UPDATE 5-Banesto Q1 profit drops in ailing Spanish market

* Q1 net profit 169.5 mln euros vs 143.4 mln forecast

* Q1 net interest income 380.4 mln euros vs 374.5 mln f/cast

* Bad loans ratio 4.15 pct end-March vs 4.08 pct end-Dec

* Shares little changed

(Releads, adds detail on provisions)

By Sonya Dowsett

MADRID, April 12 (Reuters) - Spanish retail bank Banesto's (BTO.MC) net profit slumped 20 percent in the first quarter, dragged lower by provisioning against exposure to a sickly property market and higher funding costs.

Quarterly profit margins improved and the number of loans falling into arrears dropped, providing a bright spot against a background of rising bad loans and disappointing loan growth in a country with the highest unemployment rate in the euro zone.

"It's a decent enough quarter with better-than-expected results, but the key will be managing expectations for provisions for the remainder of the year," said Daragh Quinn, banking analyst at Nomura.

Banesto, majority owned by Santander (SAN.MC), is the first Spanish bank to report earnings this quarter, giving a flavour of the challenges facing a sector reeling from a property boom and bust that left banks owed billions by bankrupt developers.

The euro zone's fourth biggest economy has been almost stagnant since emerging from recession last year and most economists see government forecasts of 1.3 percent growth in 2011 as optimistic.

Spanish banks have found it harder and more expensive to access wholesale funding markets as confidence in the country's economy has waned. This has led to a pricing war on interest-paying savings accounts as banks chase retail deposits.

Spain has undertaken a wide-ranging reform of its banking system as part of measures to reassure markets on the health of its economy and ward off concerns it may be next to seek a European Union bailout after Greece, Ireland and Portugal.

Ireland's Allied Irish Banks (ALBK.I) reported a massive net loss on Tuesday, and said it would cut 2,000 jobs over this year and next. [ID:nLDE73A1LB]

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For a graphic on Banesto's quarterly margin, click on: r.reuters.com/tuc98r For a graphic of Spain's bad loan ratio vs unemployment, click: r.reuters.com/puc98r ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Banesto said it had booked loan loss provisions of 91.7 million euros ($133 million) during the quarter, and set aside additional provisions of 25 million euros against real estate writedowns.

The bank said it had 100 million euros left of generic provisions. Analysts expect this to run out in the second quarter.

Banesto has been tipped as a possible buyer for the branch network and deposits of Caja Mediterraneo (CAM), the savings bank which has asked for state funds as part of a government-driven overhaul of the banking sector.

Banesto Chief Executive Officer Jose Garcia Cantera said there was no official decision on any possible acquisition of CAM and that the process of restructuring of the savings banks, know as 'cajas', was likely to take a long time.

"We remain focused on organic growth," he told analysts at a presentation.

Banesto's shares rose 0.6 percent to 6.7 euros, outpacing European rivals .SX7P. Parent Santander was 0.5 percent lower.

Bad loans rose to 4.15 percent of the total at the end of March compared with 4.08 percent end-December, but analysts said this showed some stabilisation. (Reporting by Sonya Dowsett, Editing by Jane Merriman and Louise Heavens) ($1=.6916 Euro)