(Reuters) -National Bank of Canada on Wednesday set aside larger than expected reserves for bad loans, signaling challenges ahead even as strong income from dealmaking helped deliver a profit beat.

Shares of Montreal-based National Bank, Canada's sixth largest bank, were down 3.7% at C$122.8 in Toronto.

Canadian banks are setting aside provisions for potential loan losses to shield themselves in a souring economy as the threat of tariffs increases and tensions with the United States escalate.

Bank of Montreal on Tuesday said clients were pausing activity that could potentially hurt loan growth and M&A activity as they wait for the full impact of the tariff war to play out.

Unlike other big banks that have sought growth opportunities in the U.S., National Bank has expanded in Canada, acquiring Canadian Western Bank.

CEO Laurent Ferreira said the move would accelerate its domestic growth.

"We have a negative view of Q1," RBC Capital Markets analyst Darko Mihelic said, noting that credit has deteriorated even before any potential tariff impact has been seen.

The Canadian central bank's move to lower interest rates has boosted appetite for mergers and acquisitions, helping National Bank and bigger peers BMO and Bank of Nova Scotia beat analysts' estimates for quarterly profits. On an adjusted basis, National Bank earned C$2.93 per share in the three months ended January 31, compared with the average analysts estimate of C$2.65, according to LSEG data.

Provision for credit losses of C$254 million was more than the estimate of C$198 million. It had set aside C$120 million a year ago.

The country's seventh largest lender, EQB Inc, which offers services through its digital EQ Bank platform, reported better than expected profit, helped by lower loan loss provisions.

The lender earned C$2.98 per share, topping estimates of C$2.76.

($1 = 1.4334 Canadian dollars)

(Reporting by Pritam Biswas in Bengaluru and Nivedita Balu in Toronto; Editing by Tasim Zahid and Ros Russell)