Commercial and industrial lending is rising at some community banks, but it's unclear how much of the gain reflects rebalancing and how much suggests a deepening economic recovery.

Either reason, analysts say, leads to a healthier industry at the community banking level.

C&I loans at small banks have increased recently, including a $5 billion spike in the first half of January, according to Federal Reserve data. At $376 billion, the amount of C&I loans on balance sheets is the biggest since the end of 2009.

Many community bankers have long talked about focusing on commercial loans after being burned by overexposure to real estate markets. The shift proved daunting, in part because of soft demand from clients who preferred to hunker down rather than expand after the financial crisis.

"Banks are hopeful [C&I] is going to grow because, frankly, it's the one space that didn't blow up," said Mark Fitzgibbon, an analyst at Sandler O'Neill & Partners LP.

Those clients may finally be ready to borrow again.

In the fourth quarter the $2.9 billion-asset Berkshire Hills Bancorp Inc. in Pittsfield, Mass., had a 26% increase in commercial business loans from a quarter earlier, to $286.1 million. Similar loans at the $4.3 billion-asset Flushing Financial Corp. in Lake Success, N.Y., edged up 1.4% from the previous quarter, to $187.2 million.

"Everybody is trying to improve their portfolio diversification, so everybody is trying to pick up C&I loans," said Alvin Kang, the president and chief executive at Nara Bancorp Inc. in Los Angeles. "Commercial real estate is a transactional business. In the good old days, it was OK to focus on … volume and booking as many [CRE loans] as you could, but we've all seen the falling of that."

By targeting the more "relational" clients that C&I loans produce, Nara let $14 million in loans run off, mainly in construction and commercial real estate, to focus on C&I, Kang said in an interview Thursday. The $3 billion-asset company shrunk gross loans by 1% in the fourth quarter, to $2.2 billion. Kang said the company booked $27 million in new C&I loans in the fourth quarter.

Kang said the stiffest competition for C&I has come from national and regional banks. "It is competitive, but a lot of it also depends on the capital position of the institution," he said. It depends on "whether they really have the liquidity to make loans or are trying to shrink their portfolio so on balance, it is not as much competitive given some are trying to work out problems."

Rebalancing may be as much a cause of small banks' stronger C&I lending. Trustmark Corp. in Jackson, Miss., has shed about $130 million of loans in Florida, mostly in land development, as well as indirect lending after leaving the business in 2006. But C&I loans grew by $52 million in the fourth quarter after sliding each quarter in 2010. Due to rebalancing, total loans grew for the first time in a year, by 1%, to $6 billion. Some analysts argue that the uptick does not indicate a massive wave of C&I loan growth this year.

"There's a little bit of growth but with the caveat of curb your enthusiasm," said Jeff Davis, an analyst at Guggenheim Partners LLC. Business contraction, and the fact that many companies are hoarding cash instead of taking on debt, could limit borrowing, he said.

Jerry Host, Trustmark's chief executive, agreed. Most growth in the $9.6 billion-asset Trustmark's C&I book was from clients looking to replace equipment or expand their equipment line for greater efficiencies, he said. Demand from clients tapping existing credit lines or for expansion remains soft.

"People have reduced their inventory levels and have not taken on new capital spending," Host said in an interview Thursday. "As we talked to businesses about hiring practices, we've seen virtually no … significant hiring."

Industry observers said it may be too early to project how much growth in C&I loans would affect returns and net interest margins.

Kang said the interest rate outlook is up and "will continue to go up, even though it's flat for the near term, so it makes sense to book C&I loans." He estimated a 5.5%-6% rate on Nara's C&I loans, consistent with floors set on the loans and low- to mid-single-digit overall loan growth in 2011.

Davis remained wary of returns. "We're seeing a lot of green shoots, but it is unclear whether it will turn into full-grown stock," he said.

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