NEW YORK (Reuters) - Citigroup Inc. reported its third straight quarterly profit, beating forecasts and boosting optimism that the banking sector is on track to recover even amid a tepid economic expansion.

Relief about the improving results, bolstered by slowing credit losses and reduced reserves for bad loans, outweighed lingering concern about the foreclosure crisis, boosting the bank's shares six percent.

Citigroup, whose problems during the financial crisis were so severe that it needed three different taxpayer rescues, is the second of the top banks to beat forecasts. JPMorgan Chase & Co posted better-than-expected earnings last week. The No.1 US bank, Bank of America Corp., is due to report today.

The gain in Citigroup shares helped fuel a broader rally in bank shares and lifted US stock indexes.

"It kind of fits what JPMorgan said on their conference call, that they expect the losses to persist but the worst is behind them," said Anthony Polini, an analyst with Raymond James. "But...until we can be more certain about foreclosure issues etc., these stocks could have a ceiling on them. "looking at the home loans it bundled into bonds and sold to investors to make sure the paperwork is in order. So far, it has not found any problems.

Investors in such mortgage bonds may be entitled to sell bad loans back to banks at face value because of documentation issues. US banks could be left holding billions of dollars of bad loans, which could affect profits for years to come.

Citigroup executives repeated their assurances of recent weeks, saying the bank has intensified its regular reviews of its foreclosure process and is "fairly confident" its methods are sound.

Those assurances are "certainly favourable" but "it's a little early to start calling who did good and who did bad" in the foreclosure process, said Michael Nix, co-chief investment officer of Greenwood Capital Associates.

Citigroup, the third-largest US bank by assets, will be dealing with mortgage-related losses for some time to come. It more than tripled its repurchase reserve balance from a year earlier and now has set aside $950 million to buy back loans that did not meet the bank's underwriting standards.

Citigroup's third-quarter revenue rose slightly from a year earlier but fell from the second quarter, and the bank dipped into reserves to cover bad loans. The bank said revenues were hit by a slump in fixed income trading and losses on credit derivative hedges.

CEO Vikram Pandit told investors and analysts that the bank was well on its way to "continued profitability" and could start returning capital to shareholders as soon as 2012.

Mr. Pandit has sold assets, laid off staff and tried to focus Citigroup on its main businesses, including investment banking and retail banking for affluent customers globally. The bank is on track to have less than $400 billion of unwanted assets, or 20 percent of total assets, by the end of 2010.

Citigroup is still 12 percent owned by the US government, which originally planned to finish selling off the stake by mid-December. Mr. Gerspach said yesterday that the bank expects the government will try to meet that target.

Like stronger rival JPMorgan, Citigroup beat earnings expectations in part by releasing money it had set aside to cover bad loans.

Analysts, who tend to discount earnings powered by reserve releases as "low-quality", have questioned how bank profits can keep growing if a sluggish economy results in low loan demand and relatively high credit losses.

"It's a problem for all the banks now - they have trouble raising revenues," said Matt McCormick, a portfolio manager, Bahl & Gaynor Investment Counsel Inc.

"Reducing loan loss reserves is not something you can do indefinitely - eventually, they'll get to the point where they'll say, 'We can't keep going down this path.'"

Citigroup's outstanding loans, after subtracting money set aside to cover losses, fell 5.5 percent in the quarter as consumer loans dropped. Corporate loans edged higher.

In North America and Western Europe, "we're not necessarily seeing the same shrinkage that we saw in the loan book before, but it's not robust growth," Chief financial officer John Gerspach said on the media call.

Separately yesterday, Citigroup faced the start of a high-profile trial in Manhattan federal court.

British buyout firm Terra Firma has sued the bank over whether a Citigroup banker duped it into overpaying for the EMI music company.

Citigroup posted a third-quarter profit of $2.2 billion, or seven cents per share, compared with a year-earlier loss to shareholders of $3.2 billion, or 27 cents per share.

Analysts on average had expected a profit of 6 cents a share, according to Thomson Reuters I/B/E/S.

Excluding an $800 million pre-tax loss on the sale of its student lending operations, Citigroup earned $2.6 billion, or eight cents per share.

Revenue was $20.7 billion, the lowest figure for any quarter this year.