The industry's biggest banks showed dramtic year-over-year gains in income, despite a slight contraction in profit margins and small gains in new loans.

The earnings gains at the 25 biggest banks were up 69% in the third quarter of this year, compared with the same period in 1992, according to figures compiled by the American Banker.

To be sure, that rise comes off a slightly depressed base. Earnings in the third quarter of 1992 were good at most of the biggest banks, although below the record levels seen this year. But the stellar third-quarter 1993 earnings weren't enought to keep bank stocks from heading into a prolonged tailspin as soon as the results were reported.

Attention Focused Elsewhere

"A lot of analysts are ho-humming some very impressive earnings," said Richard Pike, a money manager at Chancellor Capital in New York.

Perhapds because analysts and investors largely expected banks to show big earnings gains, many members of the investment community focused their attention elsewhere, primarily on shrinking net interest margains and minimal growth in loans.

For the top 25 banks, the net interest margin shrunk 4 basis points to 4.25% in the third quarter. At some banks, though, margins fell drastically. First Union Corp.'s margin contracted by 27 basis points and NationsBank Corp.'s dropped 34.

Meanwhile, loans grew by 1 % on average in the third quarter at the top 25 banks. To many investors, the combination of those two factors meant the game in bank stocks was up.

Some see Growth Topping Out

"There was some margin erosion in the quarter, which we had expected," said James J. McDermott Jr., president of Keefe, Bruyette & Woods Inc., New York. "That has fueled the perception in some quarters that the growth rate of profitability at the banks is topping out."

That focus on net interest margins is misguided, said some money managers.

"The bottom line is where I look," said Harry Keefe, whose New York investment fund, Keefe Partners, specializes in bank securities. "Income is what pays dividends and that's what drivers stock prices."

Bank income, he points out, is not solely dependent on mnet interest margins. "People miss the point that there are a lot of ways to get to the bottom line. If income isn't going up, you can cut expenses, and increase profits. Or you can expand your products," said Mr. Keefe.

Mr. Keefe points to Bank ot New York, which showed sizable gains in year-over-year net income. Hafl of the bank's revenues come from fees that have nothing to do with margins, loan demand, or interest rates. The bank had strong loan demand as well, up 7.63% in the quarter.

"In the long run, earnings are the most important thing," said Mr. Pike of Chancellor. "Sometimes in the short run there are other issues that overshadow that, but I've never known a stock to to up a tremendous amount without good earnings."

Mr. McDermott said he expects margins to continue easing from their wide levels of the past two years, "but not to come cascading down." And in the areas where loan growth is improving, margins may hold up well.

Loan growth is likely to continue to be spotty, with some regions showing strong demand and others being relatively quiet, he said.

Margins held up well and in some case expanded for western banks outside California, noted R. Jay Tejera, an analyst in Seattle for Dain, Bosworth & Co.

New loan volume in the West has bolstered margins at Keycorp, he said.

Volume outside California has also helped stabilize margins at both First Interstate Bancorp and Bank America Corp.

But Mr. Tejera said "the margin strength of the past two years has been icing on the cake." The real driving force has been improved credit quality.

He cited a study of 1992 bank profitability by the Federal Reserve Bank of Cleveland, which found that 55% of earning improvement "was due to reduced [loan-loss] provision expenses."

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