3Q Outlook: Weak Loan Demand May Offset Gains

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Byline: Kate Davidson

Community banks are slogging through the muck, making some progress toward recovery and hoping that things don't get much worse.

That's how analysts describe their expectations for the third-quarter performance of community banks, which are preparing to post financial results in coming weeks. Those who follow mid to small-cap banks anticipate that as a group they will report stabilizing credit quality, flat loan growth and modest earnings.

Some predict the conversation will shift to mergers and acquisitions as banks continue to face earnings pressure.

"No doubt about it, the balance sheets have gotten better, and I think by and large they're going to look better in the third quarter than they did in the second," said Rick Weiss, an analyst with Janney Montgomery Scott in Philadelphia. "But the problem is more on the income statement side."

Earnings will be weighed down by weak loan demand and shifts in overdraft fee income, coupled with uncertainty over regulatory changes, analysts said.

In a report published Monday, KBW Inc.'s Keefe, Bruyette & Woods Inc. predicted that income growth for this sector would slow, with earnings per share rising 36% from a year earlier, compared with 46% year-over-year growth in the second quarter. Yet the firm expects only slight growth - 3.4% -from the second quarter.

Robert Bohlen, a KBW analyst, said the modest growth would be offset somewhat by an estimated 2.2% reduction in fee income as a result of changes from Regulation E, which required banks to limit overdraft protection to those who opt in for the service.

First Horizon National Corp. of Memphis, for example, is expected to show improved credit quality and credit costs, according to a preview from Sterne Agee & Leach Inc. But those gains could be more than offset by declining fee income as a result of Reg E.

The changes took effect for new customers on July 1, and for existing customers on Aug. 15. Analysts said some smaller banks may be hurt less than expected.

"I think initially the message has been, 'We've been actually pleased with the amount of people that have opted in,'" said Jeff Rulis, an analyst with D.A. Davidson & Co.

On the credit-quality side, Sandler O'Neill & Partners forecasts that trends will mirror those of the second quarter, in which nonperforming assets leveled off. …