Higher than expected profits from Barclays and Commerzbank failed to dispel concerns over the underlying health of Europe's top banks on Thursday.

The banks' higher profits were principally due to a sharp drop in bad debts as economies improve and some accounting gains, rather than top-line growth.

We are a bit skeptical and we've started to sell some of our banking shares, said Christophe Gautier from Paris-based GSD Gestion, which manages around 100 million euros ($131.2 million) in assets.

Earnings this week from many of Europe's banks, including HSBC , BNP Paribas and Lloyds have beaten expectations as bad debts have fallen sharply to more than compensate for a second quarter slowdown in invesment banking.

Barclays, Europe's sixth-biggest bank by market value, said revenues at its investment bank arm fell 15 percent in the second quarter from the first quarter, although analysts said that was a more resilient performance than most rivals, where income was on average down by about a third.

The bank's bad debts fell 32 percent, helping it achieve a 44 percent rise in half-year profits to just under 4 billion pounds.

Commerzbank, in which the German government owns a 25 percent stake, lowered its expectations for risk provisions in 2010 and said it might return to profitability in 2010, earlier than previous guidance.

State-supported Belgian bank KBC also benefited from reduced bad debt provisions as it posted a 35 percent gain in its underlying second quarter net profit, helping its shares gain over 3 percent.

Clearly the banking sector is gaining in momentum and it has been helped by the delay of Basel III, said Cedric Ozazman, an investment advisor Swiss financial services firm Reyl.

Reassuring stress test results and a delay to the Basel III set of tough new banking rules helped the DJ Stoxx European bank sector <.SX7P> rise some 30 percent from June to July.

The index, however, has drifted back since early August, despite a week of bumper profits from the likes of HSBC and BNP Paribas .

Barclays shares shed 3.3 percent and Commerzbank's profits failed to breathe life into its flat stock price.

Although banks showed good results, the market is well aware of opaque accounting practices, window dressing, and their books are still full of bad loans, which shows up in the lackluster trading, said a Geneva-based trader.

JITTERS REMAIN

Barclays' exposure to Spanish bad debts remains a worry for investors. The UK bank, which didn't need bailing out during the financial crisis, had a 433 million pound jump in losses on corporate loans in Spain.

All investment banks had a tough second quarter as U.S. financial industry reform and the euro-zone debt crisis hit activity, and a recovery in the third quarter is needed if many top names are to hit expectations for 2010, analysts say.

Bob Diamond, the chief executive of Barclays investment arm, was optimistic: The second quarter environment was tough and there were a number of things overhanging the market ... all of those things are behind us now, and in the second half of July we definitely saw a pickup in flows, he said in an interview.

But British fund management company Schroders said it expected financial markets to remain volatile in the coming months and investors said banking shares might not be able to resume their recent rally.

I don't think the outperformance will last for a long time and I think the sector will move back in line with the market, said Reyl's Ozazman, whose company manages 4 billion Swiss francs ($3.8 billion) in assets.

($1=.7620 Euro)

($1=1.052 Swiss Franc)

(Writing by Sudip Kar-Gupta; editing by Elaine Hardcastle)

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