* Q3 adj EPS C$1.36 vs est C$1.31
* Capital markets income, M&I takeover drive profit
* Shares rise 4.3 pct, other banks also strong (Adds comment from conference call, RBC rate hike. In U.S. dollars, unless noted)
By Cameron French
TORONTO, Aug 23 (Reuters) - Bank of Montreal's (BMO.TO) quarterly profit rose by a higher-than-expected 18 percent as capital markets income surged and a recent U.S. acquisition started to contribute, Canada's No. 4 lender said on Tuesday.
The results, the first in a wave of Canadian bank reports due over the next two weeks, drove bank stocks higher in anticipation of strong results from BMO's rivals.
"They beat expectations on all the main factors, which is not only positive for BMO, but bodes well for the group," said John Aiken, an analyst at Barclays Capital.
BMO's stock climbed 4.3 percent to C$59.80 on the Toronto Stock Exchange, and shares of other Canadian banks also rose.
Income at BMO's capital markets division more than doubled to C$279 million ($282 million) from C$130 million as trading revenue and mergers and acquisition activity rebounded from a poor performance a year earlier.
"The beat was primarily driven by capital markets trading revenue," said National Bank Financial analyst Peter Routledge. "The stress of the summer didn't get into their third-quarter results."
The banks' third quarter runs from May through July, meaning the results caught the leading edge of the market sell-off that began in late July.
Profit at BMO's U.S. division rose 94 percent to $95 million, helped by the $4 billion acquisition of Wisconsin bank Marshall & Ilsley, a deal that closed about a month before the end of the quarter.
The M&I acquisition more than doubled BMO's branch count in the U.S. Midwest. BMO entered the region when it bought Harris Bank in the 1980s, and had been slowly expanding the franchise before the M&I transaction.
The bank said annual cost savings from the integration of M&I would exceed $300 million.
Canada's banks have been active buyers in the wake of the global financial crisis. Their strong balance sheets and steady profits have enabled them to shop for bargains among their international rivals.
Net income rose to C$793 million, or C$1.27 a share, in the third quarter ended July 31, from C$669 million, or C$1.13 a share, a year earlier.
Adjusted earnings reached C$1.36 a share, topping analyst estimates of a profit of C$1.31 a share.
Profit at BMO's core Canadian retail bank rose a slim 1.8 percent to C$432 million. Loan growth offset narrowing interest margins, with rates still near historic lows.
Low rates had also eroded retail banking profit in the previous quarter, prompting dire warnings from analysts that revenue growth at Canadian banks would slow sharply.
In the event, the narrowing margins were not as bad as expected in the third quarter, Aiken said.
The stronger-than-expected profit performance also reflected credit quality and more effective cost controls -- a focus as revenue growth slows, he said.
Loan-loss provisions fell to C$174 million from C$214 million a year earlier.
Speaking on a conference call, Frank Techar, who heads BMO's Canadian retail bank, said the pressure on interest margins would continue.
"My expectation as we go through the next quarter is more downside risk on margins," he said.
In another sign of the margin pressure on Canadian banks, Royal Bank of Canada (RY.TO) said on Tuesday it was raising the rate on its five-year variable closed residential mortgage by 0.2 percentage points.
Such moves generally follow central bank rate hikes, but a bank spokesman said it was raising the rate due to rising funding costs.
Profit at BMO's private client group climbed 14 percent [ID:nN1E77M0DD].
National Bank of Canada (NA.TO), the country's No. 6 bank, and RBC, the No. 1 lender, report results on Thursday and Friday, respectively.
$1=$0.99 Canadian Reporting by Cameron French; editing by Peter Galloway