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 360 locations in Missouri, Kansas, Illinois, Oklahoma and Colorado 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 focus on the local markets it services and its concentration on relationship banking, with high service levels and competitive products. In order to enhance shareholder value, the Company grows 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:

• Growth in earnings per share - Diluted earnings per share declined 7.8% in 2008 compared to 2007.

• Growth in total revenue - Total revenue is comprised of net interest income and non-interest income. Total revenue in 2008 grew 6.5% over 2007, which resulted from growth of $54.7 million, or 10.2%, in net interest income coupled with growth of $4.1 million, or 1.1%, in non-interest income. Total revenue has risen 3.9%, compounded annually, over the last five years.

• Expense control - Non-interest expense grew by 7.2% this year. Salaries and employee benefits, the largest expense component, grew by 8.0%, partly due to increased staffing in areas such as commercial bank card, private banking, and commercial banking, which were part of certain growth initiatives established by the Company in 2007.

• Asset quality - Net loan charge-offs in 2008 increased $27.1 million over those recorded in 2007, and averaged .64% of loans compared to .42% in the previous year. Total non-performing assets amounted to $79.1 million, an increase of $45.7 million over balances at the previous year end, and represented .70% of loans outstanding.

• Shareholder return - Total shareholder return, including the change in stock price and dividend reinvestment, was 4.8% over the past 5 years and 7.3% over the past 10 years.

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



(Based on average balance sheets):                      2008         2007         2006         2005         2004


Return on total assets                                    1.15 %       1.33 %       1.54 %       1.60 %       1.56 %
Return on stockholders' equity                           11.83        14.00        15.96        16.19        15.19
Tier I capital ratio                                     10.92        10.31        11.25        12.21        12.21
Total capital ratio                                      12.31        11.49        12.56        13.63        13.57
Leverage ratio                                            9.06         8.76         9.05         9.43         9.60
Equity to total assets                                    9.69         9.54         9.68         9.87        10.25
Non-interest income to revenue*                          38.80        40.85        40.72        40.03        38.84
Efficiency ratio**                                       63.16        62.72        60.55        59.30        59.16
Loans to deposits***                                     92.11        88.49        84.73        81.34        78.71
Net yield on interest earning assets (tax equivalent
basis)                                                    3.93         3.80         3.92         3.89         3.81
Non-interest bearing deposits to total deposits           5.47         5.45         5.78         6.23        12.47
Cash dividend payout ratio                               38.39        33.76        30.19        28.92        28.26

* Revenue includes net interest income and non-interest income.

** The efficiency ratio is calculated as non-interest expense (excluding intangibles amortization) as a percent of revenue.

*** Includes loans held for sale.

Selected Financial Data



(In thousands, except per share data)       2008             2007             2006             2005             2004


Net interest income                     $    592,739     $    538,072     $    513,199     $    501,702     $    497,331
Provision for loan losses                    108,900           42,732           25,649           28,785           30,351
Non-interest income                          375,712          371,581          352,586          334,837          315,839
Investment securities gains, net              30,294            8,234            9,035            6,362           11,092
Non-interest expense                         616,113          574,758          525,425          496,522          482,769
Net income                                   188,655          206,660          219,842          223,247          220,341
Net income per share-basic*                     2.50             2.72             2.84             2.77             2.59
Net income per share-diluted*                   2.48             2.69             2.80             2.73             2.55
Cash dividends                                72,055           68,915           65,758           63,421           61,135
Cash dividends per share*                       .952             .907             .847             .790             .721
Market price per share*                        43.95            42.72            43.91            45.02            41.30
Book value per share*                          20.80            20.26            18.70            17.09            17.20
Common shares outstanding*                    75,791           75,386           77,123           78,266           82,967
Total assets                              17,532,447       16,204,831       15,230,349       13,885,545       14,250,368
Loans, including held for sale            11,644,544       10,841,264        9,960,118        8,899,183        8,305,359
Investment securities                      3,780,116        3,297,015        3,496,323        3,770,181        4,837,368
Deposits                                  12,894,733       12,551,552       11,744,854       10,851,813       10,434,309
Long-term debt                             1,447,781        1,083,636          553,934          269,390          389,542
Stockholders' equity                       1,576,632        1,527,686        1,442,114        1,337,838        1,426,880
Non-performing assets                         79,077           33,417           18,223           11,713           18,775

* Restated for the 5% stock dividend distributed in December 2008.

Results of Operations

                                                                                     $ Change                      % Change
(Dollars in thousands)          2008            2007            2006          '08-'07        '07-'06       '08-'07         '07-'06


Net interest income          $  592,739      $  538,072      $  513,199      $  54,667      $  24,873          10.2 %           4.8 %
Provision for loan losses      (108,900 )       (42,732 )       (25,649 )       66,168         17,083         154.8            66.6
Non-interest income             375,712         371,581         352,586          4,131         18,995           1.1             5.4
Investment securities
gains, net                       30,294           8,234           9,035         22,060           (801 )       267.9            (8.9 )
Non-interest expense           (616,113 )      (574,758 )      (525,425 )       41,355         49,333           7.2             9.4
Income taxes                    (85,077 )       (93,737 )      (103,904 )       (8,660 )      (10,167 )        (9.2 )          (9.8 )


Net income                   $  188,655      $  206,660      $  219,842      $ (18,005 )    $ (13,182 )        (8.7 )%         (6.0 )%

For the year ended December 31, 2008, net income amounted to $188.7 million, a decrease of $18.0 million, or 8.7%, compared to $206.7 million in 2007. The decline in net income was mainly the result of an increase in the provision for loan losses of $66.2 million coupled with a 7.2% increase in non-interest expense, but partly offset by increases in net interest income, investment securities gains and non-interest income. Net interest income increased $54.7 million, or 10.2%, in 2008 compared to 2007, mainly as a result of growth in loans and investment securities, coupled with a large reduction in rates paid on interest bearing liabilities. These effects were partly offset by lower loan yields and higher borrowings. In 2008, net investment securities gains totaled $30.3 million compared to $8.2 million in 2007. Gains in 2008 included a $22.2 million gain on the redemption of Visa, Inc. (Visa) stock and a gain of $7.9 million on the sale of certain auction rate securities (ARS), further described in the Investment Securities Gains section of this discussion.

Non-interest income totaled $375.7 million in 2008, an increase of $4.1 million, or 1.1%, over amounts reported in the previous year and included a $9.4 million impairment charge on certain loans held for sale. Non-interest expense totaled $616.1 million, an increase of $41.4 million, or 7.2%, over 2007. Included in non-interest expense was a non-cash loss of $33.3 million as a result of the Company's purchase of ARS from its customers in the third quarter of 2008. Non-interest expense also included a $9.6 million reduction in an

indemnification obligation for the Company's share of certain Visa litigation costs, which is discussed further in the Non-Interest Expense section of this discussion. The provision for loan losses totaled $108.9 million in 2008, an increase of $66.2 million, and reflected higher net loan charge-offs, mainly in consumer and consumer credit card loans, and the need to increase loan loss reserves to address inherent risk in the loan portfolio. Income tax expense declined 9.2% in 2008 and resulted in an effective tax rate of 31.1%, which was slightly lower than the effective tax rate of 31.2% in the previous year. The decrease in income tax expense in 2008 compared to 2007 was mainly due to lower pre-tax earnings.

For the year ended December 31, 2007, net income amounted to $206.7 million, a decrease of $13.2 million, or 6.0%, from 2006. Net income in 2007 included a pre-tax charge of $21.0 million recorded in the fourth quarter, related to the Company's share of certain Visa litigation costs. Exclusive of this item, net income in 2007 amounted to $219.9 million, virtually the same as in 2006. Net interest income increased $24.9 million, or 4.8%, reflecting growth in average loan balances and higher average overall rates earned on loans and investment securities, partly offset by declining average balances in investment securities. Countering these effects was a rise in interest expense on deposit accounts and short-term borrowings, resulting from increases in interest rates on virtually all deposit accounts, coupled with growth in certificate of deposit balances and higher average short-term borrowings. Non-interest income rose $19.0 million, or 5.4%, largely due to increases of 9.1% in bank card fees, 1.6% in deposit account fees, and 9.2% in trust revenues. Exclusive of the Visa charge, non-interest expense grew $28.4 million, or 5.4%, which was mainly the result of a 7.1% increase in salaries and benefits. The provision for loan losses increased $17.1 million to $42.7 million, reflecting higher incurred losses in nearly all loan categories, with the largest increases in business, consumer, and consumer credit card loans. Income tax expense declined 9.8% in 2007 and resulted in an effective tax rate of 31.2%, compared to an effective tax rate of 32.1% in the prior year. The decrease in income tax expense in 2007 occurred mainly due to the change in the mix of taxable and non-taxable income.

The Company acquired two banking franchises during 2007. In April 2007, the Company acquired South Tulsa Financial Corporation. In this transaction, the Company acquired the outstanding stock of South Tulsa and issued shares of Company stock valued at $27.6 million. The Company's acquisition of South Tulsa added two branch locations in Tulsa, Oklahoma. In July 2007, the Company acquired Commerce Bank in Denver, Colorado. In this transaction, the Company acquired all of the outstanding stock of Commerce Bank for $29.5 million in cash. The acquisition added the Company's first location in Colorado.

During 2006, the Company also acquired two banks. The first acquisition was in July 2006, when the Company, through a bank subsidiary, acquired certain assets and assumed certain liabilities of Boone National Savings and Loan Association in a purchase and assumption agreement for cash of $19.1 million. Boone operated four branches in central Missouri. In September 2006, the Company acquired the outstanding stock of West Pointe Bancorp, Inc. in Belleville, Illinois, which operated five branch locations in the greater St. Louis area. The total purchase price of $80.5 million consisted of cash of $13.1 million and shares of Company stock valued at $67.5 million.

The transactions discussed above are collectively referred to as "bank acquisitions" throughout the remainder of this report. Additional information about acquired balances and intangible assets recognized is presented below.

                                             2007                          2006
   (In millions)                   Denver       South Tulsa       Boone       West Pointe


   Purchase price                  $  29.5     $        27.6     $  19.1     $        80.5
   Acquired balances:
   Total assets                      103.9             127.3       126.4             455.1
   Loans                              74.5             114.7       126.4             255.0
   Deposits                           72.2             103.9       100.9             381.8
   Intangible assets recognized:
   Goodwill                           15.1              11.9        15.6              38.3
   Core deposit premium                4.9               3.4         2.6              14.9
   Mortgage servicing rights             -                 -          .3                .5

The Company continually evaluates the profitability of its network of bank branches throughout its markets. As a result of this evaluation process, the Company may periodically sell the assets and liabilities of certain branches, or may sell the premises of specific banking facilities. In May 2008, the Company sold its banking branch, including the facility, in Independence, Kansas. In this transaction, approximately $23.3 million in loans, $85.0 million in deposits, and various other assets and liabilities were sold. The Company paid $54.1 million in cash, representing the net liabilities sold, and recorded a pre-tax gain of $6.9 million, representing the approximate premium paid by the buyer. During 2007 and 2006, the Company sold several bank facilities each year, realizing pre-tax gains on these sales of $1.6 million and $579 thousand, respectively.

In February 2009, the Company sold its branch in Lakin, Kansas. In this transaction, the Company sold the bank facility and certain deposits of approximately $6.9 million, and paid cash of approximately $5.6 million.

The Company distributed a 5% stock dividend for the fifteenth consecutive year on December 1, 2008. All per share and average share data in this report has been restated to reflect the 2008 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 current period or future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Current economic conditions may require the use of additional estimates, and some estimates may be subject to a greater degree of uncertainty due to the current instability of the economy. 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, the valuation of certain investment securities, and accounting for income taxes.

Allowance for Loan Losses

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, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, lease, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal loans, including personal mortgage, credit card and consumer loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Further discussion of the methodologies used in establishing the allowance is provided in the Provision and Allowance for Loan Losses section of this discussion.

Valuation of Investment Securities

The Company carries its investment securities at fair value, and in accordance with the requirements of Statement of Financial Accounting Standards (SFAS) No. 157, the Company employs valuation techniques which utilize observable inputs when those inputs are available. These observable inputs reflect assumptions market participants would use in pricing the security, developed based on market data obtained from sources independent of the Company. When such information is not available, the Company employs valuation techniques which utilize unobservable inputs, or those which reflect the Company's own assumptions about market participants, based on the best information available in the circumstances. These valuation methods typically involve cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, estimates, or other inputs to the valuation techniques could have a material impact on the Company's

future financial condition and results of operations. Assets and liabilities carried at fair value inherently result in more financial statement volatility. SFAS 157, which requires fair value measurements to be classified as Level 1 (quoted prices), Level 2 (based on observable inputs) or Level 3 (based on unobservable, internally-derived inputs) is discussed in more detail in Note 16 to the consolidated financial statements.

Available for sale securities are reported at fair value, with changes in fair value reported in other comprehensive income. Most of the portfolio is priced utilizing industry-standard models that consider various assumptions which are observable in the marketplace, or can be derived from observable data. Such securities totaled approximately $3.4 billion, or 94.6% of the portfolio at December 31, 2008, and were classified as Level 2 measurements. The Company also holds $168.0 million in auction rate securities. These were classified as Level 3 measurements, as no market currently exists for these securities, and fair values were derived from internally generated cash flow valuation models which used unobservable inputs which were significant to the overall measurement. The Company periodically evaluates the available for sale portfolio for other-than-temporary impairment. Impairment which is deemed other-than-temporary is reflected in current earnings and reported in investment securities gains and losses in the consolidated statements of income. Evaluation for other-than-temporary impairment includes an analysis of the facts and circumstances of each individual security such as the severity of loss, the length of time the fair value has been below cost, the creditworthiness of the issuer, and the Company's intent and ability to hold the security to maturity. Impairment is measured using a cash flows modeling technique whose results are highly dependent on estimates of default rates, loss severities, and prepayment speeds. Future economic trends which signal changes to these estimates may have a negative effect on results of operations.

The Company, through its direct holdings and its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, categorized as non-marketable securities in the accompanying consolidated balance sheets. These investments are reported at fair value, and totaled $55.4 million at December 31, 2008. Changes in fair value are reflected in current earnings, and reported in investment securities gains and losses in the consolidated statements of income. Because there is no observable market data for these securities, their fair values are internally developed using available information and management's judgment. Although management believes its estimates of fair value reasonably reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company's management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments.

Accounting for Income Taxes

As more fully discussed in Notes 1 and 9 of the consolidated financial statements, the Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". Accrued income taxes represent the net amount of current income taxes which are expected to be paid attributable to operations as of the balance sheet date. Deferred income taxes represent the expected future tax consequences of events that have been recognized in the financial statements or income tax returns. Current and deferred income taxes are reported as either a component of other assets or other liabilities in the consolidated balance sheets, depending on whether the balances are assets or liabilities. Judgment is required in applying the principles of SFAS No. 109. The Company regularly monitors taxing authorities for changes in laws and regulations and their interpretations by the judicial systems. The aforementioned changes, and changes that may result from the resolution of income tax examinations by federal and state taxing authorities, may impact the estimate of accrued income taxes and could materially impact the Company's financial position and results of operations.

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.

                                                     2008                                       2007

                                         Change due to                              Change due to
                                     Average       Average                      Average       Average
(In thousands)                       Volume          Rate          Total         Volume        Rate          Total


Interest income, fully taxable
equivalent basis
Loans                               $  57,585     $ (137,217 )   $  (79,632 )   $ 77,356     $  14,896     $  92,252
Loans held for sale                     1,741         (8,713 )       (6,972 )        412          (260 )         152
Investment securities:
U.S. government and federal
agency obligations                     (9,129 )           63         (9,066 )     (8,190 )       1,878        (6,312 )
State and municipal obligations         4,582          3,135          7,717        8,058           251         8,309
Mortgage and asset-backed
securities                             17,036          6,090         23,126       (3,547 )       9,520         5,973
Other securities                          942         (2,396 )       (1,454 )     (3,126 )      (2,090 )      (5,216 )
Federal funds sold and securities
purchased under agreements to
resell                                 (4,848 )      (12,746 )      (17,594 )     11,852        (1,608 )      10,244
Interest earning deposits with
banks                                     198              -            198            -             -             -


Total interest income                  68,107       (151,784 )      (83,677 )     82,815        22,587       105,402


Interest expense
Interest bearing deposits:
Savings                                    42           (923 )         (881 )         (5 )        (132 )        (137 )
Interest checking and money
market                                  7,117        (61,197 )      (54,080 )      8,541        11,248        19,789
Time open and C.D.'s of less than
$100,000                               (9,775 )      (23,860 )      (33,635 )     11,563        13,970        25,533
Time open and C.D.'s of $100,000
and over                                7,566        (25,640 )      (18,074 )      9,001         6,357        15,358
Federal funds purchased and
securities sold under agreements
to repurchase                         (16,534 )      (41,845 )      (58,379 )     10,826         2,484        13,310
Other borrowings                       38,018        (13,888 )       24,130        5,346          (315 )       5,031


Total interest expense                 26,434       (167,353 )     (140,919 )     45,272        33,612        78,884


Net interest income, fully
taxable equivalent basis            $  41,673     $   15,569     $   57,242     $ 37,543     $ (11,025 )   $  26,518

Net interest income totaled $592.7 million in 2008, representing an increase of $54.7 million, or 10.2%, compared to $538.1 million in 2007. On a tax equivalent . . .