What to Expect from Community Banks' 3Q Reports

Investors will likely be satisfied, though not overly ecstatic, with quarterly results at community banks.

The economy has improved and loan demand has gradually crept back. Third-quarter results should reflect those trends, though there could be a seasonal lending slowdown, industry observers said. One positive could be a continued stabilization of net interest margins, despite intense competition for the best credits.

"The economy generally seems to be picking up quite nicely," Christopher Wolking, chief financial officer at Old National Bancorp in Evansville, Ind., said during a late September conference hosted by RBC Capital Markets. "Pricing is tough. There are some structural issues that we would probably not consider appropriate for our loan book in some of the deals that we're looking at."

Net interest margins, on average, have compressed by 74 basis points since early 2010, according to data from the Federal Reserve Board. Fortunately, the margin held steady during the second quarter, settling in at 3.10%.

Margins have hopefully "slowly crawled toward stability," said Scott Siefers, an analyst at Sandler O'Neill, though he noted that "a couple of pressure points" remain.

It is difficult, for instance, to gauge how lenders will handle pricing, and aggressive pricing will remain a threat to margins.

"We're seeing growth on the loan side, but margins are continuing to get squeezed," said Bob Wray, president and chief executive of Capital Corporation, which offers consulting and investment banking services. "It is close to a zero sum game. To grow a portfolio, banks are typically doing it with pricing. We won't see the earnings following as strongly as the lending."

Net interest income at community banks is likely to be flat for the quarter, said David Powell, president of Vitex. Banks have done everything they can to bring down deposit costs, while low interest rates continue to offset increased loan volume, he said.

Banks that exercise pricing discipline could still look to creatively structure deals to land the most creditworthy borrowers. Some banks eager to book loans have been offering fixed-rate loans for up to seven years at low yields because there are few good alternatives for putting liquidity to use, Wray said.

Some banks are gaining some leverage with pricing, but have been willing to compromise "credit competence," said Jeff Davis, managing director of the financial institutions group at Mercer Capital. This isn't something that will "blow up next quarter," he said, but "this really low interest rate environment creates pervasive incentives to take additional risks to generate yields."

BancorpSouth in Tupelo, Miss., has seen competitors that are willing to price loans at low rates, while also paying more for deposits, Dan Rollins, the $13 billion-asset company's chairman and chief executive, said during the recent RBC conference. "There is always somebody willing to do something that you could scratch your head on and go, 'Gee, I wonder what the heck they are thinking when they do that,'" he said.

Margins also face pressure when deposits outpace loan growth, Siefers said. When that happens, banks often park excess liquidity into securities, which has a level of risk based on the average duration embedded in the portfolio.

Regulators are still concerned about banks that rely heavily on loans and securities with longer-term maturities, which would be susceptible to rising interest rates.

Westamerica Bancorp. in San Rafael, Calif., has been preparing for rising rates by reducing the duration of its investment portfolio in moves that have been "obviously painful," David Payne, the $4.9 billion-asset company's chairman and chief executive, said during the RBC conference.

Westamerica's margin compressed by 36 basis points in the second quarter from a year earlier, to 3.76%. Still, repositioning the asset side of the balance sheet "is going to leave us with the best flexibility … as we have so much uncertainty about the interest rate environment going forward," Payne said.

Net interest income could also suffer from a seasonal slowdown in lending volume. Mortgage production will likely decline from the second quarter, Powell said, noting that August is typically a "very slow" month for originations. "It won't be a bad quarter [for loan production], but just flattish to maybe a little down."

Banks have been able to expand their commercial-and-industrial loan books in recent quarters, and some smaller institutions have found opportunities to make more commercial real estate loans. This is especially true in Sunbelt states that are experiencing renewed population migration, spurring demand for real estate lending, Davis said.

"Every time we have a down cycle CRE becomes a four-letter word," Davis said. "It's not. It just depends on how good the underwriting is."