board-level Asset and Liability Committee, which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset and Liability Committee (“ALCO”). The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management-related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. Our goal is to maximize net interest income while mitigating market and interest rate risk.  We accomplish this through careful monitoring of the overall duration and average life of the portfolio, thorough analysis of securities we are considering for purchase, monitoring of individual securities, occasional repositioning of the investment portfolio, as well as selective sales of specific securities.

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 our 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 our 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 our exposure to changes in interest rates.  By using derivative financial instruments to hedge exposures to changes in interest rates we expose ourselves to credit risk and market risk.  Credit risk is the failure of the counterparty to perform under the terms of the derivative contract.  When the fair value of a derivative contract is positive, the counterparty owes us, which creates credit risk for us.  We minimize the credit risk in derivative instruments by entering into transactions only with high-quality counterparties.  The market risk associated with interest rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

The ALCO is responsible for ensuring that our Bank’s Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The ALCO uses an outside consultant to perform rate shocks of our balance sheet, and to perform a variety of other analyses. The ALCO consultant meets with the Board and Management-level ALCOs on a quarterly basis. During these meetings, the ALCO consultant reviews our current position and discusses future strategies, as well as reviewing the result of rate shocks of our balance sheet and a variety of other analyses. The consultant’s most recent review was as of September 30, 2013. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates are quite low, a 100 basis point falling interest rate scenario which assumes a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions.  The consultant also ran shock simulations in a 100 basis point decreasing scenario as well as 100, 200, 300 and 400 basis points rising scenarios. Additionally the consultant ran simulations with changes in the yield curve.  A summary of the results is as follows:

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Current/Flat Rates: Net interest income levels are projected to trend downward throughout the simulation as the sustained low rate environment causes continued margin pressure as assets reprice and are replaced at lower rates than the existing portfolio, while funding costs are at or near their floors.

Falling Rates: If rates fall 100 basis points, our net interest income is projected to trend in line with the base case over the first year as we bring funding costs down to near zero.  Thereafter margins contract as asset yields continue to reprice lower while funding rates have reached their floors. 

Rising Rates: Our interest rate risk profile is structurally asset sensitive due to the strong core funding base which supports a shorter-term asset portfolio. Higher rates are better for us under all scenarios as our low cost deposits are worth more to us when they can be invested at higher rates. In the up 200 basis points scenario, net interest income is projected to move up as assets reprice up more quickly than funding costs and asset cash flows are reinvested at higher rates. If rates remain at current low levels for another two years, the benefit of rising rates is muted because the starting point for asset yields will be lower.

We have established a target range for the change in net interest income in year one of zero to 7.5%. The net interest income simulation as of September 30, 2013 showed that the change in net interest income for the next 12 months from our expected or “most likely” forecast was as follows:

Rate Change	Percent Change in Net Interest Income
Up 200 basis points	2.4%
Down 100 basis points	0.9%

The change in net interest income in the second year of the simulation shows a much more pronounced downward trend in the flat and down 100 basis points scenarios, the projected change is (1.2)% and (3.0)%, respectively, while the up 200 basis points simulation produces an increase of 6.1%.  The degree to which this exposure materializes will depend, in part, on our ability to manage our balance sheet as interest rates rise or fall. We have intentionally increased our variable rate assets, through purchases and originations of variable rate investment and through the use of loan level swaps.  Average variable rate assets for the third quarter of 2013 increased to $355.86 million, a $72.44 million increase since the fourth quarter of 2012.

The preceding sensitivity analysis does not represent our forecast and should not be relied upon as being indicative of expected operating results.  These estimates are based upon numerous assumptions including among others, 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. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.

The model used to perform the base case balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest earning asset and interest bearing liability on our balance sheet. Prepayment assumptions for all residential mortgage products take into account prepayment assumptions most recently published by Applied Financial Technologies. Prepayment assumptions for commercial loan and commercial mortgage products are derived through an analysis of historical prepayment patterns combined with analysis of the current characteristics of the portfolio. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions

The most significant ongoing factor affecting market risk exposure of net interest income during the quarter ended September 30, 2013 was the sustained low interest rate environment.  Net interest income exposure is also significantly affected by the shape and level of the U.S. Government securities and interest rate swap yield curves, and changes in the size and composition of the loan, investment and deposit portfolios. 

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 the ALCO might take in responding to or anticipating changes in interest rates.

Credit Risk

The Board of Directors reviews and approves our 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 our portfolio. Our Board of Directors grants each loan officer the authority to originate loans on our behalf, 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 our Credit Division Manager, Senior Loan Officer, and/or President. With the exception of certain municipal loans, all extensions of credit of $4.0 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors. Short-term Revenue Anticipation and Tax Anticipation extensions of credit of $8.0 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants

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Bank’s Board of Directors. Our loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and the assistance of an external loan review firm.  Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers, under the supervision of the Senior Lender and Senior Credit Officer, take remedial actions to assure full and timely payment of loan balances when necessary.  Our policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectability of principal or interest become doubtful.  In certain instances the accrual of interest is discontinued prior to 90 days past due if Management determines that the borrower will not be able to continue making timely payments.

Item 4. Controls and Procedures

Our principal executive officer, principal financial officer, and other members of our senior management have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC. In addition, we have reviewed our internal control over financial reporting and there have been no changes in our internal control over financial reporting during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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MERCHANTS BANCSHARES, INC.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 1A. Risk Factors

In addition to the other information set forth in this report, please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the SEC on March 6, 2013, as updated by our Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2013 filed with the SEC on August 8, 2013, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.

General economic and market conditions in the United States of America and abroad may materially and adversely affect the market price of shares of our 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 our judgments as of the date of this Quarterly Report on Form 10-Q and we undertake no duty to update these forward-looking statements. We caution readers not to place undue reliance on such statements.

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

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosure

Not applicable.

Item 5. Other Information

None.

Item 6. Exhibits

31.1*Certification of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended

31.2*Certification of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended

32.1**Certification of Chief Executive Officer 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 Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101**The following materials from Merchants Bancshares, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2013 and December 31, 2012; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2013 and 2012; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012; and (v) Notes to Interim Unaudited Consolidated Financial Statements.

_______________________________

*Filed herewith

**Furnished herewith

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MERCHANTS BANCSHARES, INC.

SIGNATURES

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

Merchants Bancshares, Inc.

/s/ Michael R. Tuttle

Michael R. Tuttle

President & Chief Executive Officer

/s/ Janet P. Spitler

Janet P. Spitler

Chief Financial Officer & Treasurer

Principal Accounting Officer

November7, 2013

Date

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