Bank of Montreal surprised investors on Tuesday with a surge in quarterly profits, sending Canadian bank shares higher and boosting expectations for strong results from the nation's other big lenders.

Net earnings rose 6.9 percent in the third quarter, surpassing analysts' estimates, as BMO set aside less money to cover bad loans and trading revenue surged.

Shares of Canada's fourth-largest bank shot up 6.6 percent after after posting a profit of C$557 million ($513 million), defying investors who spent the last week selling the Toronto-based bank.

With capital ratios at a whopping 11.7 percent, the bank also stirred speculation about the next wave of acquisitions by saying its purchase of a U.S. bank was a reasonable possibility if such a deal fit BMO's Midwest strategy.

All in all, the bank managed to spark a big rally in Canadian financial shares, which were up 3.5 percent overall, as observers guessed BMO's four major rivals would follow suit.

We're seeing a bit of a relief rally. No one knew what exactly to expect from this quarter, said Craig Fehr, a banking analyst at Edward Jones.

Certainly the credit environment is not completely sanguine, but we've now seen some positive data (showing) that credit can be managed fairly well ... and that has a positive implication for the rest of the banks given the pessimism that has been out there, Fehr said.

While BMO's overall profit was up from the third-quarter of 2008, earnings per share fell to 97 Canadian cents from 98 Canadian cents because of an increase in shares outstanding. Analysts, on average, had expected profit of 95 Canadian cents after exceptional items, according to Reuters Estimates.

What is particularly compelling is the fact that the areas where BMO beat our forecasts -- net interest income and provisions for credit losses -- could definitely bode well for future earnings, Dundee Securities analyst John Aiken said in a research note.

The amount the bank set aside to cover bad loans fell to C$417 million from C$484 million a year earlier, defying analysts' expectations for an increase. The so-called provisions for credit losses a year earlier included C$247 million to cover two corporate accounts related to the U.S. housing market.

BMO Chief Executive Bill Downe said he expected the loan loss provisions to remain elevated into 2010, but said he was confident the bank's earnings could absorb the losses.

Banks set aside more money to cover bad loans because the economic slump is making it more difficult for consumers and businesses to repay their debts.

Downe also said the stress-test process in the United States has helped the industry by providing visibility to credit risk, which had hampered deals because no one wanted to purchase a bank whose loan portfolio was unknown.

So I think that it would be a reasonable thing for us to be involved in looking at FDIC-assisted transactions, Downe said, referring to the Federal Deposit Insurance Corp, an agency that guarantees the safety of bank deposits.

As you know, in those deals you do have to absorb a portion of the credit loss. Basically you're paying for the deposits and then your purchase price is the expected loss, Downe told analysts on a conference call.

So I hope that we'll see a good pipeline of transactions. So far there really haven't been that many, and we certainly haven't looked at banks that are not adjacent to or close to our current operating area in the U.S. Midwest, he said.

Canadian Imperial Bank of Commerce is set to report on Wednesday, Royal Bank of Canada and Toronto Dominion Bank on Thursday, and Bank of Nova Scotia on Friday. Profits had been expected to be lower than a year ago, but BMO's strong showing has tempered bearish sentiment.

BMO said capital markets boosted earnings as the rebound in global markets spurred trading and deals. Capital markets income grew 30 percent while net interest income rose 14 percent. Canadian personal and commercial banking was solid, with income up 13 percent to C$356 million.

As expected, BMO's U.S. operations were a drag on earnings. The bank, which has sizable operations in the U.S. Midwest through its subsidiary Harris Bank, said net income from U.S. operations fell 10.7 percent to C$25 million.

The dividend was unchanged at 70 Canadian cents a share.

Shares of BMO climbed 6.6 percent to C$52.23 in late afternoon trading in Toronto, while the broader financial index climbed 3.5 percent.

($1=$1.08 Canadian)

(Reporting by Andrea Hopkins; editing by Frank McGurty)

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