* Financial cos’ Q3 EPS seen rising 3.9 pct vs year ago
* EPS gain was seen at 14.6 pct on Aug. 1
* Weak loan demand, flat yield curve are squeezing profits
* Lift from reducing loan loss reserves expected to fade (Rewrites 1st paragraph, adds details on banking system profits)
By David Henry
Oct 5 (Reuters) - U.S. bank profits have been rising steadily for more than a year, but the recovery may be losing momentum due to weak loan demand and low lending rates.
For many of the biggest banks, earnings are likely to fall in the third quarter, dragged down by investment banking businesses like trading and underwriting. And the tough environment for traditional businesses like lending is only making things worse, analysts said.
“Some big banks are in the position where they are going to have to make the case to investors that they can turn things around,” said Kathleen Shanley, a financial services analyst at Gimme Credit LLC in Chicago.
Analysts estimate that financial companies in the Standard & Poor's 500 index .SPX will report third-quarter earnings only 3.9 percent higher than a year earlier, instead of the 14.6 percent increase they forecast on Aug. 1, according to Thomson Reuters Proprietary Research. (Please see graphic link.reuters.com/suc34s)
For example, Bank of America Corp (BAC.N) is under pressure to show how it will weather problems remaining with its home mortgage assets, and Morgan Stanley (MS.N) will need to show how its globally connected, investment-banking-heavy business portfolio can hold up amid the European debt crisis, Shanley said.
The dark cloud over the world economy from the trouble in Europe is feeding doubts about bank profits as well.
As of Tuesday, earnings estimates for Bank of America had fallen to 19 cents a share from 27 cents on Aug. 1.
Worse, Goldman Sachs Group (GS.N) is expected to report 77 cents a share, just one-fourth of the $2.98 estimated Aug. 1.
The first big bank to post results will be JPMorgan Chase & Co (JPM.N), which reports on Oct. 13. Analysts expect earnings of 98 cents a share, down 3 percent from a year earlier and down 22 percent from estimates on Aug. 1.
JPMorgan’s head of investment banking, Jes Staley, said at a conference last month that third-quarter trading revenue was running 30 percent below a year earlier, and investment banking fees were likely to fall by about 50 percent.
Lower long-term interest rates engineered by the Federal Reserve are compressing margins from lending, which was a factor in a recent decision by analysts at investment bank Keefe, Bruyette & Woods to cut 2011 estimates for nearly half of the banks they cover.
“We’re now in the reality of this lower yield curve,” said Jefferson Harralson, a bank analyst at the firm, referring to the narrowing gap between long-term rates and short-term rates, often used as a proxy for bank lending profits before credit costs.
Add to that weak customer demand for borrowing, and revenues are being squeezed to the point that bank executives will be pressed in earnings conference calls to show that they are effectively cutting costs, said Harralson.
“They have to take action to generate anything close to an acceptable return,” he said.
Quarterly profits for the U.S. banking system have been rising, compared with a year earlier, since the first quarter of 2010. But in this year’s second quarter they slipped to $28.8 billion from $28.9 billion in the first quarter, according to the Federal Deposit Insurance Corp.
To be sure, analysts have only postponed their forecasts for a rebound in bank profits. They estimate that 2012 earnings will rise 31.2 percent from 2011, according to Thomson Reuters Proprietary Research.
With market turmoil spoiling corporate appetites for deals, global fees for underwriting stocks and bonds fell by more than 35 percent in the third quarter from a year earlier, according to data from Thomson Reuters Deals Intelligence. Fees for work on mergers declined by 8 percent.
The drops compared with the second quarter of this year were worse, with all investment banking fees down by 37 percent.
Bank stocks in the KBW Index .BKX lost 23.6 percent from the end of July through Tuesday.
Analysts will also be pressing banks to say exactly how they will replace revenue lost to a new law limiting how much they can charge merchants for taking debit cards. Expect a lot of talk in the calls about service charges, said Harralson.
The third-quarter pain will be mitigated by another round of so-called reserve releases. The releases lift earnings when banks reverse expenses taken for loans that did not go bad. The releases will contribute 20 percent of earnings per share for banks this quarter, Harralson estimated.
It will be the sixth consecutive quarter that reversals add to reported bank earnings. But the boost will be down from 29 percent in the second quarter and will continue shrinking in coming quarters, Harralson said. (Reporting by David Henry in New York; editing by John Wallace)