UPDATE 1-US bank earnings improve but small firms suffering

* Bank earnings improve, but problem bank list still grows

* Number of insured US banks below 8,000 for first time

* Bair says decline in loan balances may have peaked

By Karey Wutkowski

WASHINGTON, May 20 (Reuters) - The overall health of the U.S. banking industry improved in the first quarter as net income set a two-year-high of $18 billion, but the largest firms enjoyed a disproportionate share of the gains.

The Federal Deposit Insurance Corp provided a mixed picture of the recovery of the bank industry on Thursday, with small institutions still feeling the strains of tough credit conditions, but with a slower rate of deterioration.

The number of U.S. "problem banks" increased about 10 percent during the quarter to 775 -- a smaller jump than the 27 percent rise during the fourth quarter.

Bank failures and consolidation drove the number of U.S. insured banks down below 8,000 -- the first time in the FDIC's 76-year history.

"There are encouraging signs in the first-quarter numbers," FDIC Chairman Sheila Bair said in a statement. "Industry earnings are up. More banks reported higher earnings, and fewer lost money."

The improvement in earnings was largely due to a reduction in the amount of money that banks set aside for anticipated loan losses. However, the bulk of that reduction was concentrated among a few of the largest banks, the FDIC said.

In a sign that the FDIC does not anticipate further huge losses to the insurance fund due to bank failures, the agency reported a $145 million increase to the fund balance. That is the first such increase in two years.

In the first quarter, the FDIC set aside $3 billion in additional provisions for expected bank failures, compared with $17.8 billion in the prior period.

The fund balance remains a negative $20.7 billion, but the FDIC has plenty of cash on hand after asking banks to prepay three years of industry assessments.

LENDING PULLBACK EASES

Banks are positioning themselves for an increase in lending -- a key initiative of the Obama administration -- but the FDIC noted that loan balances are still depressed.

An accounting change that took effect at the beginning of the year skewed the numbers, making it appear that loan balances grew by 3 percent during the first quarter. Without the change, loan balances would have declined for the seventh quarter in a row.

"Nevertheless, allowing for the effect of the accounting change, it appears that the rate of decline in loan balances may have already peaked," Bair said.

Bair also reiterated her belief that bank failures would peak this year, and said bad commercial real estate loans were still a cause of failures.

The FDIC expects the number of bank failures this year to exceed last year's 140.

But in a sign of nascent recovery, the FDIC is seeing higher bids in failed bank auctions, and in the past several weeks, more banks have been able to raise capital to boost their balance sheets or acquire other banks.

Bair struck a cautiously optimistic tone about the outlook for the bank industry, saying market disruptions are still possible and could hinder the recovery.

Her comments came as other regulators testified before a Senate panel about the still-mysterious May 6 market plunge that was complicated by fears of Greece debt problems. [ID:nN20123345]

"The banking system still has many problems to work through," Bair said, "and we cannot ignore the possibility of more financial market volatility." (Reporting by Karey Wutkowski; Editing by Tim Dobbyn)