Shrinking margins are threatening to end the record earnings run for community banks.

Though most community banks continued to post strong net income gains in the first half, analysts expect earnings to slow by yearend as loan competition heightens.

"All of the moons and stars have been aligned, and that can't continue," said Michael M. Moran, a bank analyst with Roney Capital Markets, Detroit. "The general economy aside, competitive pressures are increasing dramatically. The coming quarters should separate the men from the boys."

"Things are so competitive, a lot of chief financial officers are telling us it is getting tough to put money out there and get a good return," said Cassandra Toroian, research analyst at Ryan, Beck & Co., Livingston, N.J.

The crunch is even touching banks in rural areas, where there are fewer big banks to drive down rates.

"A lot of our good commercial customers are coming in and asking for better rates, knowing they can get that rate down the street," said Lewis J. Critelli, chief financial officer of Norwood Financial Corp., Honesdale, Pa.

Many banks are trying to make up for declining spreads by boosting fees. But though large banks have been acquiring brokerage firms and other businesses to increase noninterest income, fee income is still a comparatively small factor in community bank profits.

Community banks "are always going to be more impacted by interest rates," said Hope Willard, an analyst with J.C. Bradford & Co., Nashville.

To be sure, most community banks are reporting solid earnings growth in the quarter ended June 30, and many set records. At $2.3 billion-asset Carolina First Corp., Greenville, S.C., for example, earnings soared 72%-to a record $5.5 million-over the same three-month period in 1997. And San Diego's Bank of Commerce continued its torrid run, reporting net income of $3.3 million in the second quarter, up 93%.

However, some banks are already seeing profits shrink.

Chicago-based Corus Bankshares reported a 5.8% decline in net income from a year earlier, to $10.2 million. That's after a first quarter in which the $2.4 billion-asset bank recorded a 6.4% earnings gain.

The days of "quarter-after-quarter improvement are gone," said Wayne Bopp, a bank analyst at Robert W. Baird & Co., Milwaukee. "We're starting to see earnings bounce around."

The industry's average net interest margin has been falling for more than five years after peaking at 4.41% in 1992, according to the Federal Deposit Insurance Corp. In the first quarter the average bank's margin fell 15 more basis points to 4.06%.

Some small banks are taking steps to protect themselves from flattening spreads.

Net interest margin declined 4% at Peoples Bancorp, Marietta, Ohio, in the year ending June 30. But the $863 million bank made up the lost revenue with an 8.8% increase in fee income, charging more for deposit services and other transactions.

Other banks are compensating for shrinking margins by cranking up loan volume.

Lending at Premier Bancshares in Atlanta, for example, has grown by 24% since the middle of 1997, resulting in a 36% earnings increase.

And though its yields have fallen 12% in the past year, $1.7 billion- asset First Indiana Corp., Indianapolis, has used loan growth to boost earnings 15%. Residential loans are up 27%, construction loans 6%, and home equity lending 8%.

Community bankers attributed earnings fueled by loan growth to the recent big-bank deals.

"There couldn't be a better time to be a community bank in Florida," said Barry K. Miller, treasurer of Gulf West Banks Inc., a $295 million- asset banking company in St. Petersburg.

Since NationsBank Corp.'s $15 billion deal for Barnett Banks Inc. closed in January, Gulf West Banks' earnings are up 163% and loans have doubled.

Six Rivers National Bank, Eureka, Calif., said its 129% earnings growth in the first half partly reflects "disruption created by the megamergers in our market."

In April, NationsBank announced plans to merge with BankAmerica Corp., and in June, Wells Fargo & Co. said it would merge with Norwest Corp. Six Rivers, which has $200 million of assets, bought four BankAmerica branches and saw net loans rise 40% over second quarter 1997.

However, some industry observers are concerned that in the rush to lend, banks are sacrificing credit quality or venturing into unfamiliar lines of business.

James R. Kenney, president and chief executive officer of San Jose (Calif.) National Bank, said he fears some of his peers are relaxing credit standards for the sake of growth.

"Some banks are so hell-bent on loan volume that they may get a bloody nose down the road," Mr. Kenney said.

John Kline, an analyst with Sandler O'Neill & Partners, New York, worried about community banks straying from their traditional lending business for the sake of an extra buck.

"What concerns me is that some small banks and thrifts may be reaching for higher returns and not necessarily taking into consideration the incremental risk of extending into a business they may not be familiar with," he said.

Community banks would be better off looking for "prudent growth in their traditional business, even if it means they revert back to more normal industry growth rates," Mr. Kenney said.

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