Community banks continued to defy expectations by reducing credit costs to bolster quarterly earnings, though many industry observers contend that those opportunities are slowly drying up.

Many banks have been able to add loans, but narrowing net interest margins have made those originations less profitable. So a number of banks revisited credit — cutting loan-loss provisions — to improve profitability.

"The good news is we are seeing the number of troubled loans at most banks fall off," says Lynn David, president of Community Bank Consulting Services.

"But banks are still losing ground on the net interest margin," David adds. "The concern that I have is that we are not going to see a drastic increase in earnings even though credit quality is improving and banks are putting less into the loan-loss provision."

Provisions at banks with $40 billion or less in assets fell, on average, 7% from the first quarter and almost 50% from a year earlier, to $1.8 million, according to American Banker analysis of more than 330 reporting banks and thrifts.

On average, net income at those banks increased roughly 4% from the first quarter and nearly 14% from a year earlier.

A key component of second-quarter earnings at PrivateBancorp (PVTB) in Chicago was "improved asset quality and our consistent execution resulting in lower credit costs," Larry Richman, the $13.5 billion-asset company's president and chief executive, said during a conference call to discuss results. Nonperforming assets, nonperforming loans and net chargeoffs all declined compared to the first quarter, he said.

Better credit is putting pressure on PrivateBancorp, and other banks, to make improvements elsewhere.

"We expect the drag from credit costs to continue to ease," Richman said. "Cross-selling, deposit gathering, and strengthening of client relationships remains a key focus for us, as does actively managing expenses overall and driving operating leverage."

Banks are also shutting down special asset groups they had created during the downturn to deal with problem loans, says Paul Schaus, president and CEO of CCG Catalyst Consulting Group.

Smaller banks are likely to rely on lower credit costs over the next few quarters to improve results, though the returns will diminish over time, industry experts say.

"We'll continue to pick up efficiency gains here and there," says C.K. Lee, a managing director in the financial institutions group at Commerce Street Capital. "Many [banks] are harvesting those windfalls now but that is not sustainable."

Still, other credit metrics were mixed. Nonperforming assets tumbled 6% from March 30 and almost 21% from a year earlier, averaging $53.2 million. But net chargeoffs rose 2% from the first quarter, though they fell 41% from a year earlier, as banks stepped up efforts to sell foreclosed properties.

Banks are struggling to find other ways to bolster bottom lines. Executives continue to complain about intense competition for the best loans and shrinking margins. On average, margins were stable in the second quarter, compared to the first quarter, but they compressed by 12 basis points from a year earlier.

"It's really like a bunch of starving rats going after the one piece of bread," Schaus says. "It's difficult to get good quality credit."

Competition remained stiff for midsize companies, Richman said. Still, the "slow yet steady improvement in the Midwest economy" was promising, he said.

"Companies are starting to add jobs, housing is improving, and corporate performance is getting stronger, signaling that business confidence is improving," Richman added. "Yet, companies remain cautious on major expansion plans."

Bankers also remain cautiously optimistic, David says. Many are anxiously watching for declines in the unemployment rates and increases in the gross domestic product, he adds.

Investors, who recognize the economy's sluggish recovery, will likely remain patient as banks slowly add revenue, says David Powell, president at Vitex. But they will also expect bankers to clearly outline plans to boost profitability or provide a decent return, he says.

"There will always be the expectation of higher returns," Powell says. "It's a matter of how long investors will wait. If they don't see progress, they will want an acquisition."

Cleaner loan books and lower provisions could also spur consolidation, industry experts say. A purged balance sheet and improved earnings potential typically translate into a stronger currency for potential buyers, Lee says.

Improved credit could also turn sellers out of banks that previously had a "mind set to sell but were reluctant to do so until they repaired their balance sheet and boosted earnings," Lee says.

Several banks, including Virginia Commerce (VCBI) in Arlington; Citizens Republic Bancorp in Flint, Mich.; and West Coast Bancorp in Lake Oswego, Ore.; agreed to sell themselves after completing turnarounds. Other banks that are still struggling and need more capital could follow their lead, Powell says.

"There aren't too many investors willing to put money into smaller banks, so capital becomes awfully expensive," Powell says. "Banks have to earn their capital."

Paul Davis contributed to this report.

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