WASHINGTON — Banks' return to lending profitability continues to be slow and cautious, but the upward swing in interest margins suggests that may quickly change.

The Federal Deposit Insurance Corp.'s fourth-quarter update on industry conditions showed banks are still profiting mostly from lower expenses — not their lending book.

But it was the second straight quarter in which interest rates appeared headed in lenders' favor. The average net interest margin rose for the second time in a row, albeit slightly, while quarterly net interest income rose on a year-over-year basis for the first time in five quarters.

"Margins increased across all size groups in the fourth quarter except for the largest group of banks, where they generally have declined since 2010 due to growth in low-yield reserve balances held at Federal Reserve banks," FDIC Chairman Martin Gruenberg said at the release of the Quarterly Banking Profile.

Extremely low interest rates following the financial crisis squeezed margins for most of the last four years. But higher medium- and long-term interest rates last year appeared to have an immediate effect. After the average margin in the third quarter rose for the first time since 2011, it increased again last quarter — by 2 basis points — to 3.28%. The margin, which is still sharply narrower than historical levels, had not risen in consecutive quarters since the fourth quarter of 2009 and the first quarter of 2010.

"Once medium and long rates went up in the second quarter [of 2013], we had a much more positively sloped yield curve," said Ross Waldrop, the FDIC's senior banking analyst.

The change in rates had a more pronounced effect on community banks, which posted an average margin of 3.65%, since smaller institutions rely more on interest-related income and less on parking their cash with the Federal Reserve. Meanwhile, the industry's total net interest income of $106.4 billion was 1.3% higher than a year earlier, the first such increase since the third quarter of 2012.

Still, new revenues are a challenge. The FDIC said the industry's robust profit of $40.3 billion last quarter — totaling $154.7 billion for the year — was still largely driven by lower loan loss provisions. And whereas the legal expenses of one bank — presumed to be JPMorgan Chase — pushed down earnings in the third quarter, a reduction in litigation reserves likely at the same institution had the opposite effect of boosting the industry's overall income last quarter.

Overall, quarterly net income was 17% higher than a year earlier, and earnings for all of 2013 marked a 10% increase. More than 53% of institutions reported higher quarterly earnings than in the fourth quarter of 2012. The proportion of institutions reporting a quarterly loss declined nearly 3 percentage points to 12.2%.

But the $166 billion in quarterly net operating revenue was 1.7% lower than a year earlier, the second consecutive such decline, and the FDIC called loan growth "modest" as mortgage lending for the industry declined. Noninterest income, which totaled $59.7 billion, was 6.6% lower than a year earlier. Income related to trading as well as the sale and servicing of residential mortgages both declined.

Gruenberg, who noted that loan growth was stronger at community banks, reiterated that lower loss expenses can drive earnings for only so long.

"There is a limit to how long that can be sustained," he said.

James Chessen, chief economist of the American Bankers Association, said margins may be improving as borrowers — encouraged by signs of an economic recovery — start to agree to more expensive terms for credit.

There is "some opportunity for businesses, that may not have been able to qualify before, to qualify at slightly higher rates," he said.

But with interest rates still low on a historical basis, Gruenberg warned again about risks arising from a rate rebound. In a further sign of the interest rate risk institutions face from a duration mismatch between assets and liabilities, the FDIC report showed a continued decline in value last quarter for available-for-sale securities. Banks reported $9 billion in unrealized losses on such securities, down from the $6 billion in unrealized gains the previous quarter.

"Banks are seeking higher asset returns in a low interest rate environment by going out further on the yield curve," Gruenberg said. "This reach for yield has helped average asset yields, but it has left banks more vulnerable to interest rate risk as rates rise."

Total loans grew by 1.2% from the previous quarter to $7.89 trillion — the ninth increase in 11 quarters — and two-thirds of institutions reported growth in their portfolios. Industry assets increased 0.9% to $14.7 trillion. Loan growth was driven by higher balances of commercial and industrial loans, credit card accounts, real estate loans not tied to farms or residential properties, and loans to small businesses.

But home equity lines fell for the 19th straight quarter, declining 1.3% to $510.8 billion, while 1-4 family residential mortgages fell by 0.7% to $1.83 trillion. However, Gruenberg noted that community banks, by contrast, showed increases in all major loan categories, including residential mortgages. That is likely due in part to the fact that community banks hold more of the mortgages they originate compared to larger institutions.

The report said loan losses fell to a seven-year low with net chargeoffs declining on a year-over-year basis for the 14th straight quarter. The $7 billion in loan loss provisions set aside in the fourth quarter was over $8 billion less than the provision set a year earlier. But even though banks continue to lower their loss reserves — which fell 4.7% during the quarter — the so-called "coverage ratio" of loss reserves to noncurrent loans rose just over 1 percentage point to 65.6%.

The agency list of "problem" institutions fell by 48 to a total of 467. Meanwhile, even though total deposits grew by 1.5% during the quarter, the agency still reported an 11-basis point rise in its ratio of reserves to insured deposits. The reserve ratio stood at 0.79% at the end of the quarter.

Joe Adley is the Deputy Washington Bureau Chief for American Banker.