VAIL BANKS INC - 10-K Annual Report

Securities registered pursuant to Section 12(g) of the Act: Common stock, $1.00 par value per share.

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 ý No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o No ý

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter: As of June 30, 2004, 5,326,330 shares of common stock, $1.00 par value, were issued and outstanding with an aggregate value of $37,836,471 held by non-affiliates (based on market value of $12.44 per share) (computed by reference to the price at which the common stock was sold.)

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: As of February 28, 2005, there were issued and outstanding 5,357,524 shares of common stock.

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held May 16, 2005, are incorporated by reference into Part III.

Vail Banks, Inc. (Vail Banks) is a bank holding company headquartered in Avon, Colorado with consolidated assets of $634.6 million at December 31, 2004. The accompanying consolidated financial statements include the accounts of Vail Banks and its wholly-owned subsidiary, WestStar Bank. WestStar and Vail Banks own a combined 54.04% interest in Avon 56 Limited and 74.42% of Glenwood/Rose L.P. Both Avon 56 Limited and Glenwood/Rose L.P. are real estate partnerships. All entities are collectively referred to as the Company. All significant intercompany balances and transactions have been eliminated in consolidation. The Company's two trusts that had been previously consolidated with the Company are now reported separately, in accordance with Financial Interpretation No. 46 (Revised), Consolidation of Variable Interest Entities (FIN 46R).

WestStar is a Colorado state bank with 23 retail offices located primarily in the "Western Slope" and "Front Range" regions of Colorado. It was formed in 1977 as a community bank to serve the local residents and businesses of Vail. In 1993, Vail Banks was formed as a bank holding company for WestStar. Since that time, Vail Banks has grown through a combination of internal growth, de novo establishment of retail offices and external growth, including the acquisition of community banks. Vail Banks has maintained WestStar's position as an institution offering a relatively broad range of convenient banking services delivered with personalized customer service.

The "Western Slope," includes Summit County (which includes the Breckenridge, Keystone and Copper Mountain ski resorts), Grand County (which includes the Winter Park ski resort), Eagle County (which includes the Vail and Beaver Creek ski resorts), Delta County, Garfield County, Pitkin County (which includes the Aspen and Snowmass ski resorts), Mesa County, Montrose County, and San Miguel County (which includes the ski resort of Telluride). The "Front Range" includes Denver and Estes Park. These areas of Colorado are home to a variety of commercial, recreational, entertainment, and cultural enterprises.

The Western Slope has experienced growth in past years, primarily as a result of an expanding market for first and second homes, and summer and winter tourism. As the year-round population of this region has grown, local businesses have prospered by servicing this growth. Consequently, a large portion of Vail Banks' business is in construction lending and providing banking services for small-to-medium size businesses in its markets. To meet the growing needs of its customers and to prepare for future growth, Vail Banks has developed a strong infrastructure by expanding its computer technology and centralizing certain administrative, processing, accounting and other operational functions.

Vail Banks' growth has been designed to maintain customer loyalty through continuity of operations and associates. Historically, shareholders of entities merged into Vail Banks, who are typically members of the local community, have elected to hold ownership stakes in Vail Banks after the merger. The additions of Bank of Telluride (founded in 1969), Western Colorado Bank (founded in 1950), Glenwood Independent Bank (founded in 1955) and United Valley Bank (founded in 1908) expanded Vail Banks' presence in the Western Slope and Front Range markets, as these were well-established community banks that had significant local sponsorship. Several directors of the Company, as well as both its Non-Executive Chairman and Vice Chairman, have been associated with WestStar for more than fifteen years.

On August 1, 2004, First Western Mortgage Services, Inc. (First Western), a retail mortgage lending company, was merged into WestStar. The merger did not have an impact on the consolidated financial condition or results of operations of the Company as First Western was previously owned 100% by WestStar and was included in the consolidated financial statements of the Company.

In 2003, the Company opened a new business office in the Tech Center area of Denver in order to expand its Denver and Front Range presence. Additionally, in 2004, the Company opened a new business office in the Stapleton area of Denver.

WestStar provides a relatively broad range of banking products and services to consumers and businesses in all of its retail offices. Retail offices are operated with the goal of offering individualized customer service and providing superior financial services. Many administrative operations, such as data processing, loan administration, account reconciliation and maintenance, accounting, compliance and broad policy decisions are centralized to ensure consistency, accuracy and efficiency and to allow our associates to concentrate on providing superior customer service. The managers and associates of each retail office focus on day-to-day customer service, business development and selling. Management of Vail Banks believes that this organizational structure allows retail offices to offer the individualized customer service of a community bank while maximizing the benefits of technological expertise, operating synergies and other administrative cost savings and efficiencies.

Management is committed to investing in its communities. Executive officers and regional presidents live in the communities served by their retail offices, and Vail Banks encourages board members and Company associates to be actively involved in civic and public service activities in their communities.

Vail Banks intends to enhance and solidify its position as a major provider of banking services for individuals and small-to-medium size businesses on the Western Slope and the Front Range. The Company believes that it will grow in the future primarily through expansion of its existing market share and de novo establishment of retail offices. From December 1995 to December 2004, Vail Banks completed eight mergers and acquisitions and opened nine de novo offices.

Expansion of Existing Market Share. Vail Banks intends to increase its overall market share in its markets by solidifying relationships with current customers and attracting new customers who desire a local banking relationship. Management believes that this can be accomplished by (1) evaluating the needs of its existing and potential customers to determine ways to enhance services and products, (2) increasing the focus on sales training and motivating its associates, (3) providing personalized customer service, and (4) further implementing technological advances to make banking more efficient and convenient.

De Novo Establishment of Retail Offices. Vail Banks intends to continue to expand by opening new retail offices. Management believes that initially establishing a small presence in growing communities positions Vail Banks to expand with the community, thereby fostering a local identity with existing businesses and consumers in these communities, as well as offering new customers an alternative to impersonal, institutional banks. Additionally, management has committed to establishing additional banking locations to expand its presence in the Front Range and Grand Junction markets. Such offices will be opened as market opportunities and availability of banking talent dictate.

Mergers and Acquisitions. Vail Banks' merger and acquisition strategy will be a secondary approach for growth opportunities. In assessing future mergers, Vail Banks will focus primarily on credit quality, financial performance, market share, management, location, community demographics, strength of the local economy, potential merger synergies and the terms of the transaction. Management believes that merging with established banks and then methodically integrating their operations into Vail Banks allows the Company to offer its relatively broad range of products and services while maintaining the merged bank's reputation and community ties. Vail Banks' strategy is to

streamline operations judiciously to optimize the balance between cost savings and minimizing the interruption of community-based services of the acquired bank.

Segment information is presented in accordance with Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information. This standard is based on a management approach that requires segmentation based on the Company's internal organization and internal monitoring of operations. During 2004, 2003 and 2002, the Company had two reportable segments, banking and mortgage origination. The banking segment's principal source of income is the net spread between the interest earned on loans and investment securities and the interest cost associated with the deposits and borrowings used to finance such loans and investments. The mortgage origination segment originates mortgage loans and sells them to investors in the secondary market. Its principal source of income is the origination and processing fees. These two segments are strategic business units that offer different products and services. They are managed separately because each segment appeals to different markets and accordingly, requires different technology and marketing strategies.

Information about reportable segments and reconciliation of such information to the consolidated financial statements as of, and for the years ended, December 31, 2004, 2003, and 2002 is contained in "Notes to Consolidated Financial Statements—Note 24" contained in Item 15 of this Annual Report on Form 10-K. The accounting policies of the segments are the same as those described in the summary of significant accounting policies contained in "Notes to Consolidated Financial Statements—Note 1" contained in Item 15 of this Annual Report on Form 10-K. Management evaluates the performance of each segment based on profit or loss from operations. Certain administrative costs, however, are borne by the banking segment and are not allocated to the mortgage origination segment. Accordingly, the information presented is not necessarily indicative of the segments' financial condition and results of operations had each been operating as independent entities.

Parent company financial information is deemed to represent an overhead function rather than an operating segment. Also included in this category are expenses related to the guaranteed preferred beneficial interests in Vail Banks' subordinated debentures (trust preferred securities).

WestStar serves the banking needs of its business and consumer customers by providing a relatively broad range of commercial and consumer banking products and services in all of its communities. These products and services include short-term and medium-term loans, revolving credit facilities, accounts receivable financing, equipment financing, short-term commercial mortgage lending and mortgage broker services, installment loans, home equity loans, home improvement loans, short-term loans for the purchase or refinancing of principal residences or second homes, personal banking through internet and telephone access, safe deposit box services and various savings accounts, money market accounts, time certificates of deposit and checking accounts, automated teller machines, depository services, corporate cash management services and repurchase agreements. WestStar also originates mortgage loans and sells them to investors in the secondary market.

Lending. WestStar offers loans for business and consumer purposes and focuses its lending activities on individuals and small-to-medium size businesses. Lending activities are funded primarily from deposits gathered in the local communities. Loan products are concentrated in relatively short-term, variable rate loans, with 37% of the loans at December 31, 2004 having remaining terms of less than one year. Collateral for loans is concentrated in real estate and operating business assets. WestStar also offers an array of residential mortgage products.

Deposits. WestStar offers a relatively broad range of depository products including checking, savings and money market accounts, and certificates of deposit. Deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to statutory limits. Within ranges set by policies determined by WestStar's executive management, regional presidents have local authority to determine the type, mix and pricing of the depository products offered to best compete in a retail office's particular marketplace. Additionally, because many of WestStar's markets are located in resort areas, deposits tend to trend upward during the ski season. However, increases in deposits in non-resort markets have reduced the overall impact of such seasonality.

Other Services. WestStar offers its customers the flexibility of monitoring their loan and deposit account activity and conducting some banking transactions, including on-line bill pay and the receipt of electronic statements 24 hours a day from their homes or businesses via www.weststarbank.com on the internet. Additionally, telephone access allows customers to receive current account balances, deposit status, checks paid, withdrawals made, loan status, loan amounts due and other specifics relating to services provided by WestStar.

As of February 28, 2005, WestStar had 19 automated teller machines, 15 that were located at WestStar's retail offices and 4 at other locations.

The banking business is highly competitive and the profitability of WestStar depends principally upon its ability to compete in its markets. WestStar's banking segment competes with other banks, savings institutions, credit unions, finance companies, brokerage and investment banking firms, insurance companies, asset-based lenders and certain other nonfinancial institutions, including retail stores that offer credit programs and governmental organizations that offer financing programs. WestStar's mortgage segment competes with both retail and internet mortgage brokers. Many competitors of WestStar have greater financial resources, greater name recognition and more offices than WestStar. Some of these entities and institutions are not subject to the same regulatory restrictions as WestStar. WestStar believes it has been able to compete effectively with its competitors by emphasizing customer service, technology and local decision-making, by establishing long-term customer relationships and building customer loyalty, and by providing products and services designed to address the specific needs of its customers.

The factors affecting competition include banking and financial services provided, customer service and responsiveness, customer convenience and office location. Vail Banks believes that WestStar will continue to compete successfully in the communities in which it operates and that its competitive strengths include its reputation for developing and retaining banking relationships, responsiveness to customer needs and individualized customer service, and skilled, resourceful associates. Vail Banks believes that large, institutional banks cannot or are unwilling to offer a high level of individualized customer service, and that WestStar's customers and potential customers choose to bank with WestStar to take advantage of this attention while also receiving products and services at competitive prices. Vail Banks further believes that the community commitment and involvement of its associates and its commitment to providing quality financial services are factors that should allow it to continue to maintain and improve its competitive position.

The retail offices are customer-focused. Regional presidents operate with significant customer service-oriented local autonomy within policies established by WestStar's Board of Directors in providing financial services, making lending decisions, selling products and presenting a favorable impression of WestStar to the community in order to attract new customers and retain existing ones.

Administrative services, oversight and support to the retail offices, including data processing, accounting services, investments, credit policy formulation, loan administration, a customer service center, internet banking support, other customer service assistance, and audit and compliance review are centralized at the Vail Banks' administrative center in Gypsum.

Management believes that by standardizing products, services and systems, and providing appropriate centralized support, retail office associates can concentrate on customer service and community relations. Management also believes that continued centralization of services benefits the individual retail offices by lowering expenses of administration and data processing services, streamlining credit administration and supervision, and facilitating compliance with the requirements of complex banking regulations. Vail Banks believes that autonomy at the retail office level allows its banking subsidiary to better serve customers in their respective communities, and thus enhances business opportunities and operations.

Vail Banks' use of advanced technology enables it to offer customers fast, efficient services and connects all of WestStar's associates with on-line access to information concerning all customer account data. Additionally, advanced hardware and software have been installed that allow images to be taken of all items (checks, deposit tickets and payments). Once processed, the images are simultaneously associated with the appropriate customer's account, where they are stored and retrieved to be printed with customer statements or delivered to the customer in the form of an electronic statement. An imaging system also allows, via a data network, instant access at all retail offices to loan files, customer signature cards and other data that was previously available only at the administrative center or the originating retail office. Vail Banks believes that its technology platform is among the most advanced for banks of its size in Colorado and provides it with the resources to continue to offer leading-edge services to customers.

As of February 28, 2005, the Company employed 245 persons, 238 on a full-time basis and 7 on a part-time basis. The Company is not a party to any collective bargaining agreement, and believes that its employee relations are good.

The following discussion of statutes and regulations affecting bank holding companies and banks is a summary thereof and is qualified in its entirety by reference to such statutes and regulations. This explanation does not purport to describe state, federal or NASDAQ National Market supervision and regulation of general business corporations or NASDAQ listed companies.

General. Vail Banks is a registered bank holding company subject to regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the Act). Vail Banks is required to file financial information with the Federal Reserve periodically and is subject to periodic examination by the Federal Reserve.

The Act requires every bank holding company to obtain the Federal Reserve's prior approval before (1) it may acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank that it does not already control; (2) it or any of its non-bank subsidiaries may acquire all or substantially all of the assets of a bank; and (3) it may merge or consolidate with any other bank holding company. In addition, a bank holding company is generally prohibited from engaging in, or acquiring, direct or indirect control of the voting shares of any company engaged in non-banking activities. This prohibition does not apply to activities listed in the Act or found by the Federal Reserve, by order or regulation, to be closely related to banking or managing or controlling banks as to

be a proper incident thereto. Some of the activities that the Federal Reserve has determined by regulation or order to be closely related to banking include:

Although the activities of bank holding companies have traditionally been limited to the business of banking and activities closely related or incidental to banking, the Gramm-Leach-Bliley Act (the GLB Act) relaxed the previous limitations, permitting bank holding companies to engage in a broader range of financial activities. Specifically, bank holding companies may now elect to become financial holding companies that may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. Among the activities that are deemed "financial in nature" are:

A bank holding company may become a financial holding company under this statute only if each of its subsidiary banks is well capitalized, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. A bank holding company that falls out of compliance with such requirements may be required to cease engaging in certain activities. Any bank holding company that does not elect to become a financial holding company remains subject to the current restrictions of the Bank Holding Company Act.

Under this legislation, the Federal Reserve Board serves as the primary "umbrella" regulator of financial holding companies with supervisory authority over each parent company and limited authority over its subsidiaries. The primary regulator of each subsidiary of a financial holding company will depend on the type of activity conducted by the subsidiary. For example, broker-dealer subsidiaries will be regulated largely by securities regulators and insurance subsidiaries will be regulated largely by insurance authorities.

The Sarbanes-Oxley Act of 2002 was adopted to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to securities laws. The Sarbanes Oxley Act includes additional disclosure requirements and new corporate

governance rules, requires the Securities and Exchange Commission (SEC) and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between the board of directors and committees. The SEC extended the compliance deadline for non-accelerated filers to the first fiscal year ending on or after July 15, 2006. This is a one-year extension from the previously established July 15, 2005, compliance date for non-accelerated filers.

On October 28, 2004, President Bush signed into law the Check Clearing for the 21^st Century Act (Check 21). Check 21 is intended to improve the efficiency and security of the nation's payment system. Financial institutions will have the option of processing images of checks rather than transporting the original check. WestStar Bank has been utilizing check images for years and is currently evaluating and making recommendations for the implementation of Check 21.

Vail Banks must also register with the Colorado Division of Banking (CDB) and file periodic information with the CDB. As part of such registration, the CDB requires information with respect to, among other matters, the financial condition, operations, management and intercompany relationships of Vail Banks and its subsidiary. The CDB may also require such other information as is necessary to ascertain whether the provisions of Colorado law and the regulations and orders issued thereunder by the CDB have been complied with, and the CDB may examine Vail Banks and its subsidiary.

Vail Banks is an "affiliate" of its banking subsidiary under the Federal Reserve Act, which imposes certain restrictions on (1) loans by WestStar to Vail Banks, (2) investments in the stock or securities of Vail Banks by its banking subsidiary, (3) its banking subsidiary's taking the stock or securities of an "affiliate" as collateral for loans by it to a borrower and (4) the purchase of assets from Vail Banks by its banking subsidiary. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

WestStar is a member of the Federal Reserve System and is subject to the supervision of and is regularly examined by the Federal Reserve. Furthermore, WestStar, as a state banking association organized under Colorado law, is subject to the supervision of, and is regularly examined by, the CDB. Both the Federal Reserve and the CDB must grant prior approval of any merger, consolidation or other corporate reorganization involving WestStar. A bank can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of a commonly controlled institution.

Payment of Dividends. Vail Banks is a legal entity separate and distinct from WestStar. Most of the revenues of Vail Banks result from dividends paid to it by WestStar. There are statutory and regulatory requirements applicable to the payment of dividends by WestStar, as well as by Vail Banks to its shareholders.

Under the regulations of the CDB and the Federal Reserve, approval of the regulators will be required if the total of all dividends declared by WestStar in any calendar year exceed the total of its net profits of that year combined with its retained net profits of the preceding two years, less any required transfers to surplus or fund for the retirement of any preferred stock.

The payment of dividends by Vail Banks and WestStar may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. In addition, if, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending upon the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and

hearing, that such bank cease and desist from such practice. Capital adequacy considerations could further limit the availability of dividends. Due to the volume of dividends paid relative to earnings in earlier years, any dividend payments from WestStar to Vail Banks currently require prior regulatory approval. Management believes that approval will be granted as long as WestStar maintains its well-capitalized regulatory status.

Monetary Policy. The results of operations of WestStar are affected by credit policies of monetary authorities, particularly the Federal Reserve. The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. government securities, changes in the discount rate on bank borrowings and changes in reserve requirements against bank deposits. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of Vail Banks' banking subsidiary.

Capital Adequacy. The Federal Reserve and the FDIC have implemented substantially identical risk-based rules for assessing bank and bank holding company capital adequacy. These regulations establish minimum capital standards in relation to assets and off-balance sheet exposures as adjusted for credit risk. Banks and bank holding companies are required to have (1) a minimum level of total capital (as defined) to risk-weighted assets of 8%; (2) a minimum Tier 1 capital (as defined below) to risk-weighted assets of 4%; and (3) a minimum shareholders' equity to risk-weighted assets of 4%. In addition, the Federal Reserve and the FDIC have established a minimum 4% leverage ratio (Tier 1 capital to average assets) for all but the most highly rated banks and bank holding companies. "Tier 1 capital" generally consists of common equity not including unrecognized gains and losses on securities, minority interests in equity accounts of consolidated subsidiaries and certain perpetual preferred stock, less certain intangibles. The Federal Reserve and the FDIC use the leverage ratio in tandem with the risk-based ratio to assess the capital adequacy of banks and bank holding companies. The FDIC's and the Federal Reserve's capital adequacy standards also provide for the consideration of interest rate risk in the overall determination of a bank's capital ratio, requiring banks with greater interest rate risk to maintain greater capital for the risk.

In addition, the FDIC regulations and Federal Reserve "prompt corrective action" provisions, designed to efficiently resolve failing financial institutions, set forth five regulatory zones in which all banks are placed largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank's financial condition declines. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank's capital leverage ratio reaches 2%. Better-capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser capital ratios.

The FDIC and the Federal Reserve regulations requiring implementation of "prompt corrective action" place financial institutions in the following five categories based on capitalization ratios (1) a "well capitalized" institution has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and a leverage ratio of at least 5%; (2) an "adequately capitalized" institution has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a leverage ratio of at least 4%; (3) an "undercapitalized" institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a "significantly undercapitalized" institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based capital ratio of under 3% or a leverage ratio of under 3%; and (5) a "critically undercapitalized" institution has a leverage ratio of 2% or less. Institutions in any of the three undercapitalized categories are prohibited from declaring dividends or making capital distributions without regulatory approval. The Federal Reserve regulations also establish procedures for "downgrading" an institution to a lower capital category based on supervisory factors other than capital.

Under the Federal Reserve's regulations, both Vail Banks and WestStar met all capital adequacy requirements to which they were subject at December 31, 2004. Vail Banks had Tier 1 and total risk-based capital ratios of 10.37% and 12.05%, respectively, and a leverage ratio of 8.01%. WestStar was deemed to be "well capitalized" with Tier 1 and total risk-based capital ratios of 10.28% and 11.14%, respectively, and a leverage ratio of 7.93%. For further information, see "Notes to Consolidated Financial Statements—Note 19" contained in Item 15 of this Annual Report on Form 10-K.

Loans. Inter-agency guidelines adopted by federal bank regulators mandate that financial institutions establish real estate lending policies with maximum allowable real estate loan-to-value limits, subject to an allowable amount of non-conforming loans as a percentage of capital. WestStar adopted the federal guidelines as its maximum allowable limits; however, policy exceptions are permitted, with justification, for real estate loan customers.

Transactions with Affiliates. Under federal law, all transactions between and among Federal Reserve member banks and its affiliates, which include holding companies, are subject to Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated thereunder. Generally, these requirements limit these transactions to a percentage of the bank's capital and require all of them to be on terms at least as favorable to the bank as transactions with non-affiliates. In addition, a bank may not lend to any affiliate engaged in non-banking activities not permissible for a bank holding company or acquire shares of any affiliate that is not a subsidiary. The Federal Reserve may impose additional restrictions on transactions with affiliates if necessary to protect the safety and soundness of a bank. The regulations also set forth various reporting requirements relating to transactions with affiliates.

Financial Privacy. In accordance with the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

Anti-Money Laundering Initiatives and the USA Patriot Act. A major focus of governmental policy on financial institutions in recent years has been aimed at combating terrorist financing. This has generally been accomplished by amending existing anti-money laundering laws and regulations. The USA Patriot Act of 2001 (the USA Patriot Act) imposed significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued a number of implementing regulations that apply the requirements of the USA Patriot Act to the Company. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution. Compliance with the USA Patriot Act requires WestStar to engage in additional record keeping and reporting, to obtain identification of account owners and to restrict or prohibit certain correspondent accounts.

Certain information regarding the executive officers and Non-Executive Chairman of the Company is set forth in the following table and paragraphs.

Name	Age	Position
E.B. Chester, Jr.	62	Non-Executive Chairman of the Board
Lisa M. Dillon	51	Vice Chairman of the Board
Gary S. Judd	64	President and Chief Executive Officer
Raymond E. Verlinde	42	Principal Financial and Accounting Officer Senior Executive Vice President and Chief Administrative Officer of WestStar Bank
Dan E. Godec	49	President and Chief Executive Officer of WestStar Bank
Paul M. Ferguson	51	Senior Executive Vice President and Chief Credit Officer

Mr. Chester has served as Chairman of the Board of Directors of Vail Banks since 1993 and the Chairman of the Board of Directors of WestStar since 1989. From May 2003 to January 2004, Mr. Chester served as Interim Chief Executive Officer of the Company. Mr. Chester became the Non-Executive Chairman in December 2004.

Ms. Dillon has served as Vice Chairman of Vail Banks since July 2000. Ms. Dillon began working with WestStar in 1979, served as President of Vail Banks from 1993 until January 2004, President of WestStar from 1989 to 1999 and has served as a director of WestStar since 1989.

Mr. Judd became a director of Vail Banks in May 2003. He was elected as President and Chief Executive Officer of Vail Banks in January 2004, and previously served as a Division President and President, Regional Operations, of WestStar since May 2003. Mr. Judd co-founded Vectra Bank in Colorado in 1989 and served as its President until January 2000. From 2000 to 2002, Mr. Judd was President and Chief Executive Officer of Metyor, Inc. Mr. Judd also spent 16 years with Citibank, N.A. in management positions in the United States and overseas.

Mr. Verlinde has served as the Senior Executive Vice President and Chief Administrative Officer of WestStar Bank since August of 2004. Mr. Verlinde has also been the acting Principal Financial and Accounting Officer for Vail Banks since August 2004. Mr. Verlinde initially joined WestStar Bank in March 2002 as the Executive Vice President, Director of Internal Auditing and Compliance. Mr. Verlinde left WestStar Bank in August 2003 to join Fidelity Investments as Vice President of Internal Audit. Mr. Verlinde also spent 6 years with KPMG and 11 years with Bank One in management positions.

Mr. Godec became a Director of Vail Banks in July 2000. Mr. Godec has served as the President and a director of WestStar since 1999 and as Chief Executive Officer of WestStar since 2000. Prior to becoming President of WestStar, Mr. Godec served as Senior Executive Vice President of WestStar from January to April 1999 and served as the Senior Vice President of WestStar from January 1996 to January 1999.

Mr. Ferguson joined WestStar Bank as Chief Credit Officer in July of 2001. He previously served as President and Chief Executive Officer of Pemi-National Bank in New Hampshire. Mr. Ferguson has over twenty years experience in commercial lending.

As of March 5, 2005, Vail Banks had 23 operating offices and an administrative center. Of these 24 properties, 11 were leased and 13 were owned. Vail Banks is in the design phase for a new retail office in Fruita and plans to open an additional office located in Southwest Denver in 2005. Vail Banks completed significant remodeling of its retail offices in Avon and Norwood in 2004 and plans to

remodel Vail and Estes Park in 2005. Additionally, Vail Banks completed construction of its Glenwood Springs building in 2004. None of the properties owned by Vail Banks are encumbered. The aggregate annual lease payments for properties in 2004 were $1.4 million. Leases for the facilities expire at various periods through 2011 with options to renew through 2028. Vail Banks considers its properties adequate for its current needs.

Vail Banks and its banking subsidiary periodically are parties to or otherwise involved in legal proceedings arising in the normal course of business, such as claims to enforce liens, claims involving the making and servicing of real property loans and other issues incident to their business. Management does not believe that there is any pending or threatened proceeding against Vail Banks or its banking subsidiary which, if determined adversely, would have a material effect on the business, results of operations, or financial position of Vail Banks or its banking subsidiary.

No matters were submitted to security holders during the fourth quarter of fiscal year 2004.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

Vail Banks' common stock trades on The NASDAQ Stock Market under the symbol "VAIL." The following table sets forth, for the periods indicated, the high and low bid prices of the common stock on The NASDAQ Stock Market.

	Year Ended December 31, 2004				Year Ended December 31, 2003
	High		Low		High		Low
First Quarter	$	13.59	$	11.94	$	12.40	$	11.32
Second Quarter		12.89		12.35		13.60		11.90
Third Quarter		14.00		12.40		14.84		13.51
Fourth Quarter		13.53		12.70		14.92		11.63

As of February 11, 2005, there were 104 record holders of the common stock. Investors who beneficially own common stock that is held in street name by brokerage firms or similar holders are not included in this number. Vail Banks believes there are approximately 2,000 beneficial holders of its common stock.

	2004
First Quarter	$	0.07	$	0.06
Second Quarter		0.07		0.06
Third Quarter		0.07		0.07
Fourth Quarter		0.07		0.07

Additionally, a cash dividend of $0.07 per share was declared on January 17, 2005 and paid on February 11, 2005 to shareholders of record on January 28, 2005.

Holders of common stock are entitled to receive dividends when, as and if declared by Vail Banks' Board of Directors out of funds legally available therefor. The final determination of the timing, amount and payment of dividends on the common stock is at the discretion of the Board of Directors. The declaration of dividends will depend on conditions then existing, including Vail Banks' profitability, financial condition, capital requirements, future growth plans and other relevant factors. The principal source of Vail Banks' income is dividends received from WestStar. The payment of these dividends by WestStar is subject to certain restrictions imposed by the federal and state banking laws and regulations.

Vail Banks' ability to pay cash dividends on the common stock is also subject to statutory restrictions, including banking regulations, and restrictions arising under the terms of securities or indebtedness which may be issued or incurred in the future. The terms of such securities or indebtedness may restrict payment of dividends on common stock until required payments and distributions are made on such securities or indebtedness. See "Supervision and Regulation" in Item 1.

The selected historical financial data set forth below should be read in conjunction with the "General," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Financial Statements and Notes to Consolidated Financial Statements" sections, as well other financial data contained elsewhere in this Annual Report on Form 10-K.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following section presents management's review of the financial condition and operating results of Vail Banks, Inc. and its subsidiary, WestStar Bank, (collectively Vail Banks or the Company). It is intended to assist readers in evaluating Vail Banks' performance. Certain reclassifications have been made to previous periods' information to conform to the 2004 presentation. The following analysis should be read in conjunction with the Consolidated Financial Statements and accompanying notes as well as the selected financial information included elsewhere in this Annual Report on Form 10-K.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated balance sheet and the reported amounts of revenues and expenses during the reporting period. The Securities and Exchange Commission has defined a company's most critical accounting policies as those that are most important to the portrayal of its financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on these criteria, management has identified the following critical accounting policies and judgments. Although management believes its estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions or conditions.

The allowance for loan losses calculation process has two components. The first component represents the allowance for impaired loans computed in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114 Component), as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures an amendment of FASB Statement No. 114. To determine the SFAS 114 Component, collateral dependent impaired loans are evaluated using internal analyses as well as third-party information, such as appraisals. If an impaired loan is unsecured, it is evaluated using a discounted cash flow of the payments expected over the life of the loan giving consideration to currently existing factors that would impact the amount or timing of the cash flows. The second component is the allowance calculated under SFAS No. 5, Accounting for Contingencies (SFAS 5 Component), and represents the estimated probable but undetected losses inherent within the portfolio due to uncertainties in economic conditions, delays in obtaining information about a borrower's financial condition, delinquent loans that have not been determined to be impaired, trends in speculative construction real estate lending, results of internal and external loan reviews, and other factors. This component of the allowance is calculated by assigning a certain risk weighting, within a predetermined range, to each identified risk factor. Management has an internal goal to maintain the allowance for loan losses between 0.75% and 1.50% of average gross loans. The recorded allowance is the aggregate of the SFAS 114 and SFAS 5 components.

At December 31, 2004, the Company had a $3.9 million allowance for loan losses. Management believes that this allowance is adequate to cover probable losses based on all currently available evidence. Future additions to the allowance may be required based on management's continuing evaluation of the inherent risks in the portfolio. Additional provisions for loan losses may need to be recorded if the economy declines, asset quality deteriorates, or historical loss experience changes. Also,

state or federal regulators, when reviewing Vail Banks' loan portfolio in the future, may require Vail Banks to increase the allowance. Any increase in the allowance would adversely affect Vail Banks' earnings. An analysis of the allowance for loan losses as well as its allocation among certain categories of the loan portfolio can be found in the "Financial Condition" section of this "Management's Discussion and Analysis of Financial Condition and Results of Operations".

In assessing the recoverability of goodwill and other intangible assets, management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, management may be required to record impairment charges not previously recorded. On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. This statement requires the Company to assess goodwill and intangible assets for impairment at least annually, using a two-step process that begins with an estimation of the fair value of the reporting unit. The first step is a screen for impairment, and the second step measures the amount of any impairment.

The Company performed its annual goodwill impairment test during the fourth quarter of 2004 and determined that the goodwill was not impaired. The Company also performed an annual impairment test of other intangible assets, comprised of core deposit premium, for the fourth quarter of 2004 and determined that the other intangible assets were not impaired.

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts. When used in this report, the words "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions are generally intended to identify forward-looking statements. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the results discussed in these forward-looking statements as a result of the factors set forth below. Vail Banks does not intend to update any forward-looking statements whether written or oral, relating to matters discussed in this Annual Report on Form 10-K.

Net income was $3.0 million in 2004, an increase of approximately $2.3 million from the $714,000 earned in 2003. The growth was primarily due to a reduction in non-interest expenses of $3.2 million, or 10%, from $31.0 million in 2003 to $27.8 million in 2004, and a $1.7 million gain, pre-tax, on the sale of the Company's Vail bank building. These increases were partially offset by a $1.8 million decrease in mortgage-broker fee income. These results are not necessarily indicative of the results that may be expected for future years. Without the gain on sale of the building, net income for the year ended December 31, 2004 would have been $1.9 million.

In 2003, the Company had a $4.9 million, or 87%, decrease in net income from $5.6 million in 2002 to $714,000. This decrease was primarily due to reduced loan volumes and falling interest rates, leading to a decrease in the net interest margin to 4.46% from 5.49% in 2002, and an increase in non-interest expense of $2.6 million, or 9%, to $31.0 million from $28.4 million in 2002. Also contributing to the decrease in net income was a $1.6 million write-off of premises and equipment.

The return on average assets was 0.49% for the year ended December 31, 2004 compared to 0.12% for the year ended December 31, 2003 and 1.00% for the year ended December 31, 2002.

The return on average equity was 5.03% for the year ended December 31, 2004 compared to 1.14% for the year ended December 31, 2003 and 8.62% for the year ended December 31, 2002.

Assets increased by $59.0 million, or 10%, to $634.6 million during 2004. This increase was primarily due to growth in loans and investment securities of $121.8 million offset by a decrease in cash equivalents of $65.3 million. Assets increased by $21.3 million, or 4%, to $575.6 million during 2003. This increase was primarily due to an increase in cash, cash equivalents and investment securities of $47.2 million, offset by a decrease in loans held for sale generated by First Western of $7.4 million and a decrease in gross loans of $19.2 million.

Net interest income continues to be Vail Banks' principal source of income, representing the difference between interest and fees earned on loans and investments and interest paid on deposits and borrowings. In this discussion, Net Interest Income on a fully tax-equivalent basis (FTE) includes tax-exempt income, such as interest on securities of states and municipalities, increased to an amount that would have been earned had such income been taxable. This adjustment places taxable and nontaxable income on a common basis and permits comparisons of rates and yields.

The following table sets forth the average balances, interest income and expense, and average yields and rates for Vail Banks' earning assets and interest bearing liabilities for the periods indicated on a fully tax-equivalent basis.

The amount of net interest income is affected by changes in the volume and mix of earning assets and interest bearing liabilities and the interest yields and rates on those assets and liabilities. An analysis of how changes in volume and yields and rates affected net interest income for the years ended December 31, 2004, 2003 and 2002 is presented below.

FTE net interest income increased by $1.3 million or 6% to $23.3 million for the year ended December 31, 2004 from $22.0 million for the year ended December 31, 2003. The net interest margin on an FTE basis was 4.55% for 2004 as compared to 4.46% for 2003. Net interest margin is influenced by the level and relative mix of earning assets, interest bearing liabilities, and non-interest bearing liabilities as well as the cost of interest bearing liabilities as compared to the yield on earning assets. The increase in net interest margin during 2004 was primarily due to a $22.1 million increase in average loan volumes since December 31, 2003 as a result of a strong economy and an internal focus on growing our loan portfolio. The Company's average yield on loans dropped 35 basis points to 7.52% during 2004 from 7.87% during 2003, due to competitive market pressures, despite increases made by the Federal Reserve. However, the increase in loan volume surpassed the decrease in average yields, to contribute $487,000 to the $1.3 million increase in net interest income. As a result of the adoption of FIN 46R in January 2004, Trust I and Trust II are no longer consolidated into the Company's financial results. Accordingly, the 2002 and 2003 financial statements include the $24.0 million of trust preferred securities and $2.4 million of related interest expense. For 2004, the financial statements include the Company's $743,000 investment in the trusts, the $24.7 million of subordinated debentures issued by the Company to the trusts, and the $2.5 million of related interest expense.

FTE interest income increased $807,000 or 3% for 2004 as compared to 2003 primarily due to an increase in loan volume and taxable investment securities volume. Loans had a yield of 7.52% during 2004 compared to 7.87% during 2003. During 2004, average loans increased to 69% of total earning assets as compared to 67% during 2003. Similarly, the average taxable investment securities increased to 20% of total earning assets as compared to 15% during 2003. As a result of these changes, the total yield on average earning assets decreased 6 basis points to 6.16% for 2004, as compared to 6.22% for 2003.

Interest expense decreased $459,000, or 5% for 2004 as compared to 2003 primarily due to a decrease in the average rate on interest bearing deposits, which decreased 15 basis points to 1.13% for 2004, as compared to 1.28% for 2003. This caused a decline in interest expense of $392,000. The average balance in interest bearing deposits increased $13.2 million in 2004 to $375.5 million, compared to $362.3 million in 2003. Long-term borrowings decreased in volume contributing to a decline in interest expense despite the 10 basis point increase in average yield. The average balance in long-term borrowings decreased $6.1 million in 2004 to $24.6 million, compared to $30.7 million in 2003.

FTE net interest income decreased by $3.6 million, or 14% to $22.0 million for the year ended December 31, 2003 from $25.6 million for the year ended December 31, 2002. The net interest margin on an FTE basis was 4.46% for 2003 as compared to 5.49% for 2002. The decrease in net interest margin during 2003 was primarily due to (1) a $32.3 million decrease in average loan volumes since December 31, 2002 as a result of the soft economy, more conservative underwriting policies, and a temporary internal focus on resolving problem loans. This resulted in additional liquidity that the Company used to purchase lower yielding investments and to sell federal funds. (2) At the same time, the Company capitalized on the low interest rate environment and its wholesale funding source to extend fixed rate financing to several customers, thereby locking in a spread. These borrowings came at a higher interest cost than deposits. (3) Also contributing to the decrease in net interest margin was the 25 basis point interest rate cut implemented by the Federal Reserve during second quarter 2003 and the 50 basis point cut during November 2002. (4) Finally, the Company deferred more loan fees during 2003 compared with 2002. During 2003, the Company deferred $696,000 in loan fees versus $159,000 in 2002, reflecting a more conservative approach that more closely recognizes loan fee income over the lives of the related loans. A portion of the deferral also included fees on long-term loans now being funded with long-term borrowings, a substantial portion of which will be recognized as income in subsequent quarters.

FTE interest income decreased $3.4 million, or 10% for 2003 as compared to 2002 despite the fact that earning assets increased $28.4 million or 6% during the same period. During 2003, the mix of earning assets continued to shift away from loans and toward lower yielding investment securities and federal funds sold. Loans had a yield of 7.87% during 2003 as compared to the 4.17% yield on investment securities and 1.01% yield on federal funds sold. During 2003, average loans declined to 67% of earning assets as compared to 78% during 2002. As a result of this shift, the total yield on average earnings assets decreased 110 basis points to 6.22% for 2003, as compared to 7.32% for 2002.

Interest expense increased $173,000, or 2% for 2003 as compared to 2002 primarily due to an increase in interest-bearing liabilities of $29.4 million during this same period. The cost of interest-bearing liabilities during this period, however, decreased 13 basis points from 2.16% during 2002 to 2.03% for 2003. This decrease was primarily due to a decrease in the cost of interest-bearing deposits from 1.48% during 2002 as compared to 1.28% during 2003. The 25 basis point interest rate cut implemented by the Federal Reserve during second quarter 2003 and the 50 basis point cut during November 2002 contributed to this lower cost.

The amount of the provision for loan losses is based on regular evaluations of the loan portfolio, with particular attention directed toward non-performing, delinquent, and other potential problem loans. During these evaluations, consideration is also given to such factors as management's evaluation of specific loans, the level and composition of delinquent and non-performing loans, historical loan loss experience, results of examinations by regulatory agencies, external and internal asset review processes, the market value of collateral, the strength and availability of guarantees, concentrations of credit and other judgmental factors.

The provision for loan losses was $704,000 in 2004, compared to $578,000 in 2003 and $382,000 in 2002. The allowance for loan losses of $3.9 million as of December 31, 2004 increased 11% from $3.5 million as of December 31, 2003 and represents 0.96% of total loans and 1,657% of non-performing loans as of December 31, 2004 as compared to 1.12% and 201%, respectively, at December 31, 2003. The Company believes that the current allowance for loan losses is adequate to absorb probable losses. During 2004, average loans increased $22.1 million, or 7%, and non-performing loans decreased $1.5 million, or 87%. Net charge-offs during 2004 were $312,000, compared to $822,000 during 2003. Overall, the allowance for loan losses increased $392,000 during 2004 compared to a net decrease of $244,000 during 2003 and a net decrease of $628,000 in 2002.

The following table sets forth Vail Banks' non-interest income for the years indicated.

		2004		2003		2002
		(in thousands)
Mortgage broker fees		$	3,146	$	4,936	$	4,943
Service charges on deposits			2,783		3,080		3,495
Gain on sale of premises and equipment			1,769		—		—
Other fee income			1,136		1,164		1,812
Rental income			812		907		993
Gain on sale of foreclosed properties			130		540		138
Other			427		515		643

	Total non-interest income	$	10,203	$	11,142	$	12,024

Non-interest income decreased $939,000, or 8%, to $10.2 million in 2004 from $11.1 million in 2003. This decrease was primarily due to a decrease in mortgage broker fee income as refinancing activity slowed during 2004. Service charges on deposits decreased $297,000, or 10%, primarily due to a decline in the number of insufficient funds charges. Rental income declined during 2004 due to the sale of the Vail building and vacancies in rental properties owned by the Company. The gain on sale of foreclosed properties declined due to a decline in the number of foreclosed properties. These decreases were partially offset by the $1.7 million gain on the sale of the Vail bank building.

Non-interest income decreased $882,000, or 7%, to $11.1 million in 2003 from $12.0 million in 2002. This decrease was primarily due to a decrease in other fee income and service charges on deposits. Other fee income decreased $648,000, or 36%, from 2002 primarily due to the outsourcing of the Company's merchant card program. During 2003, service charges on deposits decreased $415,000, or 12% due primarily to a decline in the number of insufficient funds charges. Rental income decreased during 2003 due to several tenant vacancies in rental properties owned by the Company.

The following table sets forth Vail Banks' non-interest expense for the years indicated.

		2004		2003		2002
		(in thousands)
Salaries and employee benefits		$	16,484	$	17,593	$	16,776
Occupancy			3,741		3,820		3,224
Furniture and equipment			2,439		2,768		2,871
Professional fees			985		774		1,079
Marketing and promotions			752		561		481
Banking service fees			657		659		639
Retail banking			476		481		875
Telephone and data communications			415		633		613
Loss on sale of securities			311		—		—
Supplies and printing			289		313		342
Postage and freight			209		221		270
Litigation settlement			76		150		—
Amortization of intangible assets			40		617		74
Loss on sale, disposal or write-off of premises and equipment			—		1,578		121
Other			927		870		1,075

	Total non-interest expense	$	27,801	$	31,038	$	28,440

Total non-interest expense decreased $3.2 million during 2004, or 10%, from $31.0 million in 2003 to $27.8 million in 2004. The decrease is primarily due to the write-off of premises and equipment, which was $0 in 2004 compared to $1.6 million in 2003, and decreases in salaries and employee benefits and amortization expense on intangible assets. These decreases were partially offset by an increase in marketing and promotion costs primarily due to the opening of new offices and an increased focus on deposit and loan growth.

Total non-interest expense increased $2.6 million during 2003, or 9%, from $28.4 million in 2002. The increase is primarily due to the write-off of premises and equipment, and increases in salaries and employee benefits, occupancy expense, amortization expense on intangible assets, the opening of a de novo office in Denver during the third quarter 2003 and the settlement of litigation. These increases were partially offset by the reduction in retail banking expenses and the Company's concerted efforts to reduce operational costs such as postage, supplies and professional fees.

During 2003, the Company scrutinized its premises and equipment listing and determined that certain premises and equipment were no longer required for the efficient operation of the Company. These premises and equipment were written off during the fourth quarter of 2003 resulting in a pre-tax charge to income of $1.6 million

Salaries and employee benefits expense decreased $1.1 million during 2004, or 6% from 2003. This decrease is primarily due to: (1) a $996,000 decrease in mortgage incentive pay as a result of lower mortgage origination volumes, (2) a $217,000 decrease in employee insurance costs primarily due to favorable healthcare claim volumes, partially offset by (3) $296,000 increase in salaries and employee benefit expense attributable to a full year of costs for the new Denver Tech Center office which opened during the third quarter of 2003 and (4) $173,000 increase in salaries and employee expense attributable to the new Stapleton office that opened during the third quarter of 2004. Additionally, stock based compensation expense decreased $304,000 in 2004. During 2003, the Company recognized compensation expense of $171,000 related to grants of restricted stock. Additionally, an officer of the Company terminated employment during 2003 and all of their restricted stock and stock options

became fully vested as of December 31, 2003, resulting in $138,000 of additional compensation expense. Finally, during 2003 the Company accelerated the stock option vesting of a former officer of the Company and recognized additional compensation expense of $152,000.

Expenses associated with furniture and equipment decreased $329,000 in 2004 due in part to the fourth quarter 2003 write-off of $453,000 of obsolete assets, which decreased depreciation expense in 2004.

Occupancy expenses decreased in 2004 $79,000, or 2%. The overall decrease is comprised of the following: (1) decrease of $306,000 for offices closed in 2003, (2) decrease of $225,000 due to decreased depreciation expense in 2004 as a result of the $1.1 million write-off of obsolete assets during the fourth quarter of 2003, partially offset by (3) $140,000 increase in rent for the Vail office as the building was sold and then the office premises were leased-back in March of 2004, (4) $42,000 increase attributable to the new Stapleton office opened during the third quarter 2004, (5) an additional $56,000 attributable to an expansion of the Avon office, (6) an additional $48,000 attributable to the new Denver Tech office opened during the third quarter 2003 and (7) $169,000 increase attributable to the relocation of Vail Banks' executive offices during June 2003. Prior to June 2003, the executive offices were located in a Company-owned facility, so no rent expense was incurred.

Amortization of intangible assets decreased in 2004 by $577,000 or 94% from 2003 primarily due to the impairment of intangible assets of $543,000 recognized in 2003, while no impairment was recognized in 2004. The Company performed its annual impairment test of other intangible assets for the fourth quarter of 2004 and concluded that no impairment charge was necessary. However, in 2003, due to the attrition of acquired deposit accounts the Company determined that $543,000 of core deposit premium created by former acquisitions was determined to be impaired and recorded this amount as additional amortization expense during 2003.

Retail banking expenses remained consistent with 2003, decreasing only $5,000 or 1% during 2004.

Litigation settlements decreased $74,000 or 49% in 2004. During 2004, the Company settled three cases at a cost of $76,000. During third quarter 2003, the Company settled a lawsuit at a cost of $150,000. The lawsuit resulted from actions taken by a former officer at an acquired bank prior to the Company's acquisition of such bank.

During the fourth quarter 2004, the Company sold $19.6 million of investment securities taking a pre-tax loss of $311,000. The purpose of the sale was to increase the Company's funding to support the significant loan growth experienced during 2004.

The efficiency ratio represents non-interest expense as a percentage of the sum of net interest income and non-interest income and is a measure of the cost to generate a dollar of revenue. The efficiency ratio improved in 2004 to 84% from 95% in 2003. It was 76% in 2002. The improvement in 2004 was primarily due to an increase in revenue and the decrease in non-interest expense discussed above. The increase in 2003 (95%) over 2002 (76%) was primarily due to the decline in revenue (net interest income plus non-interest income) of $4.8 million over 2002 while non-interest expenses increased $2.6 million during the same period.

Income tax expense as a percentage of pre-tax income was 33.8% for 2004 compared with 30.3% and 34.8% for 2003 and 2002, respectively. In 2004, taxable income increased, primarily from loan growth, causing an increase in income tax expense as a percentage of pre-tax income. During 2003, the Company had a significant increase in tax-exempt interest income as a percentage of total income as a result of municipal bond purchases and the reduced level of total income. This reduction in current income tax expense was offset by additional deferred tax expense associated with the adjustment of the tax bases of certain premises and equipment. A reconciliation of income tax expense to the amount

computed by applying the statutory federal income tax rate to pre-tax income is provided in Note 11 of the Notes to Consolidated Financial Statements, contained in Item 15 of this Annual Report on Form 10-K.

At December 31, 2004, the carrying value of investment securities was $104.0 million, an increase of $27.1 million, or 35%, over $76.9 million at December 31, 2003 due to a concerted effort to improve yields by investing excess cash in available for sale securities.

At December 31, 2003, the carrying value of investment securities was $76.9 million, which was an increase of $18.6 million, or 32%, over $58.3 million at December 31, 2002. During this period, quality loan demand decreased while deposits continued to grow, resulting in additional funds to invest. In 2002, the Company completed a short-term leverage strategy by borrowing from the Federal Home Loan Bank and reinvesting those funds primarily in mortgage backed securities.

Vail Banks' investment policy is designed primarily to ensure liquidity and to meet pledging requirements and secondarily to provide acceptable investment income. Management's focus is on maintaining a high-quality investment portfolio oriented primarily toward mortgage-backed and other government agency securities. The determination of the amount and maturity of securities purchased is a function of liquidity and income projections based on the existing, and expected, balance sheet and interest rate forecasts.

Vail Banks is required to account for investment securities in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. At the date of purchase, Vail Banks is required to classify debt and equity securities into one of three categories: held to maturity, trading, or available for sale. Investments in debt securities are classified as held to maturity and measured at amortized cost in the financial statements only if management has the positive intent and ability to hold those securities to maturity. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and measured at fair value in the statements with unrealized gains and losses included in earnings. Since its inception, Vail Banks has not had any trading account activities. Investments not classified as either held to maturity or trading are classified as available for sale and measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, as a separate component of other comprehensive income or loss until realized. Since the initial classification of its investment securities, Vail Banks has not transferred any investment securities between categories, nor has it sold any investment securities classified as held to maturity. The following tables set forth information regarding the investment composition of Vail Banks as of the dates indicated.

The following tables set forth the estimated carrying value and approximate weighted average yield of the debt securities in the investment portfolio by type and contractual maturity at December 31, 2004. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities also provide a cash flow of principal and interest over time that is not reflected in the table below.

	Over 10 Years or Non-Maturing
	Amount		Yield
	(in thousands)
Mortgage-backed securities(1)	$	246	5.97	%

Total and weighted average yield	$	246	5.97	%

The following table sets forth the composition of Vail Banks' loan portfolio by type of loan at the dates indicated. Management believes that the balance sheet information as of the dates indicated should be read in conjunction with the average balance information in the previous tables above under the caption Average Balance Sheet and Net Interest Income Analysis. Vail Banks has followed a policy to manage the loan portfolio composition to mitigate risks in specific markets by diversifying the loan portfolio. However, Vail Banks does have a concentration of loans in the commercial, industrial and

land category. As a result of seasonal trends in the retail, service and real estate markets, balances of commercial loans may fluctuate significantly.

At December 31, 2004, gross loans were $407.6 million, which was an increase of $95.1 million, or 30%, over $312.5 million at December 31, 2003. This increase was primarily due the strengthening of the economy, a focused effort to generate loan volume, stronger loan management recruiting, and a focus on customer needs. Significant growth occurred across the Company's commercial, real estate-construction, and real estate-mortgage portfolios. At December 31, 2003, gross loans were $312.5 million, which was a decrease of $18.6 million, or 6%, over $331.2 million at December 31, 2002. This decrease was primarily due to the continued softening of the economy, a continued conservative underwriting policy, and a temporary internal focus on resolving problem loans.

Commercial, industrial, and land loans principally include loans to service, real estate and retail businesses and to a small degree, agricultural interests. These loans are primarily secured by real estate and operating business assets. Commercial, industrial and land loans are made on the basis of the repayment ability and financial strength of the borrower as well as the collateral securing the loans.

Real estate-construction loans principally include short-term loans to fund the construction of buildings and residences or to purchase land for planned and near-term commercial or residential development. These loans are primarily non-revolving lines of credit and are secured by real estate, typically well margined with a first security lien.

Real estate-mortgage loans principally include short-term financing for existing one-to-four family residences. The majority of these loans have maturities of less than five years. These loans are secured by the subject real estate, typically well margined with a first lien position.

Consumer loans to individuals principally include one-to-five year loans for consumer items, such as automobiles, motor homes and other goods. These loans are typically secured, at minimum, by the items being financed.

Banking officers are assigned various levels of credit extension approval authority based upon their respective levels of experience and expertise. Credit relationships exceeding $1.0 million, and in other circumstances pursuant to the Company's credit policy, are evaluated and acted upon by the Directors' Credit Committee and are reported to the Board of Directors (Board) on a monthly basis. Vail Banks' strategy for approving or disapproving extensions of credit is to follow a conservative credit policy and underwriting practices which include: (1) extending credit on a sound and collectible basis; (2) investing funds for the benefit of shareholders and the protection of depositors; (3) serving the needs of the community and Vail Banks' general market area while obtaining a balance between maximum yield and minimum risk; (4) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the credit extended; (5) developing and maintaining diversification in the loan portfolio as a whole and of the loans within each loan category; and (6) ensuring that each extension of credit is properly documented and, if appropriate, insurance coverage is adequate. Vail Banks' credit review and compliance associates interact daily with commercial and consumer lenders to identify

potential underwriting or technical exception variances. In addition, Vail Banks has placed increased emphasis on early identification of problem loans in an effort to aggressively seek resolution of such situations. Management believes that this strict adherence to conservative credit policy guidelines has contributed to Vail Banks' reduced level of credit losses.

The following table presents loans by maturity in each major category at December 31, 2004. Actual maturities may differ from the contractual repricing maturities shown below as a result of renewals and prepayments. Loan renewals are evaluated in the same manner as new credit applications.

Non-performing assets consist of nonaccrual loans, restructured loans and foreclosed properties. When, in the opinion of management, a reasonable doubt exists as to the collectibility of interest, regardless of the delinquency status of the loan, the accrual of interest income is discontinued and interest accrued but uncollected during the current year is generally reversed through a charge to current year earnings. While the loan is on nonaccrual status, interest income is recognized only upon receipt and then only if, in the judgment of management, there is no reasonable doubt as to the collectibility of the principal balance. Loans 90 days or more delinquent generally are changed to nonaccrual status unless the loan is in the process of collection and management determines that full collection of principal and accrued interest is probable. Interest income that would have been recorded for nonaccrual loans, had they been performing in accordance with their contractual requirements, was $34,000 and $357,000 for the years ended December 31, 2004 and 2003, respectively. Actual interest income recorded for these loans was $10,000 and $186,000 for the years ended December 31, 2004 and 2003, respectively.

Restructured loans are those for which concessions, including reduction of interest rate below a rate otherwise available to the borrower or the deferral of interest or principal, have been granted due to the borrower's weakened financial condition. Interest on restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur.

The following table sets forth information concerning the non-performing assets of Vail Banks as of the dates indicated.

Since 2002, the Company completed foreclosures and subsequent sales of real estate as well as achieved resolution on several large loans that were previously on non-accrual, resulting in a decrease in non-performing loans and related ratios. The majority of the non-accrual loans are real estate secured, are recorded at net realizable value, and are subject to foreclosure or other collection proceedings. Management believes Vail Banks is adequately collateralized to recover the majority of the balance of these nonaccrual loans. Management generally obtains and maintains appraisals on real estate collateral. Management is not aware of any adverse trends relating to Vail Banks' loan portfolio, not reflected above.

At December 31, 2004, there were no loans excluded from non-performing loans set forth above where known information about possible credit problems of borrowers caused management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in such loans becoming non-performing.

The allowance for loan losses (the allowance) represents management's recognition of the risks of extending credit and its evaluation of the loan portfolio. The allowance is maintained at a level considered adequate to provide for probable loan losses based on management's assessment of various factors affecting the loan portfolio, including a review of problem loans, business conditions, historical loss experience, evaluation of the quality of the underlying collateral, and holding and disposal costs. The allowance is increased by additional charges to operating income and reduced by loans charged off, net of recoveries.

The Company has established a formal process for determining an adequate allowance. WestStar lending associates are responsible for ongoing reviews of the quality of the loan portfolio. During 2003, the Company established an internal loan review function that issues quarterly reports to the Audit Committee. State and federal regulatory agencies, as an integral part of their examination process, also review WestStar's loans and its allowance. A list containing problem loans is updated and reviewed by management and the Board monthly. Management has an internal goal to maintain the allowance for loan losses between 0.75% and 1.50% of average gross loans. The recorded allowance is the aggregate of the SFAS 114 and SFAS 5 components.

In order to comply with certain regulatory requirements, management has prepared the following allocation of Vail Banks' allowance for loan losses among various categories of the loan portfolio for each of the years in the five-year period ended December 31, 2004. In management's opinion, such allocation has, at best, a limited utility. It is based on management's assessment as of a given point in time of the risk characteristics for each of the component parts of the total loan portfolio and is subject to changes as and when the risk factors of each such component part change. Such allocation is not indicative of either the specific amounts or the loan categories in which future charge-offs may be taken, nor should it be taken as an indicator of future loss trends. By presenting such allocation, management does not mean to imply that the allocation is exact or that the allowance has been precisely determined from such allocation. Additionally, during 2001, the Company changed its methodology for computing the allowance for loan losses. A significant portion of the SFAS 5 Component has not been allocated to each of the four categories specified in the table below, but rather represents loans in all four categories. It is represented by the term "cross-allocated" in the table below.

Vail Banks' primary source of funds has historically been in-market customer deposits. Deposit products are concentrated in business and personal checking and money market accounts, including interest bearing and non-interest bearing accounts. Generally, deposits are short-term in nature with approximately 79% of deposits having a committed term less than three months and approximately 93% having a committed term of less than one year. Vail Banks' resort locations experience a seasonality of deposits; however, deposits in non-resort- oriented markets help to mitigate such seasonality.

Total deposits were $500.4 million at December 31, 2004, a $52 million, or a 12%, increase from the balance at December 31, 2003. This increase was primarily related to a focused effort to gather funding in anticipation of a positive turnaround in the economy and greater loan demand. Additionally, the selective pricing of deposit products as well as the maturing of newer offices also contributed to the increase in deposits. This was offset by a decrease in public funds deposits of $2.8 million, or 4%, from December 31, 2003. Total deposits were $448.5 million at December 31, 2003, a $19.8 million, or a 5%, increase from the balance at December 31, 2002. Non-interest-bearing demand deposits comprised 24% of total deposits at December 31, 2004 and 23% of total deposits at both December 31, 2003 and December 31, 2002.

The following table sets forth the composition of Vail Banks' deposits by type at December 31, 2004, 2003 and 2002.

The following table presents average deposits by type during 2004, 2003 and 2002 and the related average interest rate paid by deposit type for each of those years.

The following table sets forth the amount and maturity of certificates of deposit that had balances equal to or greater than $100,000 at December 31, 2004, 2003 and 2002.

In the ordinary course of business, the Company has loans receivable from directors, executive officers and principal shareholders (holders of more than five percent of the outstanding shares of common stock) of the Company and their affiliates as follows:

Deposits from related parties held by WestStar at December 31, 2004 and 2003 amounted to $5.6 million and $4.2 million, respectively. Such loans and deposits are on the same terms and conditions as then prevailing at the time for comparable transactions with non-related parties.

On March 5, 2004, the Company sold its bank building in Vail, Colorado in which a WestStar branch is located. Commissions related to the sale amounting to $261,000 were paid to two related parties.

Liquidity is a measure of the Company's ability to meet its commitments and obligations with available funds. These commitments may include paying dividends to shareholders, funding new loans for borrowers, funding withdrawals by depositors, paying general and administrative expenses, and funding capital expenditures. Historically, the Company's primary source of funds has been customer deposits. Scheduled loan repayments are also a relatively stable source of funds. Deposit inflows and unscheduled loan repayments, which are influenced by fluctuations in the general level of interest rates, returns available on other investments, competition, economic conditions and other factors, are relatively unstable. Other sources of liquidity include sale or maturity of investment securities and the ability to borrow funds. Company borrowing may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Company borrowing may also be used on a longer-term basis to support expanded lending and investing activities and to match the maturity or repricing intervals of assets.

During the year ended December 31, 2004, net cash of $747,000 was provided by operating activities consisting primarily of net income of $3.0 million, increased by non-cash items of $2.2 million and reduced by net changes in operating assets and liabilities of $4.4 million from 2003. Non-cash expenses consisted primarily of $1.9 million of depreciation and amortization expense on premises and equipment, $40,000 of intangible asset amortization, $912,000 of net amortization of premiums on investment securities, a $704,000 loan loss provision, $686,000 million of deferred income tax expense, and $356,000 of stock compensation expense, offset by a $1.8 million gain on sale, disposal or write-off of premises and equipment, a $130,000 gain on sales of foreclosed properties, and $907,000 of deferred loan fee amortization. The net increase in operating assets and liabilities was primarily due to a $4.6 million increase in loans held for sale and a $398,000 increase in interest payable and liabilities.

During the year ended December 31, 2003, net cash of $12.0 million was provided by operating activities consisting primarily of net income of $714,000, non-cash expenses of $5.0 million and net decreases in operating assets and liabilities from 2002 of $6.3 million. Non-cash expenses consisted primarily of $2.4 million of depreciation and amortization expense on premises and equipment, a

$1.6 million loss on sale, disposal or write-off of premises and equipment, $617,000 of intangible asset amortization, $579,000 of net amortization of premium on investment securities, a $578,000 loan loss provision, and $660,000 of stock compensation expense, offset by a $467,000 gain on sales of foreclosed properties, $465,000 of deferred income tax benefit, and $334,000 of deferred loan fee amortization. The net decrease in operating assets and liabilities was primarily due to a $7.4 million decrease in loans held for sale offset by a $955,000 increase in other assets. This decrease in loans held for sale during the last quarter of 2003 was primarily attributable to slowing mortgage refinancing activity.

During the year ended December 31, 2002, net cash of $6.6 million was provided by operating activities consisting primarily of net income of $5.6 million and non-cash expenses of $2.8 million, offset by net increases in operating assets and liabilities from 2001 of $1.8 million. Non-cash expenses consisted primarily of $2.3 million of depreciation and amortization expense on premises and equipment, $398,000 of net amortization of premium on investment securities and a $382,000 loan loss provision, offset by $416,000 of gains on sales of investment securities. The net increase in operating assets and liabilities was primarily due to a $2.9 million increase in loans held for sale offset by a $657,000 decrease in interest receivable and a $356,000 increase in interest payable and other liabilities. With favorable mortgage interest rates during 2002, refinancings continued to be strong, accounting for the increase in loans held for sale. The decline in the loan portfolio during 2002 resulted in a related decline in the interest receivable on loans. The increase in interest payable and other liabilities was partly due to the $8.9 million increase in FHLB borrowings over December 31, 2001.

During 2004, net cash of $120.1 million was used by investing activities. These outflows consisted primarily of $95.3 million increase in net loans, $80.3 million of purchases of investment securities, and the purchase of $7.0 million of premises and equipment to complete the construction of the building in Glenwood Springs, to remodel several owned buildings and to upgrade equipment. These outflows were partially offset by the maturity and/or calls of $29.3 million of investment securities, $22.0 million from the sales of investment securities, $8.3 million of proceeds from the sales of premises and equipment, $2.0 million from the maturity of a CD, and $1.0 million from the sales of foreclosed properties.

During 2003, net cash of $6.5 million was used by investing activities. These outflows consisted primarily of $78.0 million of purchases of investment securities and interest-bearing deposits in banks, and the purchase of $3.2 million of premises and equipment to begin construction of a new building in Glenwood Springs to replace an existing facility, to remodel several owned buildings and to upgrade equipment. These outflows were partially offset by the maturity and/or calls of $40.7 million of investment securities, $14.5 million from the sales of investment securities, a $14.3 million decrease in net loans, and $5.0 million from the sales of foreclosed properties.

During 2002, net cash of $40.5 million was provided by investing activities. These inflows consisted primarily of a $59.1 million decrease in net loans, the maturity and/or calls of $16.2 million of investment securities, $15.4 million from the sales or redemption of investment securities, and $2.8 million from the sales of premises and equipment. These inflows were partially offset by $51.4 million of purchases of investment securities and the purchase of $2.3 million of premises and equipment to construct and furnish a new building in Dillon to replace an existing facility, to construct tenant improvements and furnish a new leased facility in Glenwood Springs to replace an existing facility, and to upgrade equipment.

During 2004, net cash of $54.1 million was provided by financing activities consisting primarily of an increase in deposits of $51.9 million, the receipt of $3.0 million of net proceeds from short and

long-term FHLB advances, and $716,000 of proceeds from the issuance of common stock. These inflows were partially offset by the payment of dividends on common stock of $1.5 million.

During 2003, net cash of $20.4 million was provided by financing activities consisting primarily of an increase in deposits of $19.8 million and the receipt of $9.5 million of net proceeds from short and long-term FHLB advances. These inflows were partially offset by the repurchase of $8.4 million of outstanding common stock of the Company, and the payment of dividends on common stock of $1.4 million.

During 2002, net cash of $7.7 million was used in financing activities consisting primarily of a decrease in deposits of $13.7 million, the repurchase of $1.9 million of outstanding common stock of the Company, and the payment of dividends on common stock of $1.3 million. These outflows were partially offset by the receipt of $8.9 million of net proceeds from short and long-term FHLB advances. The decrease in deposits was largely attributable to a decline in money market rates, offset by the introduction of a new short-term certificate of deposit product. This new product enabled WestStar to attract new money as well as retain funds from maturing certificates of deposit.

Capital expenditures for 2005 are estimated to be between $2 million and $3 million associated primarily with the construction of a new facility in Fruita, expansion or remodeling of existing facilities, and routine replacement and upgrades of furniture and equipment. The Company will fund these expenditures from various sources, including operating cash flows, retained earnings and borrowings.

The following table presents an analysis of the Company's borrowing activities for the years indicated.

WestStar is a member of the FHLB of Topeka and, as a regular part of its business, obtains advances from the FHLB. Advances are collateralized by certain mortgage loans or deeds of trust as well as FHLB stock owned by WestStar. As of December 31, 2004, the authorized borrowing line totaled $139.3 million. Of this amount, $18.0 million was an irrevocable stand-by letter of credit pledged as collateral for uninsured public fund deposits, $15.7 million was outstanding as short-term advances and $26.7 million was outstanding as long-term advances. The long-term advances mature from 2006 through 2018. Early repayment of advances will result in a prepayment penalty.

WestStar has established an unsecured, overnight federal funds line with Bankers' Bank of the West that expires on August 31, 2005. As of December 31, 2004, the authorized borrowing line totaled $38.2 million, with no amounts outstanding.

WestStar has also established overnight federal funds lines with First Tennessee Bank, N.A. totaling $20.0 million. If drawn upon, $10.0 million will be a secured line and $10.0 million will be an unsecured line. These lines are subject to cancellation by First Tennessee at any time upon the occurrence of certain conditions. As of December 31, 2004, no amounts were outstanding under the lines.

During February 2001, Vail Banks formed Vail Banks Statutory Trust I (Trust I), a wholly-owned statutory trust. On February 22, 2001, Trust I issued $16.5 million of 10.20% trust preferred securities (the Trust I Securities). Interest on the Trust I Securities is payable semi-annually. The Trust I Securities have a 30-year maturity and can be called beginning in February 2011. In connection with the issuance of the Trust I Securities, Vail Banks issued to Trust I $17.0 million principal amount of its 10.20% subordinated notes (the Trust I Notes), that are due in 2031 and can be called beginning in February 2011. Interest on the Trust I Notes is payable semi-annually to Trust I.

During March 2001, Vail Banks formed Vail Banks Statutory Trust II (Trust II), a wholly-owned statutory trust. On March 28, 2001, Trust II issued $7.5 million of 10.18% trust preferred securities (the Trust II Securities). Interest on the Trust II Securities is payable semi-annually. The Trust II Securities have a 30-year maturity and can be called beginning in March 2011. In connection with the issuance of the Trust II Securities, Vail Banks issued to Trust II $7.7 million principal amount of its 10.18% subordinated notes (the Trust II Notes), that are due in 2031 and can be called beginning in March 2011. Interest on the Trust II Notes is payable semi-annually to Trust II.

On January 1, 2004, the Company adopted FIN 46R. As a result of adoption, the Company no longer includes Trust I and II in its consolidated financial condition and results of operations. As permitted by FIN 46R, prior period information has not been restated. Accordingly, the 2002 and 2003 financial statements include the $24.0 million of trust preferred securities and $2.4 million of related interest expense. For 2004, the financial statements include the Company's $743,000 investment in the trusts, the $24.7 million of subordinated debentures issued by the Company to the trusts, and the $2.5 million of related interest expense.

At its meeting on January 17, 2005, the Company's Board of Directors reauthorized the Company's stock repurchase program that was originally approved in February 2001. The total amount of repurchases under the program, both previously completed and allowable up to January 2006, aggregate approximately $29 million. Since inception of the program through December 31, 2004, the Company has repurchased 1,535,380 shares at an average price of $12.10 per share, or approximately $19 million.

The Company is a party to credit related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit.

A commitment to extend credit is an agreement to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the commitments do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained is based on management's credit evaluation. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment and income producing commercial properties.

Letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Letters of credit are used to guarantee performance primarily on development and construction projects. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Those commitments are primarily issued on behalf of local businesses.

The exposure to credit loss in the event of nonperformance by the other party to the commitments to extend credit and letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit underwriting procedures for making commitments and letters of credit as for on-balance-sheet instruments. The Company evaluates each customer's creditworthiness on a case-by-case basis and the amount of collateral, if deemed necessary, is based on the credit evaluation. Collateral held varies, but may include unimproved and improved real estate, certificates of deposit, personal property or other acceptable collateral. All of these instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The total amounts of these instruments do not necessarily represent future cash requirements because a significant portion of these instruments often expire without being used.

The amounts outstanding under these financial instruments are described below as "Other Commercial Commitments." We are not involved in off-balance sheet contractual relationships, other than those disclosed in this report, that could result in liquidity needs or other commitments or that could significantly impact earnings.

The following tables present the Company's contractual obligations and commercial commitments as of December 31, 2004:

As of December 31, 2004, the Company had cash and cash equivalents (including federal funds sold) of $35.7 million and investment securities of $104.0 million. Almost 100% of the Company's investment portfolio is classified as available-for-sale and can be readily sold to meet liquidity needs, however $62.4 million of this amount has been pledged to secure public fund deposits and $894,000 has been sold under agreements to repurchase. Accordingly, those pledged amounts may not be available to meet general liquidity needs. Based on current plans and business conditions, the Company expects that its cash, cash equivalents, investment securities and available borrowing capacity under its credit facilities, together with any amounts generated from operations, will be sufficient to meet the Company's liquidity requirements for the next 12 months. However, there can be no assurance that the

Company will not be required to seek other financing sooner or that such financing, if required, will be available on terms satisfactory to the Company.

Concentrations of credit risk arise when a number of counterparties have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in the economy or other conditions. The Company's loan portfolio consists primarily of commercial and real estate loans located in Colorado, making the value of the portfolio susceptible to declines in real estate values and other changes in economic conditions in Colorado. The Company does not believe it has excessive exposure to any individual customer.

The banking industry is unique in that substantially all of the assets and liabilities are of a monetary nature. As a result, interest rates have a more profound effect on a bank's performance than does inflation. Although there is not always a direct relationship between the movement in the prices of goods and services and changes in interest rates, increases in inflation generally lead to increases in interest rates. However, in short periods of time interest rates may not move in the same direction or magnitude as inflation.

Vail Banks' earnings depend to a significant extent on its net interest income. Net interest income is the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings. The net interest margin is highly sensitive to many factors that are beyond Vail Banks' control. These factors include competitive and general economic conditions and policies of various governmental and regulatory authorities. Changes in the discount rate or targeted federal funds rate by the Federal Reserve Bank usually lead to general changes in interest rates. These interest rate shifts affect Vail Banks' interest income, interest expense and investment portfolio. Also, governmental policies, such as the creation of a tax deduction for individual retirement accounts, can increase savings and affect the cost of funds. From time to time, the interest rate structures of earning assets and liabilities may not be balanced, and a rapid increase or decrease in interest rates could have an adverse effect on the net interest margin and results of operations of Vail Banks. Vail Banks cannot predict the nature, timing and effect of any future changes in federal monetary and fiscal policies.

The liquidity position of Vail Banks is monitored by management and its Asset/Liability Committee. A principal function of asset/liability management is to coordinate the levels of interest-sensitive assets and liabilities to minimize net interest income variances in times of fluctuating market interest rates. Interest-sensitive assets and liabilities are those that are subject to repricing in the near term, including both variable rate instruments and those fixed rate instruments which are approaching maturity. Changes in net interest income can occur when interest rates on interest sensitive assets, such as loans and investment securities, change in a different time period from that of the interest rates on liabilities, such as deposits. These differences, or "gaps," provide an indication of the extent that net interest income may be affected by future changes in interest rates.

A positive gap exists when interest-sensitive assets exceed interest-sensitive liabilities and indicates that a greater volume of assets than liabilities will reprice during a given time period. With a positive gap, rising rate environments generally enhance earnings, while a declining rate environment has a tendency to depress earnings. Conversely, a negative gap exists when interest-sensitive liabilities exceed interest-sensitive assets. With a negative gap, rising rate environments usually depress earnings, while declining rate environments tend to enhance earnings.

The following table sets forth the interest rate sensitivity of Vail Banks' assets and liabilities at December 31, 2004, and sets forth the repricing dates of Vail Banks' interest-earning assets and interest-bearing liabilities as of that date, as well as Vail Banks' interest rate sensitivity gap percentages for the periods presented. This table indicates Vail Banks will be in an asset sensitive or positive gap position for the twelve-month period ending December 31, 2005. During that period, $383.8 million of interest earning assets will reprice compared to $377.2 million of interest bearing liabilities. This asset sensitive position would generally indicate that Vail Banks' net interest income would decrease should interest rates fall and increase should interest rates rise. Changes in the mix of earning assets or supporting liabilities can either increase or decrease the net interest margin without affecting interest rate sensitivity. In addition, the interest rate spread between an asset and its supporting liability can vary significantly while the timing of the repricing for both the asset and the liability remains the same. The table is based on assumptions as to when assets and liabilities will reprice in a changing interest rate environment, and since such assumptions can be no more than estimates, certain assets and liabilities indicated as maturing or otherwise repricing within a stated period may, in fact, mature or reprice at different times and at different volumes than those estimated. Also, the renewal or repricing of certain assets and liabilities can be discretionary and subject to competitive and other pressures. Therefore, the following table does not necessarily indicate the actual future impact of interest rate movements on Vail Banks' net interest income. See Item 7A "Quantitative and Qualitative Disclosures About Market Risk" for additional information on interest rate risk faced by the Company.

Shareholders' equity at December 31, 2004 increased $2.0 million, or 3%, to $59.9 million from $57.9 million at December 31, 2003. During 2003, shareholders' equity decreased $8.9 million, or 13%, to $57.9 million from $66.8 million at December 31, 2002. The increase in 2004 was primarily due to the retention of earnings of $3.0 million and $716,000 of proceeds from the issuance of common stock, partially offset by the payment of cash dividends on common stock of $1.5 million. The decrease in 2003 was primarily due to the repurchase of 651,000 shares of common stock during 2003 at a cost of $8.4 million and the payment of cash dividends on common stock of $1.4 million, partially offset by the retention of earnings of $714,000.

In January 2003, the Financial Accounting Standards Board (the FASB) issued Financial Interpretation No. 46 (Revised), Consolidation of Variable Interest Entities (FIN 46R). This interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements (ARB 51), addresses consolidation by business enterprises where ownership interests in an entity may vary over time or in many cases, of special-purpose entities (SPE's). To be consolidated for financial reporting, these SPE's must have certain characteristics. ARB 51 requires that an enterprise's consolidated financial statements include only subsidiaries in which the enterprise has a controlling financial interest. The Company adopted FIN 46R on January 1, 2004. As a result of adoption, the Company no longer consolidates its two subsidiary trusts that had been formed in 2001 to issue trust preferred securities because the Company does not have controlling financial interests over the trusts, as specifically defined by FIN 46R. The effect of this change is that the Company now excludes the trust preferred securities issued by the subsidiary trusts from its consolidated balance sheets and includes the subordinated debentures issued by the Company to the trusts. In accordance with FIN 46R, prior period information was not restated. Additionally, there was no cumulative effect on retained earnings or a change in the Company's capital ratios as a result of this adoption.

In November 2003, the Emerging Issues Task Force (EITF) published issue summary 03-1 (EITF 03-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 addressed an entity's treatment of the impairment of securities when such impairment is considered other than temporary. The preliminary summary required disclosures only related to other than temporary impairment. In March 2004, the EITF continued its discussion and reached a consensus on the procedures for recognizing an impairment of securities considered other than temporarily impaired. The guidance in EITF 03-1 was intended to be effective for reporting periods beginning after June 15, 2004. However, in September 2004, the FASB issued FSP EITF 03-1-1, which deferred the effective date for the measurement and recognition provisions of EITF 03-1 until further implementation guidance could be established. Management does not believe the provision of this standard, as currently written, will have a material impact on the results of future operations. The Company has determined that it has the ability and intent to hold its investments classified as available for sale for a reasonable period of time sufficient for the fair value of the securities to recover.

On March 9, 2004, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 requires that when a company is recognizing and valuing a loan commitment at fair value, only differences between the guaranteed interest rate in the loan commitment and a market interest rate should be included. Any expected future cash flows related to the customer relationships or loan servicing should be excluded from the fair value measurement. The expected future cash flows that are excluded from the fair-value determination include anticipated fees for servicing the funded loan, late-payment charges, other ancillary fees, or other cash flows from servicing rights. The guidance in SAB No. 105 is effective for mortgage-loan commitments that are accounted for as derivatives and are entered into after March 31, 2004. The initial adoption of this standard did not have an impact on the

financial condition or the results of operations of the Company. Management does not believe the provisions of this standard will have a material impact on the results of future operations.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets—an amendment of APB Opinion No. 29. The guidance in APB Opinion No. 29, Accounting forNonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Opinion No. 29 included, however, certain exceptions to that principle. This statement amends Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This statement is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not expect adoption of this statement to have an effect on the Company's consolidated financial condition or results of operations.

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, a revision of SFAS 123, Accounting for Stock-Based Compensation. This statement also supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. This statement requires the fair value method of accounting for share-based payments and eliminates the intrinsic value method. This statement applies to all share-based awards granted after the required effective date July 1, 2005 and to awards modified, repurchased, or cancelled after that date. This statement also requires application of either the modified prospective or modified retrospective application method for the portion of outstanding awards that are unvested as of the effective date. The Company estimates it will have approximately 25,000 unvested stock options upon adoption of this statement for which the modified prospective application method will be applied. The Company estimates that adoption of this standard will have an insignificant effect on the Company's consolidated financial condition or results of operations. Should the Company grant new stock options in 2005, the effect on the Company's consolidated financial condition or results of operations will change.

The tables below provide information about the Company's financial instruments as of December 31, 2004 and 2003 that are sensitive to changes in interest rates.

Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which the Company is exposed is interest rate risk arising from the instruments and transactions into which the Company enters. These include loans, securities available for sale, deposit liabilities, and borrowings. Interest rate risk occurs when interest-sensitive assets and liabilities reprice at different times as market interest rates change. Interest-sensitive assets and liabilities are those that are subject to repricing in the near term, including both variable rate instruments and those fixed rate instruments that are approaching maturity. For example, if fixed-rate assets are funded with floating-rate debt, the spread between asset and liability rates will decline or turn negative if rates increase. Additionally, interest rate risk results from changing spreads between asset and liability rates.

Interest rate risk is managed by the Company's Asset/Liability Committee. The principal objective of asset/liability management is to manage the levels of interest-sensitive assets and liabilities to

minimize net interest income fluctuations in times of fluctuating market interest rates. To effectively measure and manage interest rate risk, the Company uses computer simulations that determine the impact on net interest income of numerous interest rate scenarios, balance sheet trends and strategies. These simulations cover the following financial instruments: short-term financial instruments, investment securities, loans, deposits, and borrowings. These simulations incorporate assumptions about balance sheet dynamics, such as loan and deposit growth and pricing, changes in funding mix, and asset and liability repricing and maturity characteristics. Simulations are run under various interest rate scenarios to determine the impact on net income and capital. From these computer simulations, interest rate risk is quantified and appropriate strategies are developed and implemented. As of December 31, 2004, the Company has never used interest rate derivative financial instruments as an asset/liability management tool to hedge mismatches in interest rate exposures.

Management continually monitors the Company's exposure to fluctuations in market rates. One of the tools management utilizes to estimate the sensitivity of net interest revenue to changes in interest rates is an interest rate simulation model. Such estimates are based upon a number of assumptions for each scenario, including the level of loan growth and deposit and loan repricing characteristics. The simulation model measures the potential change in net interest income for future periods under various interest rate scenarios. Based on these simulation models, if interest rates increased 200 basis points during 2005, net interest income would increase an estimated $1.9 million for the year ended December 31, 2005 and an estimated $4.5 million for the year ended December 31, 2006. On the contrary, if interest rates decreased 100 basis points during 2005 net interest income would decrease an estimated $851,000 for the year-end December 31, 2005 and $2.1 million for the year ended December 31, 2006.

The response to this item is included in Part III, Item 15 of this Annual Report on Form 10-K.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

Company management, including the Chief Executive Officer, Vice Chairman and Principal Financial and Accounting Officer, supervised and participated in an evaluation of the Company's disclosure controls and procedures (as defined in rules of the Securities and Exchange Commission) as of December 31, 2004. Based on, and as of the date of, that evaluation, the Company's Chief Executive Officer and Principal Financial and Accounting Officer have concluded that the Company's disclosure controls and procedures were effective in accumulating and communicating information to management, including the Chief Executive Officer and Principal Financial and Accounting Officer, as appropriate to allow timely decisions regarding required disclosures of that information under the Securities and Exchange Commission's rules and forms and that the disclosure controls and procedures are designed to ensure that the information required to be disclosed in reports that are filed or submitted under the Securities and Exchange Act of 1934, as amended, are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.

There were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

The information contained under the headings "Information About Nominees and Continuing Directors", "Board Operations and Other Corporate Governance Matters" in the definitive Proxy Statement to be used in connection with the solicitation of proxies for Vail Banks' annual meeting of shareholders to be held on May 16, 2005, to be filed with the Securities and Exchange Commission, is incorporated herein by reference. Information regarding executive officers is included in "Executive Officers of Vail Banks" in Item 1 of this Annual Report on Form 10-K.

The information contained under the heading "Executive Compensation" in the definitive proxy statement to be used in connection with the solicitation of proxies for Vail Banks' annual meeting of shareholders to be held on May 16, 2005, to be filed with the SEC, is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND STOCK RELATED MATTERS.

The information contained under the heading "Beneficial Ownership of Securities" and "Equity Compensation Plan Information" in the definitive proxy statement to be used in connection with the solicitation of proxies for Vail Banks' annual meeting of shareholders to be held on May 16, 2005, to be filed with the SEC, is incorporated herein by reference.

The information contained under the heading "Certain Relationships and Related Transactions" in the definitive proxy statement to be used in connection with the solicitation of proxies for Vail Banks' annual meeting of shareholders to be held on May 16, 2005, to be filed with the SEC, is incorporated herein by reference.

The information contained under the heading "Information Concerning Vail Banks' Independent Public Accountants" in the definitive proxy statement to be used in connection with the solicitation of proxies for Vail Banks' annual meeting of shareholders to be held on May 16, 2005, to be filed with the SEC, is incorporated herein by reference.

The following consolidated financial statements and notes thereto of Vail Banks begin on page F-1 of this Annual Report on Form 10-K.

Report of Independent Registered Public Accounting Firm		F-1
Consolidated Balance Sheets as of December 31, 2004 and 2003		F-2
Consolidated Statements of Income for the years ended December 31, 2004, 2003 and 2002		F-3
Consolidated Statements of Shareholders' Equity and Comprehensive Income for the years ended December 31, 2004, 2003 and 2002		F-4
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002		F-5
Notes to Consolidated Financial Statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003, and 2002		F-7

The following exhibits are required to be filed with this Annual Report on Form 10-K by Item 601 of Regulation S-K.

Exhibit No.		Description of Exhibit
3.1		Amended and Restated Articles of Incorporation of the Registrant (incorporated by reference from Exhibit 3.1 on the Registrant's Form SB-2, as amended, Commission File No. 333-60347)
3.2		Amended and Restated Bylaws of the Registrant (incorporated by reference from Exhibit 3.2 on the Registrant's Form SB-2, as amended, Commission File No. 333-60347)
10.1		Stock Incentive Plan, as amended (incorporated by reference from Exhibit 10.3 on the Registrant's Form SB-2, as amended, Commission File No. 333-60347)*
10.2		Amendment No. 2 to the Vail Banks, Inc. Amended and Restated Stock Incentive Plan dated April 19, 2004 (incorporated by reference from Exhibit 4.4 on the Registrant's Registration Statement on Form S-8, Commision File No. 333-122170)*
10.3		Change in Control Severance Payment Agreement by and between Vail Banks and E.B. Chester, dated November 19, 1999 (incorporated by reference from Exhibit 10.3 on the Registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999)*
10.4		Change in Control Severance Payment Agreement by and between Vail Banks and Lisa M. Dillon, dated November 19, 1999 (incorporated by reference from Exhibit 10.4 on the Registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999)*
10.5		Form of Restricted Stock Award Agreement (incorporated by reference from Exhibit 10.6 on the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2001)*
10.6		Change in Control Severance Payment Agreement by and between Vail Banks and Dan E. Godec, dated August 18, 2003 (incorporated by reference from Exhibit 10.1 on the Registrant's Quarterly Report on Form 10-Q filed as of November 7, 2003)*
10.7		Change in Control Severance Payment Agreement by and between Vail Banks and Gary S. Judd, dated August 18, 2003 (incorporated by reference from Exhibit 10.2 on the Registrant's Quarterly Report on Form 10-Q filed as of November 7, 2003)*
10.8		Agreement for the sale of the Vail Bank Building, dated March 5, 2004 (incorporated by reference from Exhibit 10.8 on the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2003)

We have audited the accompanying consolidated balance sheets of Vail Banks, Inc. and subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders' equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Vail Banks, Inc. and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Footnote 13, the Company adopted Financial Interpretation No. 46 (Revised), Consolidation of Variable Interest Entities (FIN 46R), effective January 1, 2004, which changed its method of accounting for its trust preferred securities.