Quarterly Report (10-q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


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

For the quarterly period ended March 31, 2017


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

For the transition period from to

Commission File Number:

0-11595

Merchants Bancshares, Inc.

(Exact name of registrant as specified in its charter)


Delaware	03-0287342
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

275 Kennedy Drive, South Burlington, 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. ☒ 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). ☒ Yes ☐ No

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

Large accelerated filer ☐	Accelerated filer ☒	Non‑accelerated filer ☐
		(Do not check if a smaller reporting company)

Smaller reporting company ☐

Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b‑2 of the Exchange Act). ☐ Yes ☒ No

As of April 20, 2017, there were 6,932,945 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

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MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

FORM 10-Q

TABLE OF CONTENTS

		Page Reference
PART I	FINANCIAL INFORMATION
Item 1	Financial Statements
	Consolidated Balance Sheets (Unaudited)	3
	Consolidated Statements of Income (Unaudited)	4
	Consolidated Statements of Comprehensive Income (Unaudited)	5
	Consolidated Statements of Cash Flows (Unaudited)	6
	Notes to Interim Unaudited Consolidated Financial Statements	7
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	33
Item 3	Quantitative and Qualitative Disclosures about Market Risk	48
Item 4	Controls and Procedures	51

PART II	OTHER INFORMATION
Item 1	Legal Proceedings	52
Item 1a	Risk Factors	52
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	52
Item 3	Defaults on Senior Securities	52
Item 4	Mine Safety Disclosure	52
Item 5	Other Information	52
Item 6	Exhibits	53
	Signatures	54

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MERCHANTS BANCSHARES, INC.

PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(Unaudited)


	March 31,		December 31,
(In thousands except share and per share data)	2017		2016
ASSETS
Cash and due from banks	$	29,466	$	26,116
Interest earning deposits with banks and other short-term investments		30,296		56,837
Total cash and cash equivalents		59,762		82,953
Investments:
Securities available for sale, at fair value (amortized cost of $288,881 and $334,846)		287,989		333,998
Securities held to maturity (fair value of $81,088 and $85,749)		80,991		85,694
Total investments		368,980		419,692
Loans		1,542,718		1,514,209
Less: Allowance for loan losses		13,187		12,659
Net loans		1,529,531		1,501,550
Federal Home Loan Bank stock		7,044		4,976
Bank premises and equipment, net		12,597		13,078
Investment in real estate limited partnerships		7,560		6,356
Bank owned life insurance		10,805		10,758
Core deposit intangible		1,113		1,156
Goodwill		7,011		7,011
Other assets		19,141		15,128
Total assets	$	2,023,544	$	2,062,658
LIABILITIES
Deposits:
Demand (noninterest bearing)	$	630,718	$	640,922
Savings, interest bearing checking and money market accounts		690,448		687,340
Time deposits		190,510		199,208
Total deposits		1,511,676		1,527,470
Short-term borrowings		75,000		40,000
Securities sold under agreement to repurchase, short-term		249,582		312,118
Other long-term debt		3,630		3,651
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		20,619
Other liabilities		4,389		2,297
Total liabilities		1,864,896		1,906,155
STOCKHOLDERS' EQUITY
Preferred stock
Class A non-voting shares authorized - 200,000, none outstanding		—		—
Class B voting shares authorized - 1,500,000, none outstanding		—		—
Common stock, $.01 par value		72		72
Authorized: 10,000,000 shares; Issued: 7,202,556 at March 31, 2017 and 7,184,922 at December 31, 2016
Outstanding: 6,916,443 at March 31, 2017 and 6,887,856 at December 31, 2016
Capital in excess of par value		56,563		55,806
Retained earnings		115,085		113,407
Treasury stock, at cost: 549,981 shares including 263,868 shares held by the Deferred Compensation Plans for Non-Employee Directors and Trustees at March 31, 2017 and 585,866 shares including 288,800 shares held by the Deferred Compensation Plans for Non-Employee Directors and Trustees at December 31, 2016		(13,486)		(13,670)
Deferred compensation arrangements: 263,868 shares at March 31, 2017 and 288,800 shares at December 31, 2016		6,071		6,670
Accumulated other comprehensive loss		(5,657)		(5,782)
Total stockholders' equity		158,648		156,503
Total liabilities and stockholders' equity	$	2,023,544	$	2,062,658

See accompanying notes to unaudited consolidated financial statements

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Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)


	Three Months Ended
	March 31,
(In thousands except per share data)	2017		2016
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	13,507	$	12,804
Investment income:
Interest and dividends on investment securities		1,836		1,997
Interest on interest earning deposits with banks and other short-term investments		82		81
Total interest and dividend income		15,425		14,882
INTEREST EXPENSE
Savings, interest bearing checking and money market accounts		471		440
Time deposits		265		391
Short-term borrowings		140		—
Securities sold under agreement to repurchase, short-term		152		109
Long-term debt		161		210
Total interest expense		1,189		1,150
Net interest income		14,236		13,732
Provision for credit losses		500		205
Net interest income after provision for credit losses		13,736		13,527
NONINTEREST INCOME
Trust division income		824		867
Net debit card income		760		649
Overdraft income		597		631
Service charges on deposits		423		415
Net gains on investment securities		255		—
Other		403		362
Total noninterest income		3,262		2,924
NONINTEREST EXPENSE
Compensation and benefits		5,823		6,308
Occupancy expense		1,101		1,139
Equipment expense		650		719
Telephone expense		171		198
Legal and professional fees		414		593
Mobile & internet banking		346		366
Core / Item processing		453		517
Marketing		120		192
State franchise taxes		399		398
FDIC insurance		217		254
Community Bank System, Inc. merger costs		1,302		—
NUVO Bank & Trust Company acquisition costs		—		133
Amortization of core deposit intangible		43		51
Other		914		1,051
Total noninterest expense		11,953		11,919
Income before provision for income taxes		5,045		4,532
Provision for income taxes		1,434		1,042
NET INCOME	$	3,611	$	3,490

Basic earnings per common share	$	0.52	$	0.51
Diluted earnings per common share	$	0.52	$	0.50

See accompanying notes to unaudited consolidated financial statements

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Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)


	Three Months Ended
	March 31,
(In thousands)	2017		2016
Net income	$	3,611	$	3,490
Other comprehensive income, net of tax:
Unrealized holding gain on securities available for sale, net of taxes of $57 and $1,411		106		2,624
Accretion of unrealized holding losses of securities transferred from available for sale to held to maturity, net of taxes of $61 and $68		113		127
Reclassification adjustments for net securities gains included in net incom e, net of taxes of $(89) and $0		(166)		—
Change in net unrealized loss on interest rate swaps, net of taxes of $0 and $19		—		35
Pension liability adjustment, net of taxes of $38 and $41		72		75
Other comprehensive income		125		2,861
Comprehensive income	$	3,736	$	6,351

See accompanying notes to unaudited consolidated financial statements

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Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)


	Three Months Ended March 31,
(In thousands)	2017		2016
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	3,611	$	3,490
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		500		215
Depreciation and amortization		481		542
Amortization of investment security premiums and accretion of discounts, net		306		298
Amortization of deferred loan costs		187		148
Amortization of core deposit intangible		43		51
Accretion of unfavorable lease liability		(17)		(17)
Stock based compensation		26		166
Net gains on sales of investment securities		(255)		—
Deferred gain on sale of premises		(129)		(129)
Equity in losses of real estate limited partnerships, net		378		393
Increase in cash surrender value of bank owned life insurance		(47)		(55)
Changes in assets and liabilities:
Net change in interest receivable		(363)		(511)
Net change in other assets		(3,656)		347
Net change in interest payable		13		(16)
Net change in other liabilities		2,557		861
Net cash provided by operating activities		3,635		5,783
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities available for sale		38,635		—
Proceeds from maturities of investment securities available for sale		7,356		8,487
Proceeds from maturities of investment securities held to maturity		4,801		4,412
Net purchases of Federal Home Loan Bank stock		(2,068)		(66)
Purchases of investment securities available for sale		—		(15,277)
Loan originations in excess of principal payments		(28,734)		(7,543)
Real estate limited partnership investments		(1,582)		(513)
Purchases of bank premises and equipment		—		(44)
Net cash provided by (used in) investing activities		18,408		(10,544)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		(15,794)		(24,651)
Net increase in short-term borrowings		35,000		—
Net decrease in securities sold under agreement to repurchase		(62,536)		(37,636)
Principal payments on long-term debt		(21)		(522)
Cash dividends paid		(1,933)		(1,920)
Proceeds from the exercise of stock warrants		390		—
Increase (decrease) in deferred compensation arrangements		71		(53)
Cash payments to taxing authorities on employees' behalf from shares withheld from stock-based compensation		(411)		—
Net cash used in financing activities		(45,234)		(64,782)
Decrease in cash and cash equivalents		(23,191)		(69,543)
Cash and cash equivalents beginning of period		82,953		150,183
Cash and cash equivalents end of period	$	59,762	$	80,640

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total interest payments	$	1,176	$	1,166
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Distribution of stock under deferred compensation arrangements	$	627	$	559
Non-cash exercise of stock options and warrants		348		—

See accompanying notes to unaudited consolidated financial statements

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Notes To Interim Unaudited Consolidated Financial Statement s

For additional information, see the Merchants Bancshares, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 2016, filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2017.

NOTE 1: FINANCIAL STATEMENT PRESENTATION

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. (the “Company”), and its wholly-owned subsidiary Merchants Bank (the “Bank,” and collectively with the Company, “Merchants,” “we,” “us,” or “our”). All material intercompany accounts and transactions are eliminated in consolidation. We offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 31 full-service banking offices throughout the state of Vermont and one full-service banking office in Massachusetts as of March 31, 2017.

Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) 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 GAAP for complete financial statements. All adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of our interim consolidated financial statements as of March 31, 2017 and December 31, 2016 and for the three months ended March 31, 2017 and 2016 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 U.S. Generally Accepted Accounting Principles (“GAAP”) requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for credit losses, income taxes, interest income recognition on loans and investments and analysis of other-than-temporary impairment of our investment securities portfolio. Operating results in the future may vary from the amounts derived from Management's estimates and assumptions.

NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS

Accounting Standards Update (“ASU”) 2014-09 – Revenue from Contracts with Customers – In May 2014, the Financial Accounting Standards Board (“FASB”) amended existing guidance related to revenue from contracts with customers. This amendment supersedes and replaces nearly all existing revenue recognition guidance, including industry-specific guidance, establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. In addition, this amendment specifies the accounting for some costs to obtain or fulfill a contract with a customer.

This amendment was originally effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. In July 2015, the FASB issued ASU 2015-14, which deferred the effective date to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that

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reporting period. Early adoption is permitted as of the original effective date. The amendments should be applied retrospectively to all periods presented or retrospectively with the cumulative effect recognized at the date of initial application. We believe these new requirements do not impact our interest income, as our financial instruments are not within the scope of this standard. We continue to evaluate the impact on our fee based income.

ASU 2016-02 – Leases – In February 2016, the FASB released this Update to increase the transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. For lessees, all leases will be required to be recognized on the balance sheet by recording a right-of-use asset and a lease liability. The accounting applied by a lessor is largely unchanged from that applied under the existing guidance. The ASU requires additional qualitative and quantitative disclosures with the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The guidance is effective for fiscal years beginning after December 15, 2018, including the interim periods. The Company is currently evaluating the impact of this new requirement on the consolidated financial statements, but the expectation is that this new requirement will result in a significant increase to assets for the right-of-use asset recognition and a significant increase to total liabilities for the lease liability.

ASU 2016-09 – Stock Compensation – In March 2016, the FASB issued this Update which includes multiple amendments intended to simplify aspects of share-based payment accounting, and was effective for us on January 1, 2017. The guidance simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of excess tax benefits in the consolidated statements of cash flows. Excess tax benefits or deficiencies for stock-based compensation are now reflected in the Consolidated Statements of Income as a component of income tax expense, whereas previously they were recognized in equity. The adoption of ASU 2016-09 did not have a material impact on our consolidated financial statements.

ASU 2016-13 – Credit Losses – In June 2016, the FASB released this Update to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this Update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments in this Update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is currently evaluating the impact of this new requirement on the consolidated financial statements.

ASU 2017-04 – Intangibles: Goodwill and Other – In January 2017, the FASB amended existing guidance to simplify the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Instead, an entity should perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount recognizing an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value (the “Goodwill Update”). The option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary is still available. A public business entity that is a SEC filer should adopt the amendments in this Goodwill Update for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates on or after January 1, 2017. The Company is evaluating the impact of these amendments on its consolidated financial statements, but it is not expected to have a significant impact.

ASU 2017-06 – Plan Accounting: Defined Benefit Pension Plans – In March 2017, the FASB amended existing guidance to improve the presentation of net periodic pension cost and net periodic postretirement benefit cost (the “Pension and Postretirement Benefit Cost Update”). This Pension and Postretirement Benefit Cost Update requires that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. Additionally, the other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. This Pension and Postretirement Benefit Cost Update also allows only the service cost component to be eligible for capitalization when

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applicable. This Pension and Postretirement Benefit Cost Update is effective for public business entities for annual periods beginning after December 15, 2017, including interim periods within those annual periods. The Company is evaluating the impact of these amendments on its consolidated financial statements.

NOTE 3: GOODWILL AND INTANGIBLE ASSETS

On December 4, 2015, the Company completed the acquisition of NUVO Bank & Trust Company (“NUVO”), Springfield, Massachusetts. NUVO's banking business operates as a division of Merchants Bank. The acquisition resulted in goodwill of $7.01 million and core deposit intangible (“CDI”) of $1.3 8 million. The goodwill and intangible balances presented below resulted from the Company’s acquisition of NUVO.

Goodwill

Goodwill is deemed to have an indefinite life and therefore is not amortized, but is instead subject to impairment tests. There was no impairment for the three months ended March 31, 2017 or December 31, 2016.


	March 31,		December 31,
(In thousands)	2017		2016
Beginning of period	$	7,011	$	7,011
Acquired goodwill		—		—
Impairment		—		—
End of period	$	7,011	$	7,011

Other Intangible Assets

Acquired CDI were as follows:


	March 31, 2017						December 31, 2016
	Gross				Net		Gross				Net
	Carrying		Accumulated		Carrying		Carrying		Accumulated		Carrying
(In thousands)	Amount		Amortization		Amount		Amount		Amortization		Amount
Amortized intangible assets:
Core deposit intangible	$	1,377	$	(264)	$	1,113	$	1,377	$	(221)	$	1,156
Total	$	1,377	$	(264)	$	1,113	$	1,377	$	(221)	$	1,156

Aggregate amortization expense for the CDI was $ 43 thousand and $51 thousand for the three months ended March 31, 2017 and December 31, 2016, respectively.

The estimated amortization expense for each of the next five years:


(In thousands)		Amount
Remainder of 2017	$	130
2018		147
2019		126
2020		120
2021		120
2022		120
Thereafter		350

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NOTE 4: INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of March 31, 2017 and December 31, 2016. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of March 31, 2017 were as follows:


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	10,089	$	75	$	—	$	10,164
U.S. Government Sponsored Enterprises ("U.S. GSEs")		83,916		127		(531)		83,512
Federal Home Loan Bank ("FHLB") Obligations		67,302		101		(353)		67,050
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		63,919		762		(404)		64,277
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		23,784		—		(414)		23,370
Agency Collateralized Mortgage Obligations ("Agency CMOs")		39,871		32		(287)		39,616
Total Available for Sale	$	288,881	$	1,097	$	(1,989)	$	287,989


			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
(In thousands)	Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	16,864	$	121	$	(6)	$	16,979
Agency MBSs		5,548		101		—		5,649
Agency CMOs		58,579		211		(330)		58,460
Total Held to Maturity	$	80,991	$	433	$	(336)	$	81,088

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The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2016 were as follows:


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	25,079	$	104	$	—	$	25,183
U.S. GSEs		93,883		106		(636)		93,353
FHLB Obligations		67,362		100		(456)		67,006
Agency MBSs		74,573		1,101		(465)		75,209
Agency CMBSs		23,972		—		(364)		23,608
Agency CMOs		49,694		46		(407)		49,333
ABSs		283		23		—		306
Total Available for Sale	$	334,846	$	1,480	$	(2,328)	$	333,998


			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
(In thousands)	Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	17,849	$	119	$	(33)	$	17,935
Agency MBSs		5,787		92		—		5,879
Agency CMOs		62,058		208		(331)		61,935
Total Held to Maturity	$	85,694	$	419	$	(364)	$	85,749

The contractual final maturity distribution of the debt securities classified as available for sale as of March 31, 2017, were as follows:


									Securities
			After One		After Five				not due
	Within		But Within		But Within		After Ten		at a Single
(In thousands)	One Year		Five Years		Ten Years		Years		Maturity		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	100	$	10,064	$	—	$	—	$	N/A	$	10,164
U.S. GSEs		—		83,512		—		—		N/A		83,512
FHLB Obligations		—		61,054		5,996		—		N/A		67,050
Agency MBSs		N/A		N/A		N/A		N/A		64,277		64,277
Agency CMBSs		N/A		N/A		N/A		N/A		23,370		23,370
Agency CMOs		N/A		N/A		N/A		N/A		39,616		39,616
Total Available for Sale	$	100	$	154,630	$	5,996	$	—	$	127,263	$	287,989
Available for Sale (at amortized cost):
U.S. Treasury Obligations	$	100	$	9,989	$	—	$	—	$	N/A	$	10,089
U.S. GSEs		—		83,916		—		—		N/A		83,916
FHLB Obligations		—		61,376		5,926		—		N/A		67,302
Agency MBSs		N/A		N/A		N/A		N/A		63,919		63,919
Agency CMBSs		N/A		N/A		N/A		N/A		23,784		23,784
Agency CMOs		N/A		N/A		N/A		N/A		39,871		39,871
Total Available for Sale	$	100	$	155,281	$	5,926	$	—	$	127,574	$	288,881

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The contractual final maturity distribution of the debt securities classified as held to maturity as of March 31, 2017, were as follows:


									Securities
			After One		After Five				not due
	Within		But Within		But Within		After Ten		at a Single
(In thousands)	One Year		Five Years		Ten Years		Years		Maturity		Total
Held to Maturity (at fair value):
U.S. Agency Obligations	$	—	$	—	$	—	$	16,979	$	N/A	$	16,979
Agency MBSs		N/A		N/A		N/A		N/A		5,649		5,649
Agency CMOs		N/A		N/A		N/A		N/A		58,460		58,460
Total Held to Maturity	$	—	$	—	$	—	$	16,979	$	64,109	$	81,088
Held to Maturity (at amortized cost):
U.S. Agency Obligations	$	—	$	—	$	—	$	16,864	$	N/A	$	16,864
Agency MBSs		N/A		N/A		N/A		N/A		5,548		5,548
Agency CMOs		N/A		N/A		N/A		N/A		58,579		58,579
Total Held to Maturity	$	—	$	—	$	—	$	16,864	$	64,127	$	80,991

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations.

The following table presents the proceeds, gross gains and gross losses on available for sale securities for the three months ended March 31, 2017 and 2016.


	Three Months Ended
	March 31,
(In thousands)	2017		2016
Proceeds	$	38,635	$	—
Gross gains		278		—
Gross losses		(23)		—
Net gains	$	255	$	—

Securities with a carrying value of $328.27 million and $370.81 million at March 31, 2017 and December 31, 2016, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes required by law.

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Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at March 31, 2017, were as follows:


	Less Than 12 Months					12 Months or More					Total
	Number	Fair				Number	Fair				Number	Fair
(In thousands)	of Issues	Value		Loss		of Issues	Value		Loss		of Issues	Value		Loss
Available for Sale:
U.S. GSEs	7	$	37,599	$	(531)	—	$	—	$	—	7	$	37,599	$	(531)
FHLB Obligations	7		35,858		(353)	—		—		—	7		35,858		(353)
Agency MBSs	15		45,753		(404)	—		—		—	15		45,753		(404)
Agency CMBSs	6		23,370		(414)	—		—		—	6		23,370		(414)
Agency CMOs	13		28,433		(287)	—		—		—	13		28,433		(287)
Total Available for Sale	48	$	171,013	$	(1,989)	—	$	—	$	—	48	$	171,013	$	(1,989)
Held to Maturity:
U.S. Agency Obligations	1	$	6,856	$	(6)	—	$	—	$	—	1	$	6,856	$	(6)
Agency CMOs	16		33,371		(215)	1		3,027		(115)	17		36,398		(330)
Total Held to Maturity	17	$	40,227	$	(221)	1	$	3,027	$	(115)	18	$	43,254	$	(336)


	Less Than 12 Months					12 Months or More					Total
	Number	Fair				Number	Fair				Number	Fair
(In thousands)	of Issues	Value		Loss		of Issues	Value		Loss		of Issues	Value		Loss
Available for Sale:
U.S. GSEs	8	$	42,404	$	(636)	—	$	—	$	—	8	$	42,404	$	(636)
FHLB Obligations	9		45,870		(456)	—		—		—	9		45,870		(456)
Agency MBSs	16		48,777		(465)	—		—		—	16		48,777		(465)
Agency CMBSs	6		23,608		(364)	—		—		—	6		23,608		(364)
Agency CMOs	15		33,935		(332)	2		2,227		(75)	17		36,162		(407)
Total Available for Sale	54	$	194,594	$	(2,253)	2	$	2,227	$	(75)	56	$	196,821	$	(2,328)
Held to Maturity:
U.S. Agency Obligations	1	$	7,230	$	(33)	—	$	—	$	—	1	$	7,230	$	(33)
Agency CMOs	13		26,480		(212)	1		3,162		(119)	14		29,642		(331)
Total Held to Maturity	14	$	33,710	$	(245)	1	$	3,162	$	(119)	15	$	36,872	$	(364)

There were no securities classified as trading at March 31, 2017 or December 31, 2016.

Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair value. These differences 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.

At March 31, 2017, all of our MBSs and CMOs held were issued by U.S. government-sponsored entities and agencies, primarily the Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”), institutions which the government has affirmed its commitment to support. As the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because we do not have the intent to sell

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these securities and it is not likely that we will be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at March 31, 2017.

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 and GNMA.

During 2014 and 2013, securities were transferred from available for sale to held to maturity. The amortization of the unamortized net holding loss reported in accumulated other comprehensive income offsets the effect on interest income of the discount for the transferred securities. The remaining unamortized balance of the net losses for the securities transferred from available for sale to held to maturity was $1.99 million or $1.30 million, net of tax, at March 31, 2017.

NOTE 5: SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

The following table presents the contractual maturity of our secured borrowings and class of collateral pledged at March 31, 2017:


	Remaining Contractual Maturity of the Agreements
	Overnight and						Greater Than
(In thousands)	Continuous		Up to 30 Days		30-90 Days		90 Days		Total
Repurchase Agreements
Available for Sale:
U.S. Treasury Obligations	$	10,064	$	—	$	—	$	—	$	10,064
U.S. GSEs		47,745		—		—		—		47,745
FHLB Obligations		58,519		—		—		—		58,519
Agency MBSs		33,553		—		—		—		33,553
Agency CMBSs		18,961		—		—		—		18,961
Agency CMOs		23,928		—		—		—		23,928
Total Available for Sale	$	192,770	$	—	$	—	$	—	$	192,770

(In thousands)
Held to Maturity:
U.S. Agency Obligations	$	14,714	$	—	$	—	$	—	$	14,714
Agency CMOs		42,098		—		—		—		42,098
Total Held to Maturity	$	56,812	$	—	$	—	$	—	$	56,812

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The following table presents the contractual maturity of our secured borrowings and class of collateral pledged at December 31, 2016:


	Remaining Contractual Maturity of the Agreements
	Overnight and						Greater Than
(In thousands)	Continuous		Up to 30 Days		30-90 Days		90 Days		Total
Repurchase Agreements
Available for Sale:
U.S. Treasury Obligations	$	24,207	$	—	$	—	$	—	$	24,207
U.S. GSEs		51,847		—		—		—		51,847
FHLB Obligations		59,505		—		—		—		59,505
Agency MBSs		44,736		—		—		—		44,736
Agency CMBSs		21,662		—		—		—		21,662
Agency CMOs		40,007		—		—		—		40,007
Total Available for Sale	$	241,964	$	—	$	—	$	—	$	241,964

(In thousands)
Held to Maturity:
U.S. Agency Obligations	$	16,646	$	—	$	—	$	—	$	16,646
Agency CMOs		53,508		—		—		—		53,508
Total Held to Maturity	$	70,154	$	—	$	—	$	—	$	70,154

The fair value of securities pledged to secure repurchase agreements may decline. The Company manages this risk by having a policy to pledge securities valued greater than the gross outstanding balance of repurchase agreements. Securities sold under agreements to repurchase are secured by securities with a carrying value of $249.68 million at March 31, 2017 and $312.23 million at December 31, 2016.

NOTE 6: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at March 31, 2017 and December 31, 2016 was as follows:


(In thousands)	March 31, 2017		December 31, 2016
Commercial, financial and agricultural	$	276,915	$	257,078
Municipal loans		113,875		114,509
Real estate loans – residential		438,424		447,527
Real estate loans – commercial		672,712		636,755
Real estate loans – construction		35,964		52,533
Installment loans		4,813		5,790
All other loans		15		17
Total loans	$	1,542,718	$	1,514,209

We primarily originate commercial, commercial real estate, municipal, and residential real estate loans to customers throughout the states of Vermont and Massachusetts. There are no significant industry concentrations in the loan portfolio. Total loans included $1.13 million and $1.19 million of net deferred loan origination costs at March 31, 2017 and December 31, 2016, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $254 thousand and $297 thousand at March 31, 2017 and December 31, 2016, respectively.

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Additionally, residential and commercial loans serviced for others at March 31, 2017 and December 31, 2016 amounted to approximately $35.61 million and $34.63 million, respectively.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended March 31, 2017:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,946	$	593	$	2,575	$	5,922	$	534	$	89	$	—	$	12,659
Charge-offs		(3)		—		—		—		—		(69)		—		(72)
Recoveries		2		—		9		—		—		23		—		34
Provision (credit)		250		(19)		(32)		434		(183)		116		—		566
Ending balance	$	3,195	$	574	$	2,552	$	6,356	$	351	$	159	$	—	$	13,187

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended March 31, 2016:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Charge-offs		(3)		—		(73)		—		—		(42)		—		(118)
Recoveries		2		—		11		4		—		19		—		36
Provision (credit)		161		32		37		(109)		45		49		—		215
Ending balance	$	2,856	$	622	$	2,857	$	5,281	$	465	$	92	$	—	$	12,173

In addition to the provision for loan losses included above, there was a provision (credit) for the reserve for undisbursed lines of $(66) thousand and $(10) thousand for the three months ended March 31, 2017 and March 31, 2016 included in the provision for credit losses in the consolidated statement of income.

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The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon the impairment method at March 31, 2017:


	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	—	$	—	$	227	$	18	$	—	$	—	$	—	$	245
Ending balance collectively evaluated for impairment		3,195		574		2,325		6,331		351		159		—		12,935
Ending balance acquired with deteriorated credit quality		—		—		—		7		—		—		—		7
Totals	$	3,195	$	574	$	2,552	$	6,356	$	351	$	159	$	—	$	13,187
Financing receivables:
Ending balance individually evaluated for impairment	$	77	$	—	$	1,447	$	2,066	$	—	$	—	$	—	$	3,590
Ending balance collectively evaluated for impairment		276,144		113,875		436,977		668,775		35,964		4,813		15		1,536,563
Ending balance acquired with deteriorated credit quality		694		—		—		1,871		—		—		—		2,565
Totals	$	276,915	$	113,875	$	438,424	$	672,712	$	35,964	$	4,813	$	15	$	1,542,718

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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, 2016:


	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	—	$	—	$	184	$	—	$	—	$	—	$	—	$	184
Ending balance collectively evaluated for impairment		2,946		593		2,391		5,922		534		89		—		12,475
Ending balance acquired with deteriorated credit quality		—		—		—		—		—		—		—		—
Totals	$	2,946	$	593	$	2,575	$	5,922	$	534	$	89	$	—	$	12,659
Financing receivables:
Ending balance individually evaluated for impairment	$	97	$	—	$	1,213	$	1,634	$	—	$	12	$	—	$	2,956
Ending balance collectively evaluated for impairment		256,239		114,509		446,314		633,217		52,533		5,778		17		1,508,607
Ending balance acquired with deteriorated credit quality		742		—		—		1,904		—		—		—		2,646
Totals	$	257,078	$	114,509	$	447,527	$	636,755	$	52,533	$	5,790	$	17	$	1,514,209

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The table below presents the recorded investment of loans segregated by class, with delinquency aging as of March 31, 2017:


	31-60		61-90		91 Days		Total
	Days		Days		or More		Past
(In thousands)	Past Due		Past Due		Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	623	$	—	$	—	$	623	$	276,137	$	155	$	276,915
Municipal		—		—		—		—		113,875		—		113,875
Real estate-residential:
First mortgage		121		—		—		121		400,689		1,343		402,153
Second mortgage		—		—		—		—		36,271		—		36,271
Real estate-commercial:
Owner occupied		501		—		—		501		241,895		2,714		245,110
Non-owner occupied		—		—		—		—		427,602		—		427,602
Real estate-construction:
Residential		—		—		—		—		2,388		—		2,388
Commercial		—		—		—		—		33,576		—		33,576
Installment		87		14		—		101		4,712		—		4,813
Other		—		—		—		—		15		—		15
Total	$	1,332	$	14	$	—	$	1,346	$	1,537,160	$	4,212	$	1,542,718

Of the total nonperforming loans in the aging table above, $4.08 million were past due of which $0 were restructured loans, $804 thousand were purchase credit impaired, and $0 were 91 days or more past due and accruing.

The table below presents the recorded investment of loans segregated by class, with delinquency aging as of December 31, 2016:


	31-60		61-90		91 Days		Total
	Days		Days		or More		Past
(In thousands)	Past Due		Past Due		Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—	$	—	$	—	$	—	$	256,894	$	184	$	257,078
Municipal		—		—		—		—		114,509		—		114,509
Real estate-residential:
First mortgage		164		71		—		235		408,597		1,104		409,936
Second mortgage		32		—		—		32		37,559		—		37,591
Real estate-commercial:
Owner occupied		—		—		—		—		224,691		1,882		226,573
Non-owner occupied		—		—		—		—		410,182		—		410,182
Real estate-construction:
Residential		—		—		—		—		2,530		—		2,530
Commercial		—		—		—		—		50,003		—		50,003
Installment		123		—		—		123		5,655		12		5,790
Other		—		—		—		—		17		—		17
Total	$	319	$	71	$	—	$	390	$	1,510,637	$	3,182	$	1,514,209

Of the total nonperforming loans in the aging table above, $1.75 million were past due of which $0 were restructured loans, $819 thousand were purchase credit impaired and $19 thous and were 91 days or more past due and accruing.

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Impaired loans by class at March 31, 2017 and for the three months ended March 31, 2017 are as follows:


	Period Ended						Three Months Ended
	March 31, 2017						March 31, 2017
			Unpaid					Average	Interest
	Recorded		Principal		Related			Recorded	Income
(In thousands)	Investment		Balance		Allowance			Investment	Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	77	$	77	$	—	$	78	$	1
Residential:
First mortgage		130		190		—		180		1
Second mortgage		—		—		—		—		—
Commercial Real Estate:
Owner occupied		1,751		1,760		—		1,687		—
Non-owner occupied		—		—		—		134		2
Construction:
Residential		—		—		—		—		—
Commercial		—		—		—		—		—
Installment		—		—		—		—		—
With related allowance recorded
Commercial, financial and agricultural		—		—		—		—		—
Residential:
First mortgage		1,317		1,330		227		1,114		—
Second mortgage		—		—		—		—		—
Commercial Real Estate:
Owner occupied		315		315		18		105		—
Total
Commercial, financial and agricultural		77		77		—		78		1
Residential		1,447		1,520		227		1,294		1
Commercial Real Estate		2,066		2,075		18		1,926		2
Construction		—		—		—		—		—
Installment		—		—		—		—		—
Total	$	3,590	$	3,672	$	245	$	3,298	$	4

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Impaired loans by class at December 31, 2016 and for the three months ended March 31, 2016 are as follows:


	Period Ended						Three Months Ended
	December 31, 2016						March 31, 2016
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
(In thousands)	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	97	$	97	$	—	$	390	$	1
Residential:
First mortgage		208		266		—		241		2
Second mortgage		—		—		—		3		—
Commercial Real Estate:
Owner occupied		1,229		1,229		—		401		—
Non-owner occupied		405		432		—		470		—
Installment		12		12		—		8		—
With related allowance recorded
Commercial, financial and agricultural		—		—		—		254		—
Residential:
First mortgage		1,005		1,026		184		425		—
Second mortgage		—		—		—		—		—
Commercial Real Estate:
Owner occupied		—		—		—		—		—
Installment		—		—		—		—		—
Total
Commercial, financial and agricultural		97		97		—		644		1
Residential		1,213		1,292		184		669		2
Commercial Real Estate		1,634		1,661		—		871		—
Installment		12		12		—		8		—
Total	$	2,956	$	3,062	$	184	$	2,192	$	3

Nonperforming loans at March 31, 2017 and December 31, 2016 are as follows:


(In thousands)	March 31, 2017		December 31, 2016
Nonaccrual loans	$	4,212	$	3,163
Loans greater than 90 days and accruing		—		19
Troubled debt restructurings ("TDRs")		—		—
Total nonperforming loans	$	4,212	$	3,182

There were no loans restructured in the three months ended March 31, 2017. One commercial real estate loan with a balance of $464 thousand was restructured during the three months ended March 31, 2016 and was considered to be a TDR.

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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. There were three restructured residential mortgages at March 31, 2017 with balances totaling $104 thousand. There was one restructured commercial loan at March 31, 2017 with a balance of $77 thousand. All of the four TDRs at March 31, 2017 continue to pay as agreed according to the modified terms, are accruing, and are considered performing. At December 31, 2016, there were three restructured residential mortgages with balances totaling $110 thousand, one restructured commercial loans with a balance totaling $78 thousand, and one restructured commercial real estate loan with a balance of $405 thousand.

At March 31, 2017, 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 91 days past due and still accruing at March 31, 2017. Interest income on restructured loans during the three months ended March 31, 2017 and 2016 was insignificant.

Nonaccrual loans by class as of March 31, 2017 and December 31, 2016 are as follows:


(In thousands)	March 31, 2017		December 31, 2016
Commercial, financial and agricultural	$	155	$	165
Real estate - residential:
First mortgage		1,343		1,104
Second mortgage		—		—
Real estate - commercial:
Owner occupied		2,714		1,882
Non owner occupied		—		—
Installment		—		12
Total nonaccruing non-TDR loans	$	4,212	$	3,163
Nonaccruing TDR’s
Commercial, financial and agricultural		—		—
Real estate – residential:
First mortgage		—		—
Real estate - commercial:
Non owner occupied		—		—
Total nonaccrual loans including TDRs	$	4,212	$	3,163

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.

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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.

Below is a summary of loans by credit quality indicator as of March 31, 2017:


					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	99		233,838	$	25,422	$	317	$	17,239	$	276,915
Municipal		—		110,222		3,653		—		—		113,875
Real estate – residential:
First mortgage		393,208		7,060		542		—		1,343		402,153
Second mortgage		36,049		—		222		—		—		36,271
Real estate – commercial:
Owner occupied		—		205,107		25,561		—		14,442		245,110
Non-owner occupied		—		385,105		41,426		—		1,071		427,602
Real estate – construction:
Residential		605		1,783		—		—		—		2,388
Commercial		116		31,948		1,512		—		—		33,576
Installment		4,813		—		—		—		—		4,813
All other loans		15		—		—		—		—		15
Total	$	434,905	$	975,063	$	98,338	$	317	$	34,095	$	1,542,718

Below is a summary of loans by credit quality indicator as of December 31, 2016:


					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	102	$	215,891	$	24,215	$	322	$	16,548	$	257,078
Municipal		—		110,864		2,824		821		—		114,509
Real estate – residential:
First mortgage		400,961		7,392		481		—		1,102		409,936
Second mortgage		37,367		—		224		—		—		37,591
Real estate – commercial:
Owner occupied		—		186,494		25,492		—		14,587		226,573
Non-owner occupied		—		369,566		38,706		—		1,910		410,182
Real estate – construction:
Residential		412		2,118		—		—		—		2,530
Commercial		152		41,373		7,476		—		1,002		50,003
Installment		5,778		—		—		—		12		5,790
All other loans		17		—		—		—		—		17
Total	$	444,789	$	933,698	$	99,418	$	1,143	$	35,161	$	1,514,209

The carrying amount of loans purchased with evidence of credit deterioration accounted for under FASB Accounting Standards Codification (“ASC”) 310-30 acquired in the NUVO acquisition totaled $2.57 million and $2.65 million at March 31, 2017 and December 31, 2016, respectively.

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NOTE 7: 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.

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:

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

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.

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.

The types of instruments valued based on quoted market prices in active markets include most U.S. government and Agency securities, liquid mortgage products, active listed equities and most money market securities. Such instruments are generally classified within Level 1 or Level 2 of the fair value hierarchy. We do not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, less liquid mortgage products, less liquid Agency securities, less liquid listed equities, state, municipal and provincial obligations, and certain physical commodities. Such instruments are generally classified within Level 2 of the fair value hierarchy.

Level 3 is for positions that are not traded in active markets or are subject to transfer restrictions; valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, Management’s best estimate will be used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Subsequent to inception, Management only changes Level 3 inputs and assumptions when corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt markets, and changes in financial ratios or cash flows.

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Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at March 31, 2017 measured at fair value on a recurring basis:


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	10,164	$	—	$	10,164	$	—
U.S. GSEs		83,512		—		83,512		—
FHLB Obligations		67,050		—		67,050		—
Agency MBSs		64,277		—		64,277		—
Agency CMBSs		23,370		—		23,370		—
Agency CMOs		39,616		—		39,616		—
Interest rate swap agreements		973		—		973		—
Total assets	$	288,962	$	—	$	288,962	$	—
Liabilities
Interest rate swap agreements		774		—		774		—
Total liabilities	$	774	$	—	$	774	$	—

The table below presents the balance of financial assets and liabilities at December 31, 2016 measured at fair value on a recurring basis:


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	25,183	$	—	$	25,183	$	—
U.S. GSEs		93,353		—		93,353		—
FHLB Obligations		67,006		—		67,006		—
Agency MBSs		75,209		—		75,209		—
Agency CMBSs		23,608		—		23,608		—
Agency CMOs		49,333		—		49,333		—
ABSs		306		—		306		—
Interest rate swap agreements		422		—		422		—
Total assets	$	334,420	$	—	$	334,420	$	—
Liabilities
Interest rate swap agreements		194		—		194		—
Total liabilities	$	194	$	—	$	194	$	—

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 Note 4 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

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interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable 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 months ended March 31, 2017 or 2016. There were no Level 3 assets measured at fair value on a recurring basis at March 31, 2017 or December 31, 2016.

Financial instruments on a non-recurring basis

Certain financial assets are also measured at fair value on a non-recurring basis, however they were not material at March 31, 2017 or December 31, 2016. These financial assets include impaired loans and other real estate owned (“OREO”).

Fair value of financial instruments

The fair value of Merchants’ financial instruments as of March 31, 2017 are summarized in the table below:


	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	59,762	$	59,762	$	59,762	$	—	$	—
Securities available for sale		287,989		287,989		—		287,989		—
Securities held to maturity		80,991		81,088		—		81,088		—
FHLB stock		7,044		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,529,531		1,511,073		—		—		1,511,073
Interest rate swap agreement		973		973		—		973		—
Accrued interest receivable		5,085		5,085		—		1,096		3,989
Total	$	1,971,375	$	1,945,970	$	59,762	$	371,146	$	1,515,062
Deposits	$	1,511,676	$	1,510,694	$	1,321,166	$	189,528	$	—
Short-term borrowings		75,000		75,000		—		75,000		—
Securities sold under agreement to repurchase		249,582		249,651		—		249,651		—
Other long-term debt		3,630		3,585		—		3,585		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,721		—		14,721		—
Interest rate swap agreement		774		774		—		774		—
Accrued interest payable		123		123		11		112		—
Total	$	1,861,404	$	1,854,548	$	1,321,177	$	533,371	$	—

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The fair value of Merchants’ financial instruments as of December 31, 2016 are summarized in the table below:


	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	82,953	$	82,953	$	82,953	$	—	$	—
Securities available for sale		333,998		333,998		—		333,998		—
Securities held to maturity		85,694		85,749		—		85,749		—
FHLB stock		4,976		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,501,550		1,484,718		—		—		1,484,718
Interest rate swap agreement		422		422		—		422		—
Accrued interest receivable		4,722		4,722		—		1,232		3,490
Total	$	2,014,315	$	1,992,562	$	82,953	$	421,401	$	1,488,208
Deposits	$	1,527,470	$	1,526,626	$	1,328,262	$	198,364	$	—
Short-term borrowings		40,000		40,000		—		40,000		—
Securities sold under agreement to repurchase		312,118		312,019		—		312,019		—
Other long-term debt		3,651		3,600		—		3,600		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,775		—		14,775		—
Interest rate swap agreement		194		194		—		194		—
Accrued interest payable		110		110		11		99		—
Total	$	1,904,162	$	1,897,324	$	1,328,273	$	569,051	$	—

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accrued interest receivable and accrued interest payable approximate fair value. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

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 resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

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 resulting in a Level 2 classification.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity resulting in a Level 2 classification.

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 not material as of March 31, 2017 and December 31, 2016.

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NOTE 8: EMPLOYEE BENEFIT PLANS

Pension Plan

Prior to January 1995, we maintained a noncontributory defined benefit plan (the “Pension Plan”) covering all eligible employees. 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.

The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized in other comprehensive income for the three months ended March 31, 2017 and 2016:


	Three Months Ended
	March 31,
(In thousands)	2017		2016
Interest cost	$	113	$	112
Expected return on plan assets		(111)		(242)
Service costs		13		14
Net loss amortization		110		116
Net periodic pension benefit	$	125	$	—

We have no minimum required contribution for 2017.

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

NOTE 9: EARNINGS PER SHARE

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the three months ended March 31, 2017 and 2016:


	Three Months Ended
	March 31,
(In thousands except per share data)	2017		2016
Net income	$	3,611	$	3,490
Weighted average common shares outstanding		6,904		6,856
Dilutive effect of common stock equivalents		25		110
Weighted average common and common equivalent shares outstanding		6,929		6,966
Basic earnings per common share	$	0.52	$	0.51
Diluted earnings per common share	$	0.52	$	0.50

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share were computed by including potentially dilutive shares on the weighted average share count. Anti-dilutive average warrants totaling 34,370 shares have been excluded from the calculation of diluted EPS for the three months ended March 31, 2016.

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NOTE 10: COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

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

Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. We use the same credit policies in making commitments as we do for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitment is expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. We evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by us upon extension of credit is based on Management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is typically obtained as collateral.

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 $ 6.77 million at March 31, 2017 and $ 5 .95 million at December 31, 2016, 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. 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 March 31, 2017 or December 31, 2016.

Reserve Balances at the Federal Reserve Bank

At March 31, 2017 and December 31, 2016, amounts at the Federal Reserve Bank included $ 26.62 million and $ 32.72 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.

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 anticipated outcome of such proceedings, any such liability will not have a material effect on our consolidated financial position.

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NOTE 11: ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the three months ended March 31, 2017.


	Unrealized		Unrealized Gains
	Gains (Losses)		(Losses) on Securities
	on Securities		Transferred From						Accumulated Other
	Available-For-		Available-For-Sale to				Interest Rate		Comprehensive
(In thousands)	Sale		Held-To-Maturity		Pension Plan		Swaps		Income (Loss)
Beginning Balance December 31, 2016	$	(551)	$	(1,408)	$	(3,823)	$	—	$	(5,782)
Other comprehensive income before reclassifications		106		—		—		—		106
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		113		—		—		113
Reclassification adjustments for (gains) losses reclassified into income		(166)		—		72		—		(94)
Net current period other comprehensive (loss) income		(60)		113		72		—		125
Balance March 31, 2017	$	(611)	$	(1,295)	$	(3,751)	$	—	$	(5,657)

The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the three months ended March 31, 2016.


	Unrealized		Unrealized Gains
	Gains (Losses)		(Losses) on Securities
	on Securities		Transferred From						Accumulated Other
	Available-For-		Available-For-Sale to				Interest Rate		Comprehensive
(In thousands)	Sale		Held-To-Maturity		Pension Plan		Swaps		Income (Loss)
Beginning Balance December 31, 2015	$	166	$	(2,297)	$	(3,737)	$	(155)	$	(6,023)
Other comprehensive income before reclassifications		2,624		—		—		35		2,659
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		127		—		—		127
Reclassification adjustments for losses reclassified into income		—		—		75		—		75
Net current period other comprehensive income		2,624		127		75		35		2,861
Balance March 31, 2016	$	2,790	$	(2,170)	$	(3,662)	$	(120)	$	(3,162)

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Details of the reclassification adjustments in the above table for the three months ended March 31, 2017 and 2016 are presented below:



Details about Accumulated Other	Three Months Ended		Three Months Ended
Comprehensive Income Components	March 31,		March 31,		Affected Line Item in the Statement
(In thousands)	2017		2016		Where Net Income is Presented
Realized gains on securities	$	(255)	$	-	Net gains on investment securities
		(255)		-	Total before tax
		89		-	Provision for income taxes
	$	(166)	$	-	Net of tax, increase to net income

Amortization of defined benefit pension plan
	$	110	$	116	Compensation and benefits expense
		110		116	Total before tax
		(38)		(41)	Provision for income taxes
	$	72	$	75	Net of tax, decrease to net income

Total reclassification adjustments	$	(94)	$	75	(Increase)/Decrease to net income

NOTE 12: DERIVATIVE FINANCIAL INSTRUMENTS

We have interest rate swaps with notional amounts with certain commercial customers totaling $ 40.23 million at March 31, 2017 and $40.73 million at December 31, 2016. In order to minimize our risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps (pay fixed/receive floating swaps) with our counterparty totaling $40.23 million at March 31, 2017 and $40.73 million at December 31, 2016. At March 31, 2017, the weighted average receive rate of these interest rate swaps was 2.87%, the weighted average pay rate was 3.85% and the weighted average maturity was 7 .3 years. The fair values of $774 thousand and $ 774 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at March 31, 2017. At December 31, 2016, the weighted average receive rate of these interest rate swaps was 2.66%, the weighted average pay rate was 3.85% and the weighted average maturity was 7.5 years. The fair values of $194 thousand and $194 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at December 31, 2016. Hedge accounting has not been applied for these derivatives. Since 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.

We have interest rate swaps with notional amounts totaling $ 7.48 million at March 31, 2017 and $7.48 million at December 31, 2016, that were designated as fair value hedges of certain fixed rate loans with municipalities. At March 31, 2017, the weighted average receive rate of these interest rate swaps was 2.30%, the weighted average pay rate was 3.11% and the weighted average maturity was 16.3 years. The fair value of $199 thousand at March 31, 2017, was reflected as a reduction to loans and an increase to other assets. At December 31, 2016 the weighted average receive rate of these interest rate swaps was 2.09%, the weighted average pay rate was 3.11% and the weighted average maturity was 16.5 years. The fair value of $2 28 thousand at December 31, 2016, was reflected as a reduction to loans and an increase to other assets. The ineffective portion of the interest swaps was immaterial and as such, amounts are not recognized in earnings.

We assessed our counterparty risk at March 31, 2017 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 Note 7 to these consolidated financial statements.

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NOTE 13: SUBSEQUENT EVENTS

On April 26, 2017, the Company and Community Bank System, Inc. issued a joint press release announcing that they have received regulatory approvals from the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency for the proposed merger. The closing date for the merger is Friday, May 12, 2017, subject to the satisfaction of customary closing conditions.

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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. These statements include, among others, statements regarding our intent, belief or expectations with respect to economic conditions, trends affecting our financial condition or results of operations, and our exposure to market, interest rate and credit risk.

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 other factors, difficulties in achieving cost savings in connection with the acquisition of NUVO Bank & Trust Company (“NUVO”) or in achieving such cost savings within the expected timeframe; adverse conditions in the capital and debt markets; changes in interest rates; competitive pressures from other financial institutions and non-bank entities; weakness in general economic conditions on a national basis or in the local markets in which we operate, including changes which adversely affect borrowers’ ability to service and repay our loans; changes in the value of securities and other assets; changes in loan default and charge-off rates; the adequacy of loan loss reserves; reductions in deposit levels necessitating increased borrowing to fund loans and investments; changes in government regulation; failure to obtain the approval of our stockholders in connection with our proposed merger with Community Bank System, Inc. (“Community”); the timing to consummate the proposed merger; the risk that a condition to closing of the proposed merger may not be satisfied; the risk that a regulatory approval that may be required for the proposed merger is not obtained or is obtained subject to conditions that are not anticipated; the parties’ ability to achieve the synergies and value creation contemplated by the proposed merger; the parties’ ability to successfully integrate operations in the proposed merger; the effect of the announcement of the proposed merger on our ability to maintain relationships with our key partners, customers and employees, and on our operating results and business generally; and changes in assumptions used in making such forward-looking statements, as well as the other risks and uncertainties detailed in our Annual Report on Form 10-K and in this Quarterly Report on Form 10-Q. Forward-looking statements speak only as of the date on which they are made. 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 statement is 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

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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. 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 Stockholders’ Equity; Interest Rates and Net Interest Margin” on page 37.

The tangible capital ratio is the ratio of tangible stockholders’ equity (total stockholders’ equity less goodwill and CDI related to the NUVO acquisition) divided by tangible assets (total assets less goodwill and CDI related to the NUVO acquisition). Tangible book value per share is calculated by dividing tangible stockholders’ equity by period end shares outstanding. A reconciliation of the tangible capital ratio and tangible book value per share can be found below.

Additionally, in several places adjusted financial measures are presented. Adjusted noninterest expense excludes non-recurring expenses not considered integral to the Company’s normal operations. Specifically excluded in adjusted noninterest expense are NUVO acquisition costs, Community Bank System, Inc. merger costs, and severance and retirement costs. Adjusted net income is GAAP net income adjusted for these non-recurring elements of noninterest expense. These adjustments are considered helpful in the comparison of quarterly noninterest expense and net income. Reconciliations of adjusted net income and adjusted noninterest expense to our consolidated financial statements prepared in accordance with GAAP appear below and are titled “Adjusted Net Income non-GAAP Reconciliation” and “Adjusted Noninterest Expense Non-GAAP Reconciliation,” respectively.

A 35.0% tax rate was used in both 2017 and 2016.

Tangible Book Value Non-GAAP Reconciliation


	Period Ended
	March 31,			December 31,
(In thousands except per share data)	2017			2016
Total assets	$	2,023,544		$	2,062,658
Core deposit intangible		1,113			1,156
Goodwill		7,011			7,011
Tangible assets	$	2,015,420		$	2,054,491

Total stockholders' equity		158,648			156,503
Core deposit intangible		1,113			1,156
Goodwill		7,011			7,011
Tangible stockholders' equity	$	150,524		$	148,336

Period end common shares outstanding		6,916			6,888

Tangible book value per share	$	21.76		$	21.54
Tangible capital ratio		7.47	%		7.22	%

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Adjusted Net Income Non-GAAP Reconciliation


	Three Months Ended
	March 31,
(In thousands except per share data)	2017		2016
Community Bank System, Inc. merger costs	$	1,302	$	—
NUVO Bank & Trust Company acquisition costs		—		133
Severance and retirement costs		—		289
Tax effect		370		97
Adjustments, net of tax	$	932	$	325

GAAP net income as reported		3,611		3,490
Adjusted net income	$	4,543	$	3,815

Weighted average common shares outstanding		6,904		6,856
Weighted average diluted shares outstanding		6,929		6,966

Adjusted basic earnings per common share	$	0.66	$	0.56
Adjusted diluted earnings per common share	$	0.66	$	0.55

Adjusted Noninterest Expense Non-GAAP Reconciliation


	Three Months Ended
	March 31,
(In thousands)	2017		2016
Noninterest expense	$	11,953	$	11,919
Less:
Community Bank System, Inc. merger costs		1,302		—
NUVO Bank & Trust Company acquisition costs		—		133
Severance and retirement costs		—		289
Adjusted noninterest expense	$	10,651	$	11,497

General

The following discussion and analysis of financial condition as of March 31, 2017 and December 31, 2016 and results of operations of Merchants and its subsidiaries for the three months ended March 31, 2017 and 2016 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 $3.61 million, or $0.52 per diluted share, for the first quarter of 2017 compared to net income of $3.49 million, or $0.50 per diluted share, in the first quarter of 2016. Excluding Community Bank System, Inc. merger costs, net of tax, adjusted net income was $4.54 million, or $0.66 per diluted share, for the three months ended March 31, 2017. This compared to adjusted net income of $3.82 million, or $0.55 per diluted share, for the same period in 2016. Refer to Adjusted Net Income Non-GAAP table on page 35.

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The return on average assets was 0.71% for the three months ended March 31, 2017, compared to 0.71% for the same period in 2016. The return on average stockholders’ equity was 9.06% for the three months ended March 31, 2017, compared to 9.32% for the same period in 2016.

Stockholders’ equity ended the quarter at $158.65 million. The book value per share at March 31, 2017 was $22.94 per share, an increase of $0.22 per share from $22.72 at December 31, 2016. The tangible book value per share at March 31, 2017 was $21.76 per share, an increase of $0.22 per share from $21.54 at December 31, 2016. At March 31, 2017, our common Tier 1 equity ratio was 12.38%. At March 31, 2017, the leverage capital ratio decreased to 8.63% from 8.71%, the total risk-based capital ratio decreased to 15.09% from 15.14% and the non-GAAP tangible capital ratio increased to 7.47% from 7.22%, at December 31, 2016. See page 34 for our non-GAAP tangible book value calculation.

Net interest income : Net interest income was $14.24 million for the three months ended March 31, 2017, compared to $13.73 million for the same period in 2016. Net interest income on a fully-taxable basis was $14.79 million for the three months ended March 31, 2017, compared to $14.27 million for the same period in 2016.

Provision for Credit Losses: The Company recorded a $500 thousand provision for credit losses for the three months ended March 31, 2017, compared to a $205 thousand provision for credit losses for the same period in 2016.

Noninterest income: Noninterest income for the three months ended March 31, 2017 was $3.26 million, an increase of $338 thousand from the same period in 2016.

Noninterest expense: Noninterest expense was $11.95 million for the three months ended March 31, 2017, an increase of $34 thousand from the same period in 2016. Excluding Community Bank System, Inc. merger costs, adjusted noninterest expense was $10.65 million for the three months ended March 31, 2017. This compared to adjusted noninterest expense of $11.50 million for the same period in 2016. Refer to the “Adjusted Noninterest Expense Non-GAAP Reconciliation” on page 35 for additional information.

Loans: Loans were $1.54 billion for the first quarter of 2017, an increase of $28.51 million from December 31, 2016. Average loans totaled $1.54 billion for the three months ended March 31, 2017, compared to average loans of $1.42 billion for the same period in 2016.

Investments: The investment portfolio, which includes FHLB stock, ended the quarter at $376.02 million, a decrease of $48.64 million from December 31, 2016.

Deposits: Total deposits were $1.51 billion at March 31, 2017, a decrease of $15.79 million from December 31, 2016. Average deposits totaled $1.51 billion for the three months ended March 31, 2017, compared to average deposits of $1.53 billion for the same period in 2016.

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Net Interest Income

As shown on the following tables, our fully taxable equivalent (“FTE”) net interest income was $14.79 million for the three months ended March 31, 2017, compared to $14.27 million for the three months ended March 31, 2016. Our fully taxable equivalent net interest margin was 3.02% for the three months ended March 31, 2017 and 2016.

The following tables present an analysis of net interest income and 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 FTE basis, using a 35% rate. Nonaccrual loans are included in the average loan balance outstanding.

Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Net Interest Margin


	Three Months Ended
	March 31, 2017						March 31, 2016
			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	$	1,538,136	$	14,058	3.70	%	$	1,417,710	$	13,337	3.78	%
Investments		402,012		1,836	1.83	%		400,501		1,997	2.01	%
Interest-earning deposits with banks and other short-term investments		38,058		82	0.88	%		74,294		81	0.44	%
Total interest earning assets		1,978,206		15,976	3.26	%		1,892,505		15,415	3.28	%
Allowance for loan losses		(12,775)						(12,073)
Cash and due from banks		25,375						31,058
Bank premises and equipment, net		12,896						14,841
Bank owned life insurance		10,775						10,571
Other assets		31,179						36,570
Total assets	$	2,045,656					$	1,973,472

LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$	687,259	$	471	0.28	%	$	671,823	$	440	0.26	%
Time deposits		196,039		265	0.55	%		239,818		391	0.66	%
Total interest bearing deposits		883,298		736	0.34	%		911,641		831	0.37	%
Short-term borrowings		72,789		140	0.77	%		—		—	—	%
Securities sold under agreements to repurchase, short-term		276,755		152	0.22	%		259,999		109	0.17	%
Other long-term debt		3,637		14	1.53	%		4,833		15	1.25	%
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		147	2.86	%		20,619		195	3.80	%
Total borrowed funds		373,800		453	0.49	%		285,451		319	0.45	%
Total interest bearing liabilities	$	1,257,098	$	1,189	0.38	%	$	1,197,092	$	1,150	0.39	%
Noninterest bearing deposits		626,936						616,553
Other liabilities		2,025						9,973
Stockholders' equity		159,597						149,854
Total liabilities and stockholders' equity	$	2,045,656					$	1,973,472

Net interest earning assets	$	721,108					$	695,413

Net interest income (fully taxable equivalent)			$	14,787					$	14,265
Tax equivalent adjustment				(551)						(533)
Net interest income			$	14,236					$	13,732

Net interest rate spread					2.88	%					2.89	%

Net interest margin					3.02	%					3.02	%

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

Analysis of Changes in Fully Taxable Equivalent Net Interest Income


	Three Months Ended						Due to
	March 31,				Increase						Volume/
(In thousands)	2017		2016		(Decrease)		Volume		Rate		Rate
Fully taxable equivalent interest income:
Loans, including fees on loans	$	14,058	$	13,337	$	721	$	1,122	$	(291)	$	(110)
Investments		1,836		1,997		(161)		8		(182)		13
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks		82		81		1		(39)		81		(41)
Total interest income		15,976		15,415		561		1,091		(392)		(138)
Less interest expense:
Savings, interest bearing checking and money market accounts		471		440		31		10		29		(8)
Time deposits		265		391		(126)		(71)		(66)		11
Federal funds purchased and Federal Home Loan Bank short-term borrowings		140		—		140		—		—		140
Securities sold under agreements to repurchase, short-term		152		109		43		7		34		2
Other long-term debt		14		15		(1)		(4)		3		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		147		195		(48)		—		(48)		—
Total interest expense		1,189		1,150		39		(58)		(48)		145
Net interest income	$	14,787	$	14,265	$	522	$	1,149	$	(344)	$	(283)

Allowance for Loan Losses

The allowance for loan losses at March 31, 2017 was $13.19 million, or 0.85% of total loans and 313% of nonperforming loans, compared to $12.66 million, or 0.84% of total loans and 398% of nonperforming loans at December 31, 2016, respectively. We recorded a $500 thousand provision for credit losses for the three months ended March 31, 2017, compared to a $205 thousand provision for credit losses for the three months ended March 31, 2016. The primary factor for the provision in the first quarter of 2017 was to support growth in loan balances. Performing loans past due 31-90 days were 0.09% of total loans at March 31, 2017 compared to 0.03% at December 31, 2016. Nonperforming loans as a percent of total loans were 0.27% at March 31, 2017 compared to 0.21% at December 31, 2016. Accruing substandard loans decreased to 1.94% of total loans at March 31, 2017 compared to 2.12% at December 31, 2016. Net charge-offs for the three months ended March 31, 2017 totaled $38 thousand compared to net charge-offs of $82 thousand for the three months ended March 31, 2016. All of these factors are taken into consideration during Management’s quarterly review of the allowance for loan losses. For a more detailed discussion of our allowance for loan loss and nonperforming assets, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Credit Quality and Allowance for Credit Losses” below.

NONINTEREST INCOME AND EXPENSES

Noninterest Income

Noninterest income for the three months ended March 31, 2017 was $3.26 million, an increase of $338 thousand from the same period in 2016. The increase over the same period in 2016 was due to an increase in other income related to the sales of investment securities in the first quarter of 2017.

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Noninterest Expense

Noninterest expense was $11.95 million for the three months ended March 31, 2017, an increase of $34 thousand from the same period in 2016. Excluding Community Bank System, Inc. merger costs, adjusted noninterest expense was $10.65 million for the three months ended March 31, 2017, a decrease of $846 thousand from the same period in 2016. The decrease in adjusted noninterest expense over the same period in 2016 was due primarily to lower compensation and benefits in 2017. Refer to the “Adjusted Noninterest Expense Non-GAAP Reconciliation” on page 35 for additional information.

Income Taxes

Merchants Bancshares’ effective tax rate was 28.4% for the three months ended March 31, 2017, compared to 23.0% for the three months ended March 31, 2016. The increase over the same period in 2016 was due primarily to an increase in estimated non-deductible merger expenses.

BALANCE SHEET ANALYSIS

Our total assets were $2.02 billion at March 31, 2017, a decrease of $39.11 million from December 31, 2016. The decrease in total assets over the linked quarter was primarily driven by a decrease in investment balances. Average earning assets increased to $1.98 billion for the three months ended March 31, 2017, from $1.89 billion for the three months ended March 31, 2016 primarily due to increased loan balances.

Loans

Average loans for the three months ended March 31, 2017 were $1.54 billion, a $49.18 million, or 3.30%, increase over average loans on a linked quarter basis and an increase of $120.43 million, or 8.49%, over the same period in 2016. Loans at March 31, 2017 were $1.54 billion, a $28.51 million increase from $1.51 billion at December 31, 2016. The increase in loan balances from December 31, 2016 is mainly driven by growth in total commercial and commercial real estate loans.

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


(In thousands)	March 31, 2017		December 31, 2016		March 31, 2016
Commercial, financial and agricultural	$	276,915	$	257,078	$	247,074
Municipal loans		113,875		114,509		105,433
Residential		438,424		447,527		461,009
Commercial Real Estate		672,712		636,755		556,836
Construction		35,964		52,533		42,209
Installment loans		4,813		5,790		9,009
All other loans		15		17		33
Total loans	$	1,542,718	$	1,514,209	$	1,421,603

Totals above are shown net of deferred loans fees of $1.13 million, $1.19 million, and $1.22 million for March 31, 2017, December 31, 2016, and March 31, 2016, respectively.

Investments

The investment portfolio is used to generate interest income, and to manage liquidity and interest rate sensitivity. The average investment portfolio, including FHLB stock, for the first quarter of 2017 was $402.01 million, an increase of $1.51 million from the average balance for the first quarter of 2016. The ending balance in the investment portfolio, including FHLB stock, at March 31, 2017 was $376.02 million, compared to $424.67 million at December 31, 2016. The book

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balance of the portfolio at March 31, 2017 includes an $892 thousand net unrealized loss on the available for sale portion of the investment portfolio, compared to a net unrealized loss of $848 thousand at December 31, 2016.

The composition of our investment portfolio as of March 31, 2017, including both available for sale and held to maturity securities, consisted of the following:


	Amortized		Fair
(In thousands)	Cost		Value
Available for Sale:
U.S. Treasury Obligations	$	10,089	$	10,164
U.S. Government Sponsored Enterprises ("U.S. GSEs")		83,916		83,512
Federal Home Loan Bank ("FHLB") Obligations		67,302		67,050
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		63,919		64,277
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		23,784		23,370
Agency Collateralized Mortgage Obligations ("Agency CMOs")		39,871		39,616
Total Available for Sale	$	288,881	$	287,989
Held to Maturity:
U.S. Agency Obligations	$	16,864	$	16,979
Agency MBSs		5,548		5,649
Agency CMOs		58,579		58,460
Total Held to Maturity		80,991		81,088
Total Securities	$	369,872	$	369,077

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or GNMA with various origination dates and maturities. Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA.

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 basis.

As a member of the Federal Home Loan Bank (“FHLB”) of Boston, we are required to invest in stock of the FHLB in an amount determined based on our borrowings from the FHLB. Our investment in FHLB stock totaled $7.04 million at March 31, 2017 compared to $4.98 million at December 31, 2016. The FHLB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, we have concluded that our investment in FHLB stock is not impaired. We will continue to monitor our investment in FHLB stock.

Deposits and Other Liabilities

Our total deposit balance was $1.51 billion at March 31, 2017, a decrease of $15.79 million from December 31, 2016. Our average deposit balance decreased by $17.96 million to $1.51 billion for the three months ended March 31, 2017 from $1.53 billion from the same period in 2016.

Securities sold under agreement to repurchase, which represent collateralized customer accounts, were $249.58 million at March 31, 2017, an increase of $579 thousand from $249.00 million at March 31, 2016. The average securities sold under agreement to repurchase balance increased to $276.76 million for the three months ended March 31, 2017 from $260.00 million from the same period in 2016. The increase in the first quarter of 2017 is primarily due to an increase in municipal customers.

CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

Recent statistics on the United States economy show continued improvement in the labor market and a Real GDP increase at an annual rate of 1.6% in 2016. Nationwide unemployment rates have declined slightly from at 4.7% at December 31, 2016 to 4.5% at March 31, 2017.

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As of March 31, 2017, the seasonally-adjusted statewide unemployment rates in Vermont and Massachusetts were 3.0% and 3.6%, respectively, both of which were below the national average of 4.5%.

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 composition of the nonperforming pool is dynamic with accounts moving in and out of this category over time.

The following table summarizes our nonperforming loans (“NPL”) and nonperforming assets (“NPA”) as of the dates indicated.



(In thousands)	March 31, 2017		December 31, 2016		March 31, 2016
Nonaccrual loans	$	4,212	$	3,163	$	3,777
Loans past due greater than 90 days and accruing		—		19		—
Troubled debt restructurings (“TDR”)		—		—		864
Total nonperforming loans		4,212		3,182		4,641
OREO		76		76		72
Total nonperforming assets	$	4,288	$	3,258	$	4,713

Nonperforming loans at March 31, 2017 were $4.21 million, including $804 thousand in nonperforming loans acquired from NUVO. Of the $4.21 million in nonperforming loans in the table above there were $2.87 million in commercial and commercial real estate loans and $1.34 million in residential mortgages. Nonperforming loans, as of March 31, 2016 were adjusted $206 thousand for accruing TDRs reflecting the Company’s policy update classifying these loans as performing loans.

Our analysis indicates any additional loss exposure on current non-accruing loans is minimal based on a combination of estimated collateral value and a specific allocation of reserve, where needed.

Excluded from the nonperforming balances discussed above are loans that are 31 to 90 days past due, which are not necessarily considered classified or impaired. Accruing loans 31 to 90 days past due as a percentage of total loans as of the periods indicated are presented in the following table:


Year Ended	31-90 Days
March 31, 2017	0.09	%
December 31, 2016	0.03	%
March 31, 2016	0.28	%
December 31, 2015	0.05	%

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 91 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 non-accruing loans, and all previously accrued and uncollected interest is charged against current income.

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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 non-accruing 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 non-accruing 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 statements of income. Nonperforming loans, which primarily consist of non-accruing residential mortgage, commercial, commercial real estate loans and non-accruing TDRs totaled $4.21 million and $3.18 million at March 31, 2017 and December 31, 2016, respectively. At March 31, 2017, $2.28 million of nonperforming loans had specific reserve allocations totaling $252 thousand.

Substandard loans at March 31, 2017 totaled $34.10 million, of which $29.88 million in loans continue to accrue interest. 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.

Accruing substandard loans at March 31, 2017 reflect a $2.19 million decrease in balances since December 31, 2016. At March 31, 2017, accruing substandard loans related to owner-occupied commercial real estate totaled $11.73 million, investor commercial real estate loans totaled $1.05 million, residential investment real estate loans totaled $25 thousand, and $17.08 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Seventeen borrowers in a variety of industries account for 92% of the total accruing substandard loans.

To date, with very few exceptions, 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 and standby letters of credit. The reserves are based on Management's estimate of the amount required to reflect the probable incurred losses in the loan portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the reserves quarterly. Factors considered in evaluating the adequacy of the reserves

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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, estimated fair values of properties that secure impaired loans and utilization rates of lines of credit.

The adequacy of the reserves are 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 adjusted for qualitative factors 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. Management believes that the reserves are 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 loan losses for the periods indicated:


	Three Months			Twelve Months			Three Months
	Ended			Ended			Ended
(In thousands)	March 31, 2017			December 31, 2016			March 31, 2016
Average loans during the period	$	1,538,136		$	1,446,443		$	1,417,710
Allowance beginning of the period		12,659			12,040			12,040
Charge-offs:
Commercial, financial & agricultural		(3)			(125)			(3)
Residential		—			(215)			(73)
Commercial Real Estate		—			—			—
Installment, Other		(69)			(168)			(42)
Total charge-offs		(72)			(508)			(118)
Recoveries:
Commercial, financial & agricultural		2			5			2
Residential		9			35			11
Commercial Real Estate		—			4			4
Construction		—			—			—
Installment, Other		23			83			19
Total recoveries		34			127			36
Net charge-offs		(38)			(381)			(82)
Provision for loan losses		566			1,000			215
Allowance end of period	$	13,187		$	12,659		$	12,173
Ratio of net charge-offs to average loans outstanding		(0.01)	%		(0.03)	%		(0.02)	%

Components:
Provision for allowance for loan losses	$	566		$	1,000		$	215
Provision for reserve for undisbursed lines and letters of credit		(66)			105			(10)
Provision for credit losses	$	500		$	1,105		$	205

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


	March 31, 2017		December 31, 2016		March 31, 2016
NPL to total loans	0.27	%	0.21	%	0.33	%
NPA to total assets	0.21	%	0.16	%	0.24	%
Allowance for loan losses to total loans	0.85	%	0.84	%	0.86	%
Allowance for loan losses to NPL	313	%	398	%	262	%

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 loan officers 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 lenders. 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 $5 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 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.

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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 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 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, construction and residential loan portfolios. The commercial loan review firm reviews a minimum threshold 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 FHLB, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan 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 March 31, 2017, we could borrow up to $55 million in overnight funds through unsecured borrowing lines established with correspondent banks. In addition, we have established both overnight and longer term lines of credit with the FHLB. These borrowings are secured by residential mortgage loans. At March 31, 2017, we pledged loans with a carrying value of $366.32 which carried a $258.82 million borrowing capacity at the FHLB, less borrowings and letters of credit of $98.56 million, resulting in quarter-end capacity of $160.26 million. At December 31, 2016, we pledged loans with a carrying value of $363.55 million which carried a $256.98 million borrowing capacity at the FHLB, less borrowings and letters of credit of $62.06 million, resulting in year-end capacity of $194.92 million. We also have the ability to borrow through the use of repurchase agreements, collateralized by our investments, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, had a carrying amount of $368.98 million at March 31, 2017, of which $328.27 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 Federal Reserve Bank, or are in a fully insured account with one of our correspondent banks.

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Presented below are our short-term borrowings during the periods indicated:


	Three Months Ended			Three Months Ended
(Dollars in thousands)	March 31, 2017			December 31, 2016
FHLB and other short-term borrowings
Amount outstanding at end of period	$	75,000		$	40,000
Maximum during the period amount outstanding		114,000			40,000
Average amount outstanding		72,789			13,380
Weighted average-rate during the period		0.77	%		0.49	%
Weighted average rate at period end		0.96	%		0.77	%
Securities sold under agreement to repurchase, short-term
Amount outstanding at end of period	$	249,582		$	312,118
Maximum during the period amount outstanding		312,117			334,023
Average amount outstanding		276,755			288,343
Weighted average-rate during the period		0.22	%		0.19	%
Weighted average rate at period end		0.22	%		0.20	%

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 $6.77 million and $5.95 million at March 31, 2017 and December 31, 2016, 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 March 31, 2017 and December 31, 2016 was insignificant.

Capital Resources

Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel Committee on Banking Supervision's capital guidelines for U.S. banks (Basel III rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under the Basel III rules, the Company must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2017 is 1.25%. The net unrealized gain or loss on available for sale securities is not included in computing regulatory capital. Management believes as of March 31, 2017, the Company and the Bank meet all capital adequacy requirements to which they are subject.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At March 31, 2017, the most recent regulatory notifications categorized the Bank as well capitalized under the

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regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution's category.

The following table summarizes Merchants’ and Merchants Bank’s capital ratios in comparison to the regulatory requirements:


									To Be Well-
									Capitalized Under				Fully Phased-in,
	Actual				For Capital				Prompt Corrective				with Capital
	March 31, 2017				Adequacy Purposes				Action Provisions				Conservation Buffers
(In thousands)	Amount		Percent		Amount		Percent		Amount		Percent		Amount			Percent
Merchants Bancshares, Inc.:
Leverage capital	$	175,991	8.63	%	$	81,614	4.00	%		N/A	N/A		$	81,614	(1)	4.00	%
Tier 1 risk-based capital		175,991	13.96	%		75,615	6.00	%		N/A	N/A			107,121		8.50	%
Total risk-based capital		190,132	15.09	%		100,820	8.00	%		N/A	N/A			132,326		10.50	%
Common Tier 1 equity		155,991	12.38	%		56,711	4.50	%		N/A	N/A			88,218		7.00	%

Merchants Bank:
Leverage capital	$	172,285	8.42	%	$	81,856	4.00	%	$	102,320	5.00	%	$	81,856	(1)	4.00	%
Tier 1 risk-based capital		172,285	13.63	%		75,853	6.00	%		101,137	8.00	%		107,458		8.50	%
Total risk-based capital		186,426	14.75	%		101,137	8.00	%		126,421	10.00	%		132,742		10.50	%
Common Tier 1 equity		172,285	13.63	%		56,890	4.50	%		82,174	6.50	%		88,495		7.00	%

(1) Capital conservation buffer does not directly affect the required leverage ratio. Institutions must still maintain the required ratio for capital adequacy purposes.

Capital amounts for Merchants Bancshares, Inc. include $20.62 million in trust preferred securities issued in December 2004. These hybrid securities qualify as Tier 2 capital up to certain regulatory limits.

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Item 3 – Quantitative and Qualitative Disclosures about Market Risk

Risk Management

General

Our Management and Board of Directors are committed to sound risk management practices throughout the organization. We have developed and implemented a 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 us 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 Act and the Sarbanes-Oxley Act of 2002.

Effective May 26, 2016, the Bank’s Board of Directors established the Enterprise Risk Management Committee. The Enterprise Risk Management Committee assists the Board in oversight of the Bank’s enterprise-wide risk management framework and associated policies and practices, risk profile and risk appetite and tolerance, and regulatory compliance program.

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. 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 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. The Investment Policy also establishes specific investment quality limits. Our Board of Directors has established a Board-level Asset/Liability Committee (“ALCO”), which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset/Liability Committee (the “Management ALCO”). The Management 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 Management ALCO manages the investment portfolio. As the portfolio has grown, the Management ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. We continued to work to maximize net interest income while mitigating risk during the year through further repositioning of the investment portfolio, selective sales of specific securities, as well as carefully monitoring the overall duration and average life of the portfolio, and monitoring individual securities, among other strategies.

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, on- and off-balance sheet, which can be accessed quickly in time of need. As discussed above under Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resource Management,” 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. Our liquidity monitoring process identifies early liquidity stress triggers, and also allows us to model worst case liquidity scenarios, and various responses to those scenarios.

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Interest Rate Risk

Interest rate risk is the exposure to a movement in interest rates, which, as previously described, affects our net interest income. Asset and liability management is governed by policies reviewed and approved annually by Merchants Bank’s Board of Directors. The ALCO meets frequently to review and develop asset/liability management strategies and tactics.

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of 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 by using a combination of on-balance sheet and off-balance sheet strategies. On-balance sheet strategies generally consist of 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 and average lives of loans and the pricing and maturity of deposits. We also use off-balance sheet strategies, such as interest rate swaps and interest rate caps and floors, to help minimize our exposure to changes in interest rates. By using derivative financial instruments to hedge exposures to changes in interest rates we are exposed 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, creating credit risk. We minimize 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 Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The investment advisory firm and ALCO consultant meet collectively 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 investment advisor reports on the overall performance of the portfolio and performs modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios; and also reviews and provides detail on individual holdings in the portfolio.

The ALCO consultant’s most recent review was as of March 31, 2017. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and a 200 basis point flat up scenario, because rates continue to be very low. The consultant also ran a 100 basis point falling interest rate scenario that assumed a parallel and pro rata shift of the yield curve over a one-year period, with no growth assumptions. Additionally, the consultants ran a 400 basis point rising simulation that assumed a parallel shift of the curve over 24 months which assumed the increase in rates was delayed by two years. A summary of the results is as follows:

Current/Flat Rates: If market rates remain unchanged, NII is projected to trend marginally upward through the simulation as asset yields are maintained (due to the aforementioned higher assumed asset replacement yields) while the assumed funding cost remains relatively stable.

Falling Rates: Should market rates decline (e.g. -100 basis points over 12 months), NII is projected to trend downward and below the Current Rates scenario throughout the simulation as the earning asset base resets into the low rate environment (accelerated by faster assumed prepayment speeds) while funding cost relief is minimal as actual and implied floors are quickly met.

Rising Rates: As a result of the composition of the Bank’s balance sheet (strong core funding base supporting a shorter-term loan portfolio), the Bank’s asset sensitive posture results in NII levels beginning above the Current/Flat Rates scenario and trending upwards for the life of the simulation in all ramped, rising rate scenarios tested, regardless of the shape of the yield curve or the duration in which market rates rise. It should be noted a flattening yield curve results in less benefit when compared to a parallel shift, as assets tied to the longer end of the curve do not reset with the same incremental spread as in a parallel curve.

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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 March 31, 2017 showed that the change in net interest income for the next 12 months from our expected or “most likely” forecast was as follows:


	Percent Change in Net
Rate Change	Interest Income
Up 200 basis points	0.09	%
Down 100 basis points	(3.39)	%

The change in net interest income in the second year of the simulation shows a more pronounced downward trend of (10.75)% in the down 100 basis points scenario, while the flat scenario shows a change of 0.93% and the up 200 basis points simulation produces an increase of 6.18%. 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.

Actual results may differ materially from those projected. The analysis assumes a static balance sheet. All rate changes are ramped over a 12 month time horizon based upon a parallel yield curve shift. In the down 100 basis points scenario, Federal funds and Treasury yields are floored at 0.01% while Prime is floored at 3.00% to maintain 20 year historical spread (300 basis points) to Fed funds. All other market rates (e.g. LIBOR, FHLB and Brokered CD) are floored at the lesser of either the current rate or 0.25% to reflect credit spreads. The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over 12 months and reprices every interest-bearing asset and liability on our balance sheet. The model incorporates product specific loan prepayment assumptions and uses contractual repricing dates for variable rate loan products and contractual maturities for fixed rate products. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions. The model uses the Yield Book, Inc. system to analyze the investment portfolio, which produces bond specific cash flow forecasts for each rate scenario tested in the analysis. The analysis details bond maturity, amortization, repricing characteristics, and optionality. The cash flow forecasts take into consideration assumptions for absolute rate movements, the period over which rates are assumed to shift and assumed changes in the shape of the yield curve. The model also assumes that the rate at which residential mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from Applied Financial Technologies.

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 without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. 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.

The most significant ongoing factor affecting market risk exposure of net interest income during the quarter ended March 31, 2017 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.

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 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

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is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 91 or more days and the ultimate collectability of principal or interest become doubtful. In certain instances the accrual of interest is discontinued prior to 91 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, interim 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 interim 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 interim 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 March 31, 2017 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

We are involved in various legal proceedings arising from our normal business activities. In the opinion of Management, based upon input from counsel on the anticipated outcome of such proceedings, final disposition of these proceedings will not have a material adverse effect on our consolidated financial position.

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, 2016 filed with the SEC on March 15, 2017, 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.

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

None.

Item 3 – Defaults on Senior Securities

None.

Item 4 – Mine Safety Disclosure

Not applicable.

Item 5 – Other Information

None.

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PART IV

Item 6 – Exhibits

The following exhibits are either filed or attached as part of this report, or are incorporated herein by reference:


Exhibit		Description

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 March 31, 2017 formatted in XBRL: (i) Consolidated Balance Sheets at March 31, 2017 and December 31, 2016; (ii) Consolidated Statements of Income for the three months ended March 31, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income for the three months ended March 31, 2017 and 2016; (iv) Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and 2016; and (v) Notes to Interim Unaudited Consolidated Financial Statements.*

+ Management contract or compensatory plan or agreement

* Filed herewith

** Furnished herewith

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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/ Geoffrey R. Hesslink
		Geoffrey R. Hesslink President and Chief Executive Officer

		/s/ Richard M. Donovan
		Richard M. Donovan Interim Principal Financial Officer, Principal Accounting Officer and Treasurer

		April 28, 2017
		Date

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