California's small banks are finally beginning to see blue sky.

After three years of consistent losses or breakeven quarters, the state's community banks have strung together two consecutive quarters of profits. And bankers and analysts are confident that the sector can maintain the momentum.

The trend began in the third quarter, when the state's smallest banks - those with less than $500 million in assets - earned a 0.38% return on assets. The return was meager but preferable to the negative ROAs of 1992 and 1993.

Banks with assets between $500 million and $2 billion earned a slightly better 0.75% ROA in the third quarter.

Preliminary figures from the fourth quarter for the state's 394 banks with less than $2 billion show a 0.41% ROA and a 4.47% return on equity. The 10 California commercial banks with assets greater than $2 billion vastly outperformed both the rest of the state and the industry, earning 1.44% ROA and a 18.05% ROE, according to the Federal Deposit Insurance Corp.

"I think we'll continue to see improvement" among community banks, said Steven R. Schroll, a bank analyst and managing director at Piper Jaffray Inc. in Minneapolis. "We have a slow recovery going on, and I put the emphasis on 'slow.' Still, all the signs point to steady, sustainable improvement."

A confluence of events turned California's small banks, especially those in Southern California, into the worst-performing part of the industry in the past three years. A slumping commercial real estate market, military base closings, a shrinking defense industry, and natural disasters conspired to make the recovery slow and torturous. California has had the only two bank failures in the country this year, after more than 28 failures in the state in the past two years.

According to Steve Didion, bank analyst at Hoefer & Arnett in San Francisco, the small banks that have provisioned so heavily for credit losses in the past two years are finally fully reserved in most cases.

"I don't think you're going to see the big provisions this year," he said. "California seems to be on the mend. Northern California has already been there, but even in the south we're seeing loan growth pick up. Bankers have been telling me they are looking for 10% to 15% growth in the loan portfolio."

Bankers are cautiously optimistic.

"We're certainly seeing improvement, not dramatic improvement, but improvement," said Boyd Lindquist, president of Republic Bank in Southern California's Torrance. "We're seeing business failures declining, some stability in housing prices."

Mr. Lindquist pointed out that what community banks are dealing with is not so much a slump in the business cycle as a complete restructuring of the economy. While community banks have been losing money, they've also been busy retooling themselves.

"What you have here is a transitional economy being bolstered by a strong economy nationwide," said Mr. Schroll. "It's fair to say the downside of that transition is behind us."

In terms of stock prices, analysts believe there are some significant turnaround and long-term improvement plays. Westamerica Bancorp., San Rafael; Bay View Capital Corp., San Mateo; Vallicorp Holdings Inc., Fresno; and CU Bancorp, Encino, are all frequently mentioned as the best investments. All these companies have either staked out an acquisition strategy or come back from varying degrees of asset quality problems.

"Just as these banks are beginning to shine, the economy is slowly starting to recover," said Jim Marks, bank analyst at Hancock Institutions Equity Services in San Francisco.

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