TORONTO, Aug 31 (Reuters) - Canadian banks started to see a much-awaited improvement in their core lending outside of mortgages in the third quarter, helping offset the impact of falling margins, but the benefits from the recovery are expected to be blunted by deposits growing at faster clip. The country"s six biggest banks grew domestic lending by 7% in the three months through July from the previous year, the biggest increase since at least the start of the pandemic, helped by business reopenings and continued record-low interest rates. But deposit growth of 10% in the same period following double-digit expansion over the past several quarters is set to weigh on the pace of lending recovery, particularly in higher-margin unsecured loans, into 2022.The surge in deposits has been a blessing and a curse. In combination with low interest rates, it has helped keep bad loans low, enabling the banks to recover large amounts of the provisions they took last year in anticipation of a spike in impairments and helping them beat earnings expectations. But customers flush with cash are likely to weigh on the pace of lending growth, adding to margin pressures the banks already face from record-low interest rates. "It"s a Catch-22," said Allan Small, senior investment adviser at Allan Small Financial Group with HollisWealth. "We want to see higher rates for NIMs (net interest margins) but when you look at loan growth, it is definitely fueled by lower rates." Royal Bank of Canada (RY.TO) Chief Financial Officer Rod Bolger told Reuters businesses" use of available credit is expected to remain below pre-pandemic levels over the next several quarters, with consumer credit card balances also lagging despite a return to normal in consumer spending. Canadian Imperial Bank of Commerce (CM.TO) executives noted only small increases in business credit usage despite the recovery in borrowing. "I"m not that positive on their bread-and-butter business," said Ryan Bushell, portfolio manager at Newhaven Asset Management. "And in a world where their core business (remains challenged), I don"t think they"re going to be the double-digit return vehicles that they"ve been... certainly in the period from 1980 to 2010." Canadian personal loans excluding mortgages grew for the first time during the pandemic, albeit at a subdued 2.3% year-on-year rate, compared with a 10% rise in residential loans, whose expansion has been accelerating every quarter during the pandemic. Commercial lending increased 4.5%.As such, banks" higher reliance on secured personal lending like mortgages to drive growth is likely entrenched, Bank of Nova Scotia (BNS.TO) CFO Raj Viswanathan said on a media call. "There"s lots of liquidity pretty much everywhere across the footprint," driving a shift to secured lending in the retail portfolio, he said. "That, we believe, at least for the foreseeable future, is here to stay." Bryden Teich, portfolio manager at Avenue Investment Management, warned that the banks and markets are failing to account for the accompanying risks of the increased reliance on mortgages to drive lending growth. "Mortgage lending is accelerating across the board, and it"s happening into a market that has house prices up 20-30%," he said. "But with the stocks at all-time highs, none of it is being priced in."The Canadian banks index (.GSPTXBA) hit a record last week, although it has come off since then, pulled down by a campaign promise by the ruling Liberal party to raise income taxes on banks if re-elected in the Sept. 20 election, as well as by profit-taking following better-than-expected earnings last week. read more ($1 = 1.2614 Canadian dollars)