Community banks are slogging through the muck, making some progress toward recovery and relieved that things don't appear to be getting 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. In a Sept. 27 report, Sandler said many banks have stopped building — and in some cases are even lowering — their loan-loss reserves.

KBW is predicting that credit costs will improve. It estimated that loan-loss provisions would decline 16.9% in the third quarter from the previous quarter, and it expects net chargeoffs will remain flat, at 1.04%. Yet KBW warned that nonperforming assets could increase as much as 4.2% quarter over quarter, with commercial real estate loans an area of particular concern.

As a case in point, Bank of Virginia in Midlothian, a $220.2 million-asset bank plagued by troubled construction and CRE loans, said Monday that it could record a $5.5 million loan-loss provision — 10 times that of the second quarter — as a result of credit-quality deterioration.

Meanwhile, overall loan demand at community banks is expected to appear weak, with average loans as a percentage of average earning assets flat at 72%, KBW predicted. Sandler warned that the pace of asset quality improvement could slow if the economic recovery fails to gain momentum.

"While the industry's credit leverage story continues to play out, it is doing so at a slower pace than many would like," Sandler analyst Scott Siefers wrote. "Nevertheless, improving credit trends will likely represent the group's largest positive variable and earnings tailwind over the next couple of years."

Also, net interest margin is becoming an issue, said Jason O'Donnell, an analyst with Boenning & Scattergood Inc. "You've had this phenomenal period of margin expansion," he said. "That story is largely coming to an end … and bank CEOs seem to think there is more likely compression coming out of the third and fourth quarter than expansion."

The major driver in margin improvement has been declining deposit costs, and those costs are expected to bottom out.

Also, O'Donnell said he expects some focus to shift from credit quality to potential M&A activity. "Even the ones that have decent credit quality … they're not going to be particularly thrilled to go out to the market to raise capital to meet these new requirements," he said. "We think they're particularly likely to merge."

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