Slowly but surely, community banks have been lending out more of the deposits they take in, a healthy sign for the industry’s profitability.

Loan-to-deposit ratios at smaller banks are on pace to improve by nearly 200 basis points in the second quarter from a quarter earlier, to 84.5%, based on American Banker research of about 200 earnings reports. If the numbers hold up, they would reverse recent declines in that ratio.

The improvement is largely due to a slowdown in deposit growth and banks' willingness to cut rates to bring in loans. Still, industry observers say they view the results favorably.

"The dramatic increase in deposits we saw . . . on the backside of the financial crisis has run its course," says Jeff Davis, managing director of the financial institutions group at Mercer Capital.

A higher loan-to-deposit ratio "is another sign of the banking system's improving health and a pathway to better earnings through remixing the balance sheet," Davis adds.

Loans, on average, jumped 10% from a year earlier, while deposits rose 7.5%, based on preliminary analysis of banks with less than $40 billion in assets. Though bankers prefer ratios above 90%, the quarterly results show that the economy is recovering.

"Community banks are focused on profitability, meaning how to grow the loan portfolio," says Jeffrey Gerrish, chairman of Gerrish McCreary Smith Consultants. "Most still have more deposits than they know what to do with."

Banks also prefer core deposits, such as checking accounts, rather than certificates of deposit, and a number of banks have avoided promoting CDs in hopes of lowering funding costs, industry experts say. Still, bankers must consider how they will manage liabilities as rates rise, even though the system for now remains flush with liquidity.

Rising rates could start to bump up funding costs in the next 12 to 24 months, something bankers must consider as they stress test balance sheets, says Steven Reider, president of Bancography.

Liquidity is "one of the big unknowns ... if the economy was to materially strengthen," Davis says, adding that bankers may be overestimating how much they have in core deposits.

At TCF Financial (TCB) in Wayzata, Minn., an "overwhelming majority" of deposits are insured, William Cooper, the company's chairman and chief executive, said during a quarterly conference call. This is "better from a liquidity perspective and better from a pricing perspective when rates rise," he said, adding that the $18.3 billion-asset company believes it can avoid a huge run off in deposits when rates rise.

Improved loan demand also varies by region, experts say. Florida, Georgia, Alabama and parts of California are still "working through the foreclosure overhang," while other states have declining unemployment rates and improving housing indicators, Reider says.

New regulations, such as the qualified mortgage rule, have small banks rethinking consumer lending and making fewer mortgages, observers say. "Community banks have raw nerves," says Jim Adkins, co-founder of Artisan Advisors. "They are so sensitive. Any kind of regulatory issue really affects community banks."

Banks have a renewed interest in commercial real estate, especially owner-occupied properties, even though CRE was deemed "a toxic term three years ago," Reider says. Commercial loans remain desirable for small banks, though concerns remain about competence and competition.

"If a bank isn't good at lending on land, which you can actually see, how they are going to be good at lending on inventory?" says Randy Dennis, president of DD&F Consulting Group. "That requires a whole different mindset, so I'm fearful for the community banks that have bit into the C&I apple."

Loan growth can also vary based on business models, Davis says. For instance, loans at Signature Bank (SBNY) in New York rose 38% from a year earlier, while deposits rose 18%. The $19.7 billion-asset company has largely expanded by hiring teams of commercial lenders from competitors.

Industry observers are also mindful of individual loan-to-deposit ratios. A tenth of the banks reviewed by American Banker had loan-to-deposit ratios above 100% at June 30, meaning they carried more loans than deposits on their balance sheets.

Several other banking companies, including Bank of the Ozarks (OZRK) in Little Rock, Ark., have 99% ratios and are eager to add more deposits in advance of loan growth.

Bank of the Ozarks will start increasing deposit pricing and marketing efforts in "several precisely targeted" areas, George Gleason, the $4 billion-asset company's chairman and CEO, said during its quarterly earnings call. Loans at the serial acquirer rose 10% in the second quarter from a year earlier, while deposits rose 6%.

The second quarter should emerge as the "low point" for Bank of the Ozarks' cost of interest-bearing deposits, Gleason said, predicting that funding costs will increase slightly in coming quarters. "Despite the intensely competitive environment, we're finding opportunities for good quality, good yielding loans," he said.

"Because our lending teams are maintaining sound practices and sound credit discipline and getting so much cash equity in most new loans, I believe that the loans we are now originating are of very high quality," Gleason added.

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