Higher credit costs are likely to weigh on earnings for the U.S. mid-cap banks in the third quarter, but expectations appear fairly realistic going into the period, Morgan Stanley said.

Results are likely to be quite challenging for the group, with higher sequential provision expenses and net charge-offs at most banks being the biggest headwind, analyst Ken Zerbe said in a note to clients.

Results would need to be considerably worse than expected for the group to materially sell off following the quarter as this persistent headwind has now become more of a consensus view, the analyst said.

Commercial loans will emerge as the next major source of credit losses for the mid-cap banks, Zerbe said.

Despite the ongoing credit challenges, the group is attractive from a long-term perspective, Zerbe said, adding that overweight-rated Hudson City Bancorp Inc (HCBK.O), Webster Financial Corp (WBS.N) and Zions Bancorp (ZION.O) remain his top picks.

Zerbe downgraded Prosperity Bancshares Inc (PRSP.O) to underweight from equal-weight, saying the stock is fully valued and will underperform as the group recovers.

The analyst also downgraded South Financial Group Inc (TSFG.O) to equal-weight from overweight, citing the stock's balanced risk-reward profile.

He, however, upgraded Associated Banc-Corp (ASBC.O) and TCF Financial Corp (TCB.N) to equal-weight from underweight, and said Associated's valuation fully reflects its growing credit problems.

Several banks recapitalized in third quarter and valuations remain relatively attractive, the analyst said.

U.S.