The Federal Deposit Insurance Corporation said on Tuesday that reserves for bad loans at the largest US banks declined in the third quarter for the first time since the financial crisis began.

The regulator said total reserves fell nearly 4 per cent, or $9.6bn, in the period, the first decrease since the fourth quarter of 2006. The drop was driven by a reduction in loan-loss reserves at the largest financial institutions, while smaller banks continued to struggle with souring commercial real estate portfolios, said Sheila Bair, FDIC chairman.

Total loans and leases held by FDIC insured institutions decreased by 0.1 per cent, or $6.8bn, in the third quarter, far less than in previous periods.

“I hope we are close to seeing a genuine increase in loan balances again,” Ms Bair said.

In spite of the positive signs, Ms Bair warned that banks were not completely in the clear. She worried that some institutions were reducing reserves too much, without “strong evidence of sustainable, improving loan performance and reduced loss rates”.

“Many institutions came into this crisis with inadequate reserve levels and they need to exercise restraint in drawing them down now,” Ms Bair added.

The number of problem banks rose slightly in the period from 829 at the end of the second quarter to 860, the highest level since March 31, 1993, when 928 banks were considered troubled.

Forty-one banks failed during the third quarter, bringing the total number of failures for the first nine months of 2010 to 127.

Nevertheless, the total assets of banks on the FDIC “problem” list decreased to $379bn from $403bn in the prior quarter.

Ms Bair also pointed to other worrying signs in the financial sector, including contingent liabilities that mortgage servicers might face as a result of recently disclosed loan documentation problems. Ms Bair warned that if these issues were not addressed promptly they “could delay the recovery of US housing markets”.

Commercial lenders and savings institutions insured by the FDIC earned $14.5bn in the third quarter, compared with $2bn in the year earlier period, the fifth consecutive quarter that earnings have marked a year-over-year increase.

FDIC reserves to cover the costs of expected bank failures shrank to $21.3bn from $27.5bn.

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