UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

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Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

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For the Fiscal Year Ended December 31, 2005 — Commission File No. 0-2989

COMMERCE BANCSHARES, INC.

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(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act:

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NONE

Securities registered pursuant to Section 12(g) of the Act:

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Title of class

$5 Par Value Common Stock

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  þ    No o

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

Yes  o    No þ

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  þ    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ        Accelerated filer o         Non-accelerated filer o

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

Yes o    No þ

As of February 9, 2006, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $2,707,000,000.

As of February 9, 2006, there were 66,865,364 shares of Registrant’s $5 Par Value Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

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Portions of the Registrant’s definitive proxy statement for its 2006 annual meeting of shareholders, which will be filed within 120 days of December 31, 2005, are incorporated by reference into Part III of this Report.

Commerce Bancshares, Inc.

Form 10-K

PART I

Item 1. BUSINESS

General

      Commerce Bancshares, Inc. (the “Company”), a bank holding company as defined in the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Missouri on August 4, 1966. The Company presently owns all of the outstanding capital stock of three national banking associations, which are headquartered in Missouri (the “Missouri bank”), Kansas (the “Kansas bank”), and Nebraska (the “Nebraska bank”). The Nebraska bank is limited in its activities to the issuance of credit cards. The remaining two banking subsidiaries engage in general banking business, providing a broad range of retail, corporate, investment, trust, and asset management products and services to individuals and businesses. The Company also owns, directly or through its banking subsidiaries, various non-banking subsidiaries. Their activities include owning real estate leased to the Company’s banking subsidiaries, underwriting credit life and credit accident and health insurance, selling property and casualty insurance (relating to consumer loans made by the banking subsidiaries), venture capital investment, securities brokerage, mortgage banking, and leasing activities. The Company owns a second tier holding company that is the direct owner of both the Missouri and Kansas banks. A list of the Company’s subsidiaries is included as Exhibit 21.

      The Company is the largest bank holding company headquartered in Missouri. At December 31, 2005, the Company had consolidated assets of $13.9 billion, loans of $8.9 billion, deposits of $10.9 billion, and stockholders’ equity of $1.3 billion.

      The Missouri bank is the Company’s largest, with total assets of $12.4 billion and comprising approximately 91% of the Company’s total banking assets. The bank’s facilities are located throughout Missouri, in eastern Kansas, and in the Peoria and Bloomington areas in Illinois. The Kansas bank has total assets of $1.2 billion. It has significant operations and banking facilities in the areas of Wichita, Hays, Hutchinson, and Garden City, Kansas.

      The markets these banks serve, being centrally located in the Midwest, provide natural sites for production and distribution facilities and also serve as transportation hubs. The economy has been well-diversified with many major industries represented, including telecommunications, automobile manufacturing, aircraft manufacturing, health care, numerous service industries, food production and agricultural production and related industries. In addition, several of the Illinois markets are located in areas with some of the most productive farmland in the world. The banks operate in areas with stable real estate markets, which in the past have avoided the volatile prices that other parts of the country have experienced.

      The Company regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions eligible for bank holding company ownership or control. In addition, the Company regularly considers the potential disposition of certain of its assets and branches. The Company’s most recent acquisition was in January 2003 when it purchased The Vaughn Group, Inc., a direct equipment lessor based in Cincinnati, Ohio with a portfolio of direct financing, sales type and operating leases. The last bank acquisition was in March 2001, when the Company acquired Breckenridge Bancshares Company and its subsidiary, Centennial Bank. For additional information on acquisition and branch disposition activity, refer to pages 14 and 56.

Operating Segments

      The Company is managed in three operating segments. The Consumer segment includes the retail branch network, consumer installment lending, personal mortgage banking, bank card activities, student lending, and discount brokerage services. It provides services through a network of 191 full-service branches, a widespread ATM network of 385 machines, and the use of alternative delivery channels such as extensive online banking and telephone banking services. In 2005 this retail segment contributed 54% of total segment pre-tax income. The Commercial segment provides a full array of corporate lending,

leasing, and international services, as well as business and government deposit and cash management services. In 2005 it contributed 37% of total segment pre-tax income. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment portfolio management services. This segment also manages the Company’s family of proprietary mutual funds, which are available for sale to both trust and general retail customers. Fixed income investments are sold to individuals and institutional investors through the Capital Markets group, which is also included in this segment. At December 31, 2005 the Money Management segment managed investments with a market value of $10.6 billion and administered an additional $9.1 billion in non-managed assets. Additional information relating to operating segments can be found on pages 37 and 71.

Supervision and Regulation

      The Company, as a bank holding company, is primarily regulated by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (BHC Act). Under the BHC Act, the Federal Reserve Board’s prior approval is required in any case in which the Company proposes to acquire all or substantially all of the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company. The BHC Act also prohibits, with certain exceptions, the Company from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any non-banking company. Under the BHC Act, the Company may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries and may not acquire voting control of non-banking companies unless the Federal Reserve Board determines such businesses and services to be closely related to banking. When reviewing bank acquisition applications for approval, the Federal Reserve Board considers, among other things, each subsidiary bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (CRA). The Missouri, Kansas and Nebraska bank charters have current CRA ratings of “outstanding”.

      The Company is required to file with the Federal Reserve Board various reports and such additional information as the Federal Reserve Board may require. The Federal Reserve Board also makes regular examinations of the Company and its subsidiaries. The Company’s three banking subsidiaries are organized as national banking associations and are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC). All banks are also subject to regulation by the Federal Deposit Insurance Corporation. In addition, there are numerous other federal and state laws and regulations which control the activities of the Company and its banking subsidiaries, including requirements and limitations relating to capital and reserve requirements, permissible investments and lines of business, transactions with affiliates, loan limits, mergers and acquisitions, issuance of securities, dividend payments, and extensions of credit. This regulatory framework is intended primarily for the protection of depositors and the preservation of the federal deposit insurance funds, and not for the protection of security holders. Statutory and regulatory controls increase a bank holding company’s cost of doing business and limit the options of its management to employ assets and maximize income.

      In addition to its regulatory powers, the Federal Reserve impacts the conditions under which the Company operates by its influence over the national supply of bank credit. The Federal Reserve Board employs open market operations in U.S. government securities, changes in the discount rate on bank borrowings, changes in the federal funds rate on overnight inter-bank borrowings, and changes in reserve requirements on bank deposits in implementing its monetary policy objectives. These instruments are used in varying combinations to influence the overall level of the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets and the level of inflation. The monetary policies of the Federal Reserve have had a significant effect on the operating results of financial institutions in the past, most notably the low rate environment in recent years. In view of changing conditions in the national economy and in the money markets, as well as the effect of credit policies of monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels or loan demand, or their effect on the financial statements of the Company.

      Under Federal Reserve policy, the Company is expected to act as a source of financial strength to each of its bank subsidiaries and to commit resources to support each bank subsidiary in circumstances when it might not otherwise do so. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

      The principal source of the Company’s cash revenues is dividends from the subsidiary banks. The Federal Reserve Board may prohibit the payment of dividends by bank holding companies if their actions constitute unsafe or unsound practices. The OCC limits the payment of dividends by bank subsidiaries in any calendar year to the net profit of the current year combined with the retained net profits of the preceding two years. Permission must be obtained from the OCC for dividends exceeding these amounts. The payment of dividends by the bank subsidiaries may also be affected by factors such as the maintenance of adequate capital.

      The Company is required to comply with the capital adequacy standards established by the Federal Reserve. These capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets and off-balance sheet items (the “Total Risk-Based Capital Ratio”), with at least one-half of that amount consisting of Tier I or core capital and the remaining amount consisting of Tier II or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common shareholders’ equity, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill and other non-qualifying intangible assets. Tier II capital generally consists of hybrid capital instruments, term subordinated debt and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics.

      In addition, the Federal Reserve also requires bank holding companies to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier I capital to its total consolidated quarterly average assets (as defined for regulatory purposes), net of the allowance for loan losses, goodwill and certain other intangible assets. The minimum leverage ratio for bank holding companies is 4%. At December 31, 2005 all of the subsidiary banks were “well-capitalized” under regulatory capital adequacy standards, as further discussed on page 74.

      These laws and regulations are under constant review by various agencies and legislatures, and are subject to sweeping change. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLB Act) contained major changes in laws that previously kept the banking industry largely separate from the securities and insurance industries. The GLB Act authorized the creation of a new kind of financial institution, known as a “financial holding company” and a new kind of bank subsidiary called a “financial subsidiary”, which may engage in a broader range of investment banking, insurance agency, brokerage, and underwriting activities. The GLB Act also included privacy provisions that limit banks’ abilities to disclose non-public information about customers to non-affiliated entities. Banking organizations are not required to become financial holding companies, but instead may continue to operate as bank holding companies, providing the same services they were authorized to provide prior to the enactment of the GLB Act.

      In 2001, President Bush signed into law comprehensive anti-terrorism legislation known as the USA Patriot Act. Title III of the USA Patriot Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as the Company’s broker-dealer subsidiary. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. In December 2005, Congress voted to extend some expiring provisions of the Patriot Act for six months.

      The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, a major reform of the bankruptcy system, was passed by Congress and signed into law by President Bush in April 2005. Changes instituted by this new law took effect on October 17, 2005. Under the new bankruptcy law, bankruptcy applicants who wish to file under Chapter 7 must meet certain eligibility requirements under a “means test”. While the immediate impact on the banking industry was a surge in bankruptcy filings in the fourth quarter of 2005, the long-term effect of the change is expected to be a reduction in bankruptcy filings, thereby limiting bankruptcy-related loan charge-offs.

Competition

      The Company’s locations in regional markets throughout Missouri, Kansas and central Illinois face intense competition from hundreds of financial service providers. The Company competes with national and state banks for deposits, loans and trust accounts, and with savings and loan associations and credit unions for deposits. In addition, the Company competes with other financial intermediaries such as securities brokers and dealers, personal loan companies, insurance companies, finance companies, and certain governmental agencies. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits, lending limits and customer convenience, such as location of offices. The passage of the GLB Act, which removed barriers between banking and the securities and insurance industries, has resulted in greater competition among these industries.

Employees

      The Company and its subsidiaries employed 4,397 persons on a full-time basis and 662 persons on a part-time basis at December 31, 2005. The Company provides a variety of benefit programs including retirement and 401K plans as well as group life, health, accident, and other insurance. The Company also maintains training and educational programs designed to prepare employees for positions of increasing responsibility.

Available Information

      The Company’s principal offices are located at 1000 Walnut, Kansas City, Missouri (telephone number 816-234-2000). The Company makes available free of charge, through its web site at www.commercebank.com, reports filed with the Securities and Exchange Commission as soon as reasonably practicable after the electronic filing. These filings include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports.

Statistical Disclosure

      The information required by Securities Act Guide 3 – “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.

Item 1a. RISK FACTORS

      Investments in Commerce Bancshares, Inc. common stock involve risk. The market price of the Company’s common stock may fluctuate significantly in response to a number of factors, including:

Geographical Risk

      The Company’s main markets are included in the states of Missouri, Kansas and central Illinois. Since the Company does not have significant presence in other parts of the country, a prolonged economic downturn in these markets could negatively impact the Company.

Industry Risk

      The Company operates in the financial services industry, a rapidly changing environment having numerous competitors including other banks and insurance companies, securities dealers, brokers, trust and investment companies and mortgage bankers. The pace of consolidation among financial service providers is accelerating and there are many new changes in technology, product offerings and regulation.

The Company must continue to make investments in its products and delivery systems to stay competitive with the industry as a whole or its financial performance may suffer.

Regulatory Risk

      The Company and its subsidiaries are subject to extensive state and federal regulation, supervision and legislation that govern nearly every aspect of its operations. Changes to these laws could affect the Company’s ability to deliver or expand its services and diminish the value of its business.

Interest Rate Risk

      The Company’s net interest income is the largest source of overall revenue to the Company and is mainly based on the difference between interest earned on loans and investment securities, and the interest paid on deposits and other borrowings. Interest rates are beyond the Company’s control, and they fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the purchase of investments, the generation of deposits, and the rates received on loans and investment securities and paid on deposits. Refer to page 35 for a discussion of the Company’s interest rate sensitivity and interest rate risk.

Lending Risk

      There are inherent risks associated with the Company’s lending activities. Changes in economic conditions and changes in interest rates among other things could impact borrowers’ capabilities to repay the Company outstanding loans. For a complete discussion of the risk elements of the Company’s loan portfolio, please refer to page 26.

Litigation Risk

      From time to time, the Company is subject to claims and litigation from customers and other individuals. Whether such claims and legal action are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business and financial performance.

Item 1b. UNRESOLVED STAFF COMMENTS

      None

Item 2. PROPERTIES

      The bank subsidiaries maintain their main offices in various multi-story office buildings. The Missouri bank owns its main offices and leases unoccupied premises to the public. The larger offices include:

      The Nebraska credit card bank leases its offices in Omaha, Nebraska. Additionally, certain other installment loan, trust and safe deposit functions operate out of leased offices in downtown Kansas City. The Company has an additional 184 branch locations in Missouri, Illinois and Kansas which are owned or leased, and 151 off-site ATM locations.

      In 2005, the Missouri bank purchased a multi-story office building at 811 Main, which is currently undergoing renovation. The bank expects to move its backroom check operations from its building at 720 Main to the new facility and eventually sell the 720 Main building. Also in 2005, the Kansas bank completed construction on a new multi-story building in Wichita and moved its principal operations staff to this location.

Item 3. LEGAL PROCEEDINGS

      The information required by this item is set forth in Item 8 under Note 18, Commitments, Contingencies and Guarantees on page 79.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      No matters were submitted during the fourth quarter of 2005 to a vote of security holders through the solicitation of proxies or otherwise.

Executive Officers of the Registrant

      The following are the executive officers of the Company, each of whom is designated annually, and there are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was designated an executive officer.

PART II

Commerce Bancshares, Inc.

Common Stock Data

      The following table sets forth the high and low prices of actual transactions for the Company’s common stock (CBSH) and cash dividends paid for the periods indicated (restated for the 5% stock dividend distributed in December 2005).

      Commerce Bancshares, Inc. common shares are publicly traded on The Nasdaq Stock Market (NASDAQ). NASDAQ is a highly-regulated electronic securities market comprised of competing Market Makers whose trading is supported by a communications network linking them to quotation dissemination, trade reporting, and order execution systems. In January 2006, the Securities and Exchange Commission approved its application to become a registered national securities exchange. The Company had 4,522 shareholders of record as of December 31, 2005.

      The following table sets forth information about the Company’s purchases of its $5 par value common stock, its only class of stock registered pursuant to Section 12 of the Exchange Act.

      On October 21, 2005, the Company announced that its Board of Directors had approved a new authorization for the purchase of up to 5,000,000 shares of Company common stock. The Company had recently completed the repurchase of 5,000,000 shares pursuant to a prior authorization by the Board of Directors.

      The required information is set forth below in Item 7.

Overview

      Commerce Bancshares, Inc. (the Company) operates as a super-community bank offering an array of sophisticated financial products delivered with high-quality, personal customer service. It is the largest bank holding company headquartered in Missouri, with its principal offices in Kansas City and St. Louis, Missouri. Customers are served from approximately 340 locations in Missouri, Kansas, and Illinois, using delivery platforms which include an extensive network of branches and ATM machines, full-featured online banking, and a central contact center.

      The core of the Company’s competitive advantage is its concentration on relationship banking with high service levels and competitive products. In order to enhance shareholder value, the Company focuses on growing its core revenue by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction.

      Various indicators are used by management in evaluating the Company’s financial condition and operating performance. Among these indicators are the following:

      The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. The historical trends reflected in the financial information presented below are not necessarily reflective of anticipated future results.

Key Ratios

Selected Financial Data

Results of Operations

      The Company’s fully diluted earnings per share amounted to $3.16 in 2005 compared to $2.95 in 2004, an increase of 7.1%. Net income for 2005 was $223.2 million, which increased 1.3% over 2004, making 2005 the 21st consecutive year of record earnings. Return on assets amounted to 1.60% compared with 1.56% last year and the return on equity totaled 16.19% compared to 15.19% last year. The efficiency ratio was 59.30% in 2005 compared with 59.16% in 2004.

      The increase in net income in 2005 compared to 2004 was due to growth in non-interest income and an improving net interest margin, combined with effective expense management and a lower loan loss provision. Non-interest income rose $14.3 million, or 4.4%, largely due to increases of 10.3% in bank card fees, 7.2% in deposit account fees, and 6.3% in trust revenues. The growth in non-interest expense was constrained to 2.8%, mainly the result of lower costs for supplies and communications (down 1.2%), coupled with increases in salaries and benefits (up 2.9%) and modest increases in occupancy, equipment, and data processing and software costs. Net interest income increased $4.4 million, reflecting the effects of higher average overall rates earned on loans and growth in average loan balances, partly offset by declining average balances in investment securities. Also, interest expense on deposit transaction accounts and short-term borrowings rose, mainly related to increases by the Federal Reserve in short-term interest rates during 2005. The provision for loan losses decreased $1.6 million to $28.8 million, reflecting lower business loan net charge-offs, partly offset by higher credit card and personal banking net loan charge-offs. Income tax expense increased 3.9% in 2005 and resulted in an effective tax rate of 29.7%, which was comparable to 29.2% in the prior year. Income tax expense in 2005 included the recognition of tax benefits of $13.7 million, representing the effects of certain corporate restructuring initiatives, and compares to $18.9 million of similar benefits recorded in 2004.

      Net income in 2004 was $220.3 million, which was a $13.8 million, or 6.7%, increase over 2003. Diluted earnings per share increased 10.5% to $2.95 compared to $2.67 in 2003. The increase in net income over 2003 was mainly due to growth in non-interest income of $25.3 million, or 8.4%, coupled with lower credit costs and strong expense control. The increase in non-interest income was largely due to increases in bank card fees of 16.6% and deposit account fees of 7.9%, partly offset by declines in bond trading account revenue and loan fees and sales. Non-interest expense increased 2.3%, mainly due to increases in data processing costs (up 13.4%) and marketing costs (up 15.9%). Net interest income declined $5.1 million from 2003, partly due to slower growth in business and business real estate loans. In addition, interest expense on deposits and borrowings rose, as the Federal Reserve began a series of short-term rate increases in the second half of 2004. The provision for loan losses decreased $10.3 million to $30.4 million, largely due to decreases in business real estate, overdraft and consumer net loan charge-offs. Income tax expense increased 7.2% and included tax benefits of $18.9 million relating to the initiatives mentioned above, compared to similar benefits of $15.2 million in 2003.

      Effective January 2003, the Company acquired The Vaughn Group, Inc. (Vaughn), a direct equipment lessor based in Cincinnati, Ohio. At acquisition, Vaughn had a lease portfolio that was principally comprised of $32.8 million of direct financing leases. These leases are secured mainly by computer hardware and office equipment. In addition, at the date of acquisition Vaughn serviced approximately $350 million of lease agreements for other institutions involving capital equipment, ranging from production machinery to transportation equipment. The Company issued a combination of cash and stock to complete this purchase. Goodwill of $5.3 million was recognized in the transaction and recorded in the 2003 consolidated balance sheet.

      The Company continually evaluates its network of bank branches throughout Missouri, Kansas and Illinois. As a result of this evaluation process, the Company may periodically sell the assets and liabilities of certain branches, or may sell specific banking facilities. In 2005, the Company sold four bank facilities, realizing pre-tax gains of $802 thousand on the sales. The Company sold three bank facilities during 2004, compared to two in 2003. The gains and losses realized on the sales of those premises in 2004 and 2003 were not significant. During 2004, the Company sold a branch with loans of $12.9 million and deposits of $16.5 million, realizing a pre-tax gain of $1.1 million.

      The Company distributed a 5% stock dividend for the twelfth consecutive year on December 13, 2005. All per share and average share data in this report has been restated to reflect the 2005 stock dividend.

Critical Accounting Policies

      The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 to the consolidated financial statements. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s reported results and financial position for the period or in future periods. The use of estimates, assumptions, and judgments are necessary most often when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments primarily by using internal cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company’s future financial condition and results of operations.

      The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses and accounting for income taxes.

      The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, nevertheless, actual outcomes may differ significantly from estimated results, especially in the areas of determining allowances for business, lease, construction and business real estate loans. These loan types are normally larger and more complex, and their collection rates are harder to predict. Consumer loans, including personal mortgage, credit card and personal loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Extensive explanation of the methodologies used in establishing the allowance is provided in the Allowance for Loan Losses section of this discussion.

      The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact the Company’s financial position and its results of operations. Discussion of income taxes is presented on page 20 of this discussion and in Note 9 on Income Taxes in the consolidated financial statements.

Net Interest Income

      Net interest income, the largest source of revenue, results from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.

      Net interest income amounted to $501.7 million in 2005, representing an increase of $4.4 million, or less than 1%, compared to $497.3 million in 2004. Net interest income decreased $5.1 million, or 1.0%, in 2004 compared to $502.4 million in 2003. The increase in net interest income in 2005 was the result of growth of $96.2 million in tax equivalent loan interest income as a result of higher rates and higher average balances, partly offset by a decline of $9.8 million in tax equivalent interest earned on investment securities due principally to lower average balances. Interest on deposits and total borrowings also grew by a combined $83.1 million as a result of higher rates on all categories of deposits and borrowings. The increase in rates on both interest earning assets and interest bearing liabilities was the result of eight 25 basis point rate increases initiated by the Federal Reserve in 2005. As a result of these rate changes and the change in the mix of assets and liabilities on the Company’s balance sheet, the net yield on interest earning assets was 3.89% in 2005 compared to 3.81% in 2004.

      During 2004, net interest income decreased slightly from amounts recorded in 2003 mainly because of downward re-pricing of interest earning assets during the first half of 2004, and lower rates on securities purchased during the year. However, during the second half of 2004, the Federal Reserve initiated five 25 basis point increases, which raised rates earned on many loans in the Company’s loan portfolio tied to variable rates. The increase in loan yields, however, was partially offset by an increase in the borrowing costs of federal funds purchased due to increases in short-term interest rates. Yields on earning assets declined 29 basis points from 2003, while rates paid on deposits decreased 12 basis points and rates paid on other borrowings increased 17 basis points. As a result, the Company’s net interest margin narrowed to 3.81% from 4.04% in 2003.

      Total interest income was $697.6 million in 2005 compared to $610.1 million in 2004 and $617.4 million in 2003. Tax equivalent interest income did not materially differ. Interest income increased in 2005 by $87.5 million, or 14.3%, as a result of a $95.9 million increase in income from loans offset slightly by an $11.3 million decrease in interest income from investment securities. The tax equivalent average rate earned on interest earning assets was 5.40% in 2005 compared to 4.67% in 2004, representing a 73 basis point increase. Interest income on loans increased as a result of an 86 basis point increase in the average yield, coupled with a $431.4 million, or 5.3%, increase in the average balance in 2005 compared to 2004. The increase in interest income on loans was offset slightly by a decrease in interest income on investment securities. The tax equivalent average yield on investment securities increased 27 basis points, which was offset by a $569.5 million, or 11.6%, decrease in the investment securities average balance, resulting in an overall decrease in interest income earned on the investment portfolio in 2005 compared to 2004. Because of its strong liquidity position during 2005, the Company has funded its loan growth principally by reducing its investment securities portfolio through both maturities and sales. This strategy improved the overall mix of earning assets and was a contributor to the increase in net interest margin in 2005.

      Interest expense increased $83.1 million, or 73.7%, in 2005 compared to 2004 and was impacted by the rising rate environment noted above. Interest expense on deposits increased $53.0 million in 2005 over the previous year as a result of a 47 basis point average rate increase, coupled with 9.2% growth in average interest bearing deposit balances. Average rates paid on premium money market accounts increased 99 basis points, and both average rates and average balances of short-term certificates of deposit increased. Additionally, interest expense on other borrowings grew by $30.2 million, resulting mainly from an increase in rates of 184 basis points on federal funds purchased. Interest rates paid on interest bearing deposits and short-term borrowings will continue to be impacted by the changing interest rate environment as the Company competes for funding sources to support loan growth.

      Total interest income declined $7.3 million, or 1.2%, in 2004 compared to 2003. The decline was primarily due to decreases in rates on loans and investment securities. Average loan balances increased $120.7 million during 2004 compared to 2003 and this growth generated $9.9 million of interest income; however, this increase was offset by the effect of lower rates which reduced interest income by over $18 million. Yields on investment securities were lower, as maturing securities were reinvested in lower earning securities. Additional purchases of securities, funded by growth in deposits and other borrowed funds, increased the average by $451.4 million and contributed $20.2 million in additional interest income.

      The average rate incurred on interest bearing liabilities was 1.00% in 2004 compared to 1.06% in 2003. The lower interest rate environment experienced in the first half of 2004 resulted in an interest rate decline of 12 basis points on deposits offset by an increase of 24 basis points on short-term borrowings. The largest decline in deposit rates was on the Company’s retail (under $100,000) certificate of deposit accounts, where rates declined 32 basis points. In addition, rates on the Company’s jumbo (over $100,000) certificates of deposit decreased 15 basis points. The re-pricing of short-term borrowings as a result of the changing interest rate environment experienced in 2004, primarily federal funds purchased, resulted in an increase of $4.1 million in interest expense. Growth of $277.2 million in the average balance of short-term borrowings caused interest expense to increase $3.2 million.

Provision for Loan Losses

      The provision for loan losses was $28.8 million in 2005, compared with $30.4 million in 2004 and $40.7 million in 2003. The $1.6 million decline in the 2005 provision for loan losses reflected lower business loan net charge-offs, partly offset by increases in credit card and personal banking loan charge-offs. The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed adequate by management based on the factors mentioned in the following “Allowance for Loan Losses” section of this discussion.

Non-Interest Income

     Non-interest income was $341.2 million in 2005, which was a $14.3 million, or 4.4%, increase over 2004, and included net securities gains of $6.4 million in 2005 and $11.1 million in 2004. Excluding these net securities gains, non-interest income grew 6.0%. In 2005, deposit account fees increased 7.2%, or $7.6 million, due to a $15.5 million increase in overdraft and return item fees, partly offset by a $4.9 million decline in fees earned on commercial cash management accounts. The growth in overdraft and return item fees over last year was the result of increasing transaction volumes during the year and pricing changes initiated in the third quarter of 2005. The decline in corporate cash management fee income was largely the effect of the rising interest rate environment. Compared to the previous year, bank card fees increased $8.1 million, or 10.3%, mainly due to higher fees earned on debit, credit and corporate card transactions, which grew by 14.3%, 10.3% and 16.3%, respectively. The strong growth in corporate card fees was attributable to transaction fees from commercial businesses and non-profit enterprises who are utilizing these electronic transactions in greater proportions. Debit and credit card transaction fees continue to grow as a result of greater utilization rates and related retail sales. Merchant fee income was flat compared with the previous year and was impacted by narrowing margins on a growing transaction base.

      Trust fees increased $4.1 million, or 6.3%, as a result of increasing market values of trust account assets and new business, occurring largely in private client trust product lines. Private client sales efforts in 2005 resulted in new annualized fees of $5.0 million, an increase of 37.0% over sales results in the previous year. Total trust assets, including managed and custodial accounts, grew to $19.7 billion, an increase of 7.7%. Trading account fees, consisting of fees from sales of fixed income securities, declined 21.5% in 2005 due to lower demand by business and correspondent bank customers. Consumer brokerage service fees increased slightly, mainly due to higher revenues from mutual fund and insurance sales, partly offset by lower annuity sales. Loan fees and sales declined $816 thousand as gains on student loan sales declined from $8.5 million in 2004 to $8.0 million in 2005. Net gains on securities transactions amounted to $6.4 million in 2005, which was a decrease of $4.7 million compared to the previous year. During 2005, the Company undertook initiatives to review and re-position its investment securities portfo-

lio to address such things as concentration, duration and interest rate risk. Consequently, during 2005 the Company sold available for sale securities totaling $1.8 billion and recorded net gains of $5.1 million. These sales were comprised mainly of $533.9 million in U.S. government agency securities, $768.4 million in asset-backed securities, and $359.1 million in inflation-indexed treasury securities. Also included in 2005 activity were net gains of $1.3 million recognized on market adjustments and sales of private equity investments.

      In 2004, non-interest income increased $25.3 million, or 8.4%, to $326.9 million. Deposit account fees increased 7.9%, or $7.7 million, due to a $9.8 million increase in overdraft and return item fees, partly offset by a $1.5 million decline in fees earned on commercial cash management accounts. Bank card fees increased $11.2 million, or 16.6%, mainly due to growth in fees on credit cardholder transactions, which rose 17.1% over the previous year. Also, merchant fees and debit card fees increased 18.7% and 14.8%, respectively. In 2004, trust fees increased $3.3 million, or 5.5%, because of growth in institutional and private client trust product lines. Trading account fees declined 16.6% in 2004 due to lower sales activity. Consumer brokerage service fees increased 4.6% mainly due to higher revenues from equity security sales. Loan fees and sales declined slightly mainly due to lower personal mortgage loan originations, partly offset by higher gains on the sales of student loans, which increased from $7.0 million in 2003 to $8.5 million in 2004. Net gains on securities transactions amounted to $11.1 million in 2004, an increase of $6.5 million over the previous year. The 2004 activity included gains of $11.2 million resulting mainly from sales of inflation-indexed bonds from the banks’ securities portfolios, and losses of $317 thousand recognized on private equity investments. Other non-interest income included a $1.1 million gain on a bank branch sale in the second quarter of 2004. In addition, farm management fees declined $1.2 million due to the sale of the farm management business in the third quarter of 2003.

Non-Interest Expense

      Non-interest expense was $496.5 million in 2005, an increase of $13.8 million, or 2.8%, over 2004. Compared with the prior year, salary and employee benefits expense increased $7.7 million, or 2.9%, as a result of higher staff salaries expense, partly offset by declines in retirement and medical insurance costs. Net occupancy expense rose 2.7% over the prior year, mainly as a result of higher depreciation and utilities expense on two new office buildings. These increases were partly offset by lower net rent expense as certain banking offices were moved from leased facilities to the new buildings and office space was leased to outside tenants. Equipment expense increased 1.3%, with the slight increase due to higher costs for small equipment purchases and maintenance contract expense. Data processing costs increased $2.2 million, or 4.9%, due to higher bank card processing costs (up $1.8 million and related to the higher bank card revenues) and higher online banking processing fees, partly offset by lower software license fees. Marketing expense increased only $606 thousand, or 3.6%, compared to the previous year. Other non-interest

expense increased $2.3 million, or 3.9%, over the prior year mainly due to increases in proprietary mutual fund expense subsidies, operating losses (mostly bank card fraud), and minority interest expense relating to investment gains recorded by venture capital affiliates. These increases were partly offset by decreases in loan collection expense and professional fees, in addition to higher capitalized loan costs.

      Non-interest expense rose 2.3% in 2004 to a total of $482.8 million, compared to $472.1 million in 2003. Compared with the prior year, salary and employee benefits expense grew slightly as a result of higher staff salaries expense and workman’s compensation insurance expense, offset by declines in incentive payments and pension plan expense. Net occupancy expense rose 2.1% over the prior year, mainly due to higher net rent expense resulting from the sale of a bank facility early in 2004, which resulted in lower outside tenant rent income and higher rent expense as banking operations in this facility were moved to other leased facilities. Equipment expense declined $1.2 million, or 5.0%, due to lower depreciation expense on computer hardware. Data processing costs increased $5.4 million, or 13.4%, due to higher bank card processing costs (up $2.3 million) and higher technology software expense. Marketing expense increased $2.3 million, or 15.9%, compared to the previous year as a result of incentives paid on new product offerings and expanded marketing efforts. Other non-interest expense increased $2.2 million over the prior period mainly due to lower capitalized loan costs and increases in loan collection expense and operating losses. These increases were partly offset by lower professional fees, operating lease depreciation, and minority interest expense resulting from venture capital activity.

Income Taxes

      Income tax expense was $94.3 million, compared to $90.8 million in 2004 and $84.7 million in 2003. Income tax expense in 2005 increased 3.9% over 2004, compared to a 2.1% increase in pre-tax income. The effective tax rate on income from operations was 29.7%, 29.2% and 29.1% in 2005, 2004 and 2003, respectively. The Company’s effective tax rates were lower than the federal statutory rate of 35% mainly due to tax exempt interest on state and municipal obligations, state and federal tax credits realized and the recognition of additional tax benefits from various corporate reorganization initiatives.

      In 2005, the Company recognized certain net tax benefits associated with various corporate reorganization initiatives amounting to $13.7 million. Similar tax benefits amounting to $18.9 million and $15.2 million were recognized in 2004 and 2003, respectively. It is not expected that material tax benefits of this nature will continue beyond 2005.

Financial Condition

Loan Portfolio Analysis

      A schedule of average balances invested in each category of loans appears on page 42. Classifications of consolidated loans by major category at December 31 for each of the past five years are as follows:

      The contractual maturities of loan categories at December 31, 2005, and a breakdown of those loans between fixed rate and floating rate loans are as follows:

     Total period end loans increased $593.8 million, or 7.1%, during 2005 compared to an increase of $162.7 million, or 2.0%, during 2004. Growth in these loan balances at December 31, 2005 compared to the previous year end came principally from business, business real estate and consumer loans. At the end of the third quarter of 2005, the Company elected to make certain reclassifications among loan categories to better realign loan reporting with related collateral and purpose and to reclassify certain construction loans that had moved into amortizing term loans following project completion. The reclassifications transferred approximately $11 million and $27 million, respectively, from the business and construction loan categories to the business real estate loan category.

      Excluding these reclassification effects, business loans grew $292.5 million, or 13.0%, and business real estate loans grew $137.7 million, or 7.9%, both mainly as a result of improving economic conditions, with added borrowings from existing customers and new customer activity. The growth in business real estate loans occurred mainly during the fourth quarter of 2005; balances during the first three quarters of 2005 were stable but lower than in 2004. Lease balances, included in the business category, increased $38.5 million, or 21.1%, compared with the previous year end balance. Construction loans rose $24.1 million, or 5.7%. Consumer loans grew $93.5 million, or 7.8%, during the year mainly as a result of continued growth in marine and recreational vehicle lending. Home equity loans grew to $448.5 million, an increase of $37.0 million, or 9.0%, over year end 2004. Personal real estate loans grew by $17.9 million, as customer originations in 2005 were slightly higher than in 2004. Credit card loans increased $31.4 million, or 5.6%, and saw solid growth, especially at year end when holiday activity is normally at its peak. Student loans declined by $27.8 million, or 7.8%, mainly due to loan sales from the portfolio.

      The growth in total loans in 2004 compared to 2003 was primarily the result of increases in business, consumer, home equity and credit card loans.

      The Company currently generates approximately 31% of its loan portfolio in the St. Louis regional market and 29% in the Kansas City regional market. The portfolio is diversified from a business and retail standpoint, with 55% in loans to businesses and 45% in loans to consumers. A balanced approach to loan portfolio management and an historical aversion toward credit concentrations, from an industry, geographic and product perspective, have contributed to low levels of problem loans and loan losses.

      Total business loans amounted to $2.5 billion at December 31, 2005 and include loans used mainly to fund customer accounts receivable, inventories, and capital expenditures. This portfolio also includes sales type and direct financing leases totaling $221.3 million, which are used by commercial customers to finance capital purchases ranging from computer equipment to office and transportation equipment. These leases comprise 2.5% of the Company’s total loan portfolio. Business loans are made primarily to customers in the regional trade area of the Company, generally the central Midwest, encompassing the states of Missouri, Kansas, Illinois, and nearby Midwestern markets, including Iowa, Oklahoma and Indiana. The portfolio is diversified from an industry standpoint and includes businesses engaged in manufacturing, wholesaling, retailing, agribusiness, insurance, financial services, public utilities, and other service businesses. Emphasis is upon middle-market and community businesses with known local management and financial stability. The Company participates in credits of large, publicly traded companies when business operations are maintained in the local communities or regional markets and opportunities to provide other banking services are present. Consistent with management’s strategy and emphasis upon relationship banking, most borrowing customers also maintain deposit accounts and utilize other banking services. There were net loan recoveries in this category of $3.0 million in 2005 compared to net charge-offs of $5.6 million in 2004, mainly because a $6.0 million charge-off in 2004 on a single business loan was partially recovered in 2005. Non-accrual business loans decreased to $5.9 million (.2% of business loans) at December 31, 2005, and included $2.8 million in leases. Total business non-accrual loans were $9.5 million (.4% of business loans) at December 31, 2004. Opportunities for growth in business loans will be based upon strong solicitation efforts in a highly competitive market environment for quality loans. Asset quality is, in part, a function of management’s consistent application of underwriting standards and credit terms through stages in economic cycles. Therefore, portfolio growth in 2006 will be dependent upon 1) the strength of the economy, 2) the actions of the Federal Reserve with regard to targets for economic growth, interest rates, and inflationary tendencies, and 3) the competitive environment.

      The portfolio of loans in this category amounted to $424.6 million at December 31, 2005 and comprised 4.8% of the Company’s total loan portfolio. This group of loans includes residential construction loans totaling $113.0 million at December 31, 2005, or 27% of the category, and commercial construction and land development loans totaling $311.6 million, or 73%. These loans are predominantly made to businesses in the local markets of the Company’s banking subsidiaries. Commercial construction loans are made during the construction phase for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, apartment complexes, shopping centers, hotels and motels, and other commercial properties. Exposure to larger speculative office properties remains low. Residential construction and land development loans are primarily for projects located in the Kansas City and St. Louis metropolitan areas. Credit losses in this portfolio are normally low, and there were no net charge-offs in 2005 compared to $4 thousand net charge-offs in 2004. No construction loans were on non-accrual status at year end 2005, compared to $685 thousand at year end 2004.

      Total business real estate loans were $1.9 billion at December 31, 2005 and comprised 21.6% of the Company’s total loan portfolio. This category includes mortgage loans for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, shopping centers, hotels and motels, and other commercial properties. Emphasis is placed on owner-occupied and income producing commercial real

estate properties which present lower risk levels. The borrowers and/or the properties are generally located in the local and regional markets of the affiliate banks. At December 31, 2005, non-accrual balances amounted to $3.1 million, or .2% of the loans in this category, compared to $6.6 million at year end 2004. The Company experienced $497 thousand net charge-offs in 2005 compared to net recoveries of $231 thousand in 2004.

      At December 31, 2005, there were $1.4 billion in outstanding personal real estate loans, which comprised 15.3% of the Company’s total loan portfolio. The mortgage loans in this category are extended, predominately, for owner-occupied residential properties. The Company originates both adjustable rate and fixed rate mortgage loans. The Company retains adjustable rate mortgage loans, and may from time to time retain certain fixed rate loans (typically 15-year fixed rate loans) as directed by its Asset/ Liability Management Committee. Other fixed rate loans in the portfolio have resulted from previous bank acquisitions. At December 31, 2005, 63% of the portfolio was comprised of adjustable rate loans while 37% was comprised of fixed rate loans. Levels of mortgage loan origination activity were virtually the same in both 2005 and 2004, with originations of $367 million in 2005 compared with $366 million in 2004. Growth in mortgage loan originations was limited in 2005 as a result of the rising interest rate environment. The Company typically does not experience significant loan losses in this category. There were net charge-offs of $30 thousand in 2005 compared to $217 thousand in 2004. The non-accrual balances of loans in this category decreased to $261 thousand at December 31, 2005, compared to $458 thousand at year end 2004. The five year history of net charge-offs in the personal real estate loan category reflects nominal losses, and the credit quality of these loans is considered to be strong.

      Total personal banking loans, which include consumer, revolving home equity and student loans, totaled $2.1 billion at December 31, 2005 and increased on average 7.1% during 2005. These categories comprised 23.2% of the total loan portfolio at December 31, 2005. Consumer loans consist of auto, marine, recreational vehicle (RV) and fixed rate home equity loans, and totaled $1.3 billion at year end 2005. Approximately 65% are originated indirectly from auto and other dealers, while the remaining 35% are direct loans made to consumers. Approximately 50% of the consumer portfolio consists of automobile loans, 26% in marine and RV loans and 7% in fixed rate home equity lending. Revolving home equity loans, of which 99% are adjustable rate loans, totaled $448.5 million at year end 2005. An additional $567.6 million was outstanding in unused lines of credit, which can be drawn at the discretion of the borrower. Home equity loans are secured mainly by second mortgages (and less frequently, first mortgages) on residential property of the borrower. The underwriting terms for the home equity line product permit borrowing availability, in the aggregate, generally up to 80% or 90% of the appraised value of the collateral property, although a small percentage may permit borrowing up to 100% of appraised value. Given reasonably stable real estate values over time, the collateral margin improves with the regular amortization of mortgages against the properties. The Company originates loans to students attending colleges and universities, which totaled $330.2 million at year end 2005. These loans are normally sold to the secondary market when the students graduate and the loans enter into repayment status. Nearly all of these loans are based on a variable rate.

      Net charge-offs for total personal banking loans were $8.8 million in 2005 compared to $7.5 million in 2004. Net charge-offs increased to .43% of average personal banking loans in 2005 compared to .39% in 2004. Consistent with industry trends, the higher personal banking loan net charge-offs occurred from an increase in bankruptcy notices received mainly in the fourth quarter 2005 in conjunction with the enactment of new bankruptcy legislation, which took effect during the same quarter.

      Total credit card loans amounted to $592.5 million at December 31, 2005 and comprised 6.7% of the Company’s total loan portfolio. The credit card portfolio is concentrated within regional markets served by

the Company. The Company offers a variety of credit card products, including affinity cards, corporate purchase cards, and standard and premium credit cards. It emphasizes its credit card relationship product, Special Connections, in which the customer maintains a deposit relationship with a subsidiary bank. The Special Connections product allows the customer ATM access using the same card. The Company has found this product to be more profitable by incurring fewer credit losses than other card products, and it allows for better cross sale into other bank products. Approximately 61% of the households in Missouri that own a Commerce credit card product also maintain a deposit relationship with a subsidiary bank. Approximately 79% of the outstanding credit card loans have a floating interest rate. Net charge-offs amounted to $24.4 million in 2005, which was a $5.0 million increase over 2004. The increase in credit card loan net charge-offs occurred mainly in the fourth quarter 2005 and was reflective of higher bankruptcy notices received in conjunction with the new bankruptcy legislation noted above. The ratio of net loan charge-offs to total average loans of 4.4% in 2005 and 3.8% in 2004 remained below national loss averages. The Company refrains from national pre-approved mailing techniques which have caused some of the credit card problems experienced by other banking companies. With bankruptcy legislation now in place which makes bankruptcy filings more difficult, the Company believes this new environment will result in lower loan losses in the future.

Allowance for Loan Losses

      The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. This process provides an allowance consisting of an allocated and an unallocated component. To determine the allocated component of the allowance, the Company combines estimates of the reserves needed for loans evaluated on an individual basis with estimates of reserves needed for pools of loans with similar risk characteristics.

      Loans subject to individual evaluation are defined by the Company as impaired, and generally consist of commercial and commercial real estate loans on non-accrual status or graded substandard and delinquent 60 days or more. These loans are evaluated individually for the impairment of repayment potential and collateral adequacy, and in conjunction with current economic conditions and loss experience, allowances are estimated. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic factors, loan risk categories and industry concentrations. Although management has allocated a portion of the allowance to specific loan categories, the adequacy of the allowance must be considered in its entirety.

      The Company’s estimate of the allowance for loan losses and the corresponding provision for loan losses rests upon various judgments and assumptions made by management. Factors that influence these judgments include past loan loss experience, current loan portfolio composition and characteristics, trends in portfolio risk ratings, levels of non-performing assets, prevailing regional and national economic conditions, and the Company’s ongoing examination process including that of its regulators. The Company has internal credit administration and loan review staffs that continuously review loan quality and report the results of their reviews and examinations to the Company’s senior management and Board of Directors. Such reviews also assist management in establishing the level of the allowance. The Company’s subsidiary banks continue to be subject to examination by the Office of the Comptroller of the Currency (OCC) and examinations are conducted throughout the year targeting various segments of the loan portfolio for review. In addition to the examination of subsidiary banks by the OCC, the parent holding company and its non-bank subsidiaries are examined by the Federal Reserve Bank.

      The allowance for loan losses was $128.4 million and $132.4 million at December 31, 2005 and 2004, respectively, and was 1.44% and 1.59% of loans outstanding. The decline in the allowance in 2005 resulted mainly from an improvement in the credit quality of the loan portfolio, evidenced by a decrease in net loan charge-offs and a 38% decrease in non-performing assets. The allowance for loan losses covered non-performing loans by 1305% at year end 2005 and 751% at year end 2004. Net charge-offs totaled $32.7 million in 2005, and decreased $446 thousand compared to $33.2 million in 2004. The ratio of net charge-offs to average loans outstanding in 2005 was .38% compared to .41% in 2004 and .46% in 2003. The provision

for loan losses was $28.8 million, compared to a provision of $30.4 million in 2004 and $40.7 million in 2003.

      Approximately 75% of total net loan charge-offs were related to credit card loans. Net credit card charge-offs increased to 4.40% of average credit card loans in 2005 compared to 3.77% in 2004. This increase was partially a result of the increased bankruptcies claimed in 2005 as a result of the new bankruptcy legislation, which took effect in the fourth quarter. The delinquency rate on credit card loans at year end 2005 was 2.76% compared to 2.45% at year end 2004.

      Net charge-offs for overdrafts increased $1.4 million in 2005 compared to 2004 as a result of an increase in charge-offs coupled with a decrease in recoveries. Charge-offs increased partially due to the increase in bankruptcies filed in 2005 and partially due to the Company’s increased efforts to charge accounts off when the account becomes 60 days past due as opposed to its previous practice of charging off accounts at 90 days past due.

      Business loan charge-offs decreased $8.7 million during 2005 compared with 2004, mainly the result of one large loan charge-off of $6.0 million recorded in 2004. In 2005, recoveries of $2.4 million on this loan and previously charged off lease loans were recorded, resulting in the significant increase in loan recoveries compared with the previous year.

      The Company considers the allowance for loan losses of $128.4 million adequate to cover losses inherent in the loan portfolio at December 31, 2005.

      The following schedule provides a breakdown of the allowance for loan losses by loan category and the percentage of each loan category to total loans outstanding at year end:

      The schedule which follows summarizes the relationship between loan balances and activity in the allowance for loan losses:

Risk Elements Of Loan Portfolio

      Management reviews the loan portfolio continuously for evidence of problem loans. During the ordinary course of business, management becomes aware of borrowers that may not be able to meet the contractual requirements of loan agreements. Such loans are placed under close supervision with consideration given to placing the loan on non-accrual status, the need for an additional allowance for loan loss, and (if appropriate) partial or full loan charge-off. Loans are placed on non-accrual status when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. Loans that are 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection, or they are 1-4 family first mortgage loans or consumer loans that are exempt under regulatory rules from being classified as non-accrual.

Accrual of interest on consumer installment loans is suspended when any payment of principal or interest is more than 120 days delinquent. Credit card loans and the related accrued interest are charged off when the receivable is more than 180 days past due. After a loan is placed on non-accrual status, any interest previously accrued but not yet collected is reversed against current income. Interest is included in income only as received and only after all previous loan charge-offs have been recovered, so long as management is satisfied there is no impairment of collateral values. The loan is returned to accrual status only when the borrower has brought all past due principal and interest payments current and, in the opinion of management, the borrower has demonstrated the ability to make future payments of principal and interest as scheduled.

      The following schedule shows non-performing assets and loans past due 90 days and still accruing interest.

      The effect on interest income in 2005 of loans on non-accrual status at year end is presented below:

      Total non-accrual loans at year end 2005 decreased $7.8 million from 2004 levels. This decline resulted from reductions of $3.6 million in business non-accrual loans, $3.4 million in business real estate loans, and $685 thousand in construction loans. The overall decline in non-accrual loans was due to sales to other financial institutions, charge-offs, or transference to foreclosure status. Real estate that was acquired in foreclosure, which is comprised mainly of small residential properties, increased $711 thousand over year end 2004. Total non-performing assets remain low compared to the Company’s peers, with the non-performing loans to total loans ratio at .11%. Loans past due 90 days and still accruing interest increased $1.0 million at year end 2005 compared to 2004. This increase was mainly due to higher delinquencies in business, business real estate and home equity loans.

      In addition to the non-accrual loans mentioned above, the Company also has identified loans for which management has concerns about the ability of the borrowers to meet existing repayment terms. These loans totaled $52.8 million at December 31, 2005 compared with $63.9 million at December 31, 2004. These loans are primarily classified as substandard for regulatory purposes. The loans are generally secured by either real estate or other borrower assets, reducing the potential for loss should they become non-performing. Although these loans are generally identified as potential problem loans, they may never become non-performing.

      At December 31, 2005, the banking subsidiaries held fixed rate residential real estate loans of approximately $6.2 million at lower of cost or market, which are to be sold to secondary markets within approximately three months.

      There were no loan concentrations of multiple borrowers in similar activities at December 31, 2005, which exceeded 10% of total loans. The Company’s aggregate legal lending limit to any single or related borrowing entities is in excess of $175 million. The largest exposures generally do not exceed $70 million.

Investment Securities Analysis

      During 2005, total investment securities decreased $997.1 million to $3.8 billion (excluding unrealized gains/losses) compared to $4.8 billion at the previous year end. The decrease was due to higher sales and maturities of securities during the year, with the proceeds used to fund loan growth and reduce the level of short-term borrowings. Also during 2005, the Company undertook initiatives to review and re-position its investment securities portfolio to address such things as concentration, duration and interest rate risk. Consequently, during 2005, the Company sold available for sale securities totaling $1.8 billion and recorded net gains of $5.1 million. These sales were comprised mainly of $533.9 million in U.S. government agency securities, $768.4 million in asset-backed securities, and $359.1 million in inflation-indexed treasury securities. Also as a result of the re-positioning, the Company purchased $2.0 billion of available for sale securities during the year. The purchases were comprised mainly of $1.0 billion in mortgage-backed securities, $518.1 million in other asset-backed securities, and $202.3 million in municipal securities. The average tax equivalent yield on total investment securities was 4.05% in 2005 and 3.78% in 2004.

      At December 31, 2005, the fair value of available for sale securities was $3.7 billion, and included a net unrealized loss in fair value of $6.3 million, compared to a net gain of $63.8 million at December 31, 2004. The amount of the related after tax unrealized loss reported in stockholders’ equity was $3.9 million at year end 2005. The unrealized loss in fair value was the result of unrealized losses of $53.2 million in the bank portfolios, partly offset by unrealized gains of $42.9 million on marketable equity securities held by Commerce Bancshares, Inc., the parent holding company (the “Parent”). Most of the unrealized loss in fair value on available for sale investment securities related to mortgage and asset-backed securities and federal agency securities in the bank portfolios. The market value of the available for sale portfolio will vary according to changes in market interest rates and the mix and duration of investments in the portfolio. Available for sale securities which are due during the next 12 months total approximately $649 million, and management expects these proceeds to meet most of the Company’s liquidity needs.

      Non-marketable securities, which totaled $77.3 million at December 31, 2005, included $45.4 million in Federal Reserve Bank stock and Federal Home Loan Bank stock held by bank subsidiaries in accordance with debt and regulatory requirements. These are restricted securities which, lacking a market, are carried at cost. Other non-marketable securities are generally held by the Parent and non-bank subsidiaries and include non-marketable venture capital investments, which are carried at estimated fair value.

      Investment securities at year end for the past two years are shown below:

     A summary of maturities by category of investment securities and the weighted average yield for each range of maturities as of December 31, 2005, is presented in Note 4 on Investment Securities in the consolidated financial statements. Mortgage and asset-backed securities comprised 61% of the investment portfolio at December 31, 2005, with a weighted average yield of 4.22% and an estimated average maturity of 2.5 years; U.S. government and federal agency obligations comprised 22% with a weighted average yield of 3.58% and an estimated average maturity of 2.4 years.

      Other debt securities, as shown in the table above, include corporate bonds, notes, commercial paper and debentures related to venture capital funding. Equity securities are comprised of short-term investments in money market mutual funds (which totaled $111.7 million at year end 2005), Federal Reserve Bank stock, Federal Home Loan Bank stock, publicly traded stock and venture capital equity investments. Investments in mutual funds and traded equities are primarily held by the Parent. During 2005, the average yield on other debt securities was 5.14%, and the average tax equivalent yield on equity securities was 4.60%.

      The Company engages in private equity and venture capital activities through direct venture investments and three venture capital subsidiaries. CFB Venture Fund I, Inc., a wholly-owned subsidiary, held $4.7 million in venture capital investments at December 31, 2005. Another subsidiary, CFB Venture Fund II, L.P. is a limited partnership venture fund with 47% outside ownership. This partnership held venture capital investments of $4.4 million at year end 2005 and is fully funded. A new series partnership, CFB Venture Fund, L.P., was organized in 2005 with approximately 20% outside ownership. Two new funds are active in this partnership, which held combined investments of $21.7 million at December 31, 2005. The Company plans to fund an additional $21.1 million to the new partnership in the future. In addition to investments held by its venture capital subsidiaries, the Company has direct investments in several private equity concerns, which totaled $5.8 million at year end 2005. Most of the venture capital and private equity investments are not readily marketable. While the nature of these investments carries a higher degree of risk than the normal lending portfolio, this risk is mitigated by the overall size of the

investments and oversight provided by management, which believes the potential for long-term gains in these investments outweighs the potential risks.

Deposits and Borrowings

      Deposits are the primary funding source for the Company’s banks, and are acquired from a broad base of local markets, including both individual and corporate customers. Total deposits were $10.9 billion at December 31, 2005, compared to $10.4 billion last year, reflecting an increase of $417.5 million, or 4.0%. On a yearly average basis, deposits increased $195.8 million during 2005 compared to 2004. At the beginning of 2005, the Company re-characterized certain additional demand and interest checking accounts as money market accounts, in accordance with Federal Reserve rules. As a result, an additional $530 million of demand deposits and $344 million of interest checking accounts were reclassified as money market accounts during the first quarter of 2005. Excluding these and other ongoing reclassifications permissible under Federal Reserve rules, the increase in average deposits in 2005 compared to 2004 grew 1.9% and was fueled by growth in short-term certificate of deposit accounts and interest checking accounts, partly offset by a decline in money market accounts.

      The following table shows year end deposits by type as a percentage of total deposits.

      Core deposits (defined as all non-interest and interest bearing deposits, excluding short-term C.D.’s of $100,000 and over) supported 76% of average earning assets in 2005 and 75% in 2004. Average balances by major deposit category for the last six years appear at the end of this discussion. A maturity schedule of time deposits outstanding at December 31, 2005 is included in Note 7 on Deposits in the consolidated financial statements.

      Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase. Balances outstanding at year end 2005 were $1.3 billion, a $587.5 million decrease from $1.9 billion outstanding at year end 2004. Balances in these accounts, which generally have overnight maturities, can fluctuate significantly on a day-to-day basis. The average balance of federal funds purchased and repurchase agreements was $1.6 billion during 2005, decreasing $217.6 million from 2004 averages. The average rate paid on these borrowings was 3.03% during 2005 and 1.23% during 2004.

      Subsidiary banks also borrow from the Federal Home Loan Bank (FHLB). At year end 2005 these advances totaled $251.8 million, of which $238.2 million is due in 2006. The debt maturing in 2006 may be refinanced or may be repaid with funds generated by maturities of loans or investment securities or by deposit growth. Of the FHLB advances outstanding at year end, $200.0 million had a floating rate and $51.8 million had a fixed rate. The average rate paid on FHLB advances was 3.40% during 2005 and 1.94% during 2004. The weighted average year end rate on outstanding FHLB advances at December 31, 2005 was 4.19%. Long-term debt also includes $11.1 million borrowed from insurance companies by a venture capital subsidiary in order to fund certain investing activity as a Missouri Certified Capital Company.

Liquidity and Capital Resources

Liquidity Management

      Liquidity is managed within the Company in order to satisfy cash flow requirements of deposit and borrowing customers while at the same time meeting its own cash flow needs. The Company maintains its liquidity position by providing a variety of sources including:

      The Company’s most liquid assets include available for sale marketable investment securities, federal funds sold, and securities purchased under agreements to resell (resale agreements). At December 31, 2005 and 2004, such assets were as follows: