* Net income falls 17.1 pct, beats poll estimates
* Forward-looking default ratios seen rising further
* ROE declines, results lag behind those of key peers
By Guillermo Parra-Bernal and Aluísio Alves
SAO PAULO, July 26 (Reuters) - Banco Santander Brasil's earnings slumped in the second quarter after a spike in loan delinquencies forced the nation's largest foreign-owned lender to increase bad loan provisions by 23 percent.
Shares tumbled the most in two weeks.
The local unit of Spain's Banco Santander, earned 1.464 billion reais ($721 million) in the quarter, down 17.1 percent from the prior three months, it said in a securities filing on Thursday. The bank began to report earnings under Brazilian accounting rules this year.
Profit, excluding expenses from the lender's purchase of local rival ABN Amro Banco Real in 2008, fell 5.5 percent from a year earlier. The results were, however, above the 1.425 billion reais estimate of 10 analysts in a Reuters poll.
Santander Brasil, unlike larger rivals Itaú Unibanco Holding and Banco Bradesco, had deteriorating indicators on delinquencies -- signaling its profit may continue to suffer from the slowing economy, weaker job creation and record-low interest rates.
"After these results, the risks that Santander Brasil continues to underperform its peers are high, even after the sharp selloff seen in recent weeks, as arguably earnings revisions are necessary and visibility has deteriorated," said Fabio Zagatti, a Barclays banking analyst in São Paulo.
Units of Santander Brasil, a blend of the bank's common and preferred stock, dropped as much as 4 percent to 13.60 reais in Thursday trading -- its lowest level since late November. Units have shed 7 percent over the past 12 months.
Santander Brasil set aside a record 3.808 billion reais to cover losses stemming from bad credit in the second quarter, after overdue loans jumped to 4.9 percent of the bank's loan book at the end of June. The so-called default ratio reached 4.5 percent in the first quarter and 4.3 percent in the second quarter of 2011.
Loans in arrears for more than 60 days jumped to 6 percent from 5.7 percent at the end of March, driven by a rise in consumer defaults. Corporate loan defaults for the same term remained unchanged.
An economic recovery expected to gain traction in the last months of this year should ease recent increases in delinquencies and put a lid on provisions, Chief Executive Marcial Portela Álvarez told reporters in São Paulo.
"Defaults have peaked. We expect them to be stable this quarter and falling in the fourth" quarter, Portela said. "That said, provisions should begin to fall significantly in coming quarters."
A government push to bring down borrowing costs in Brazil close to single-digit percentage rates is likely to have a more long-lasting, negative impact on Santander than on its private sector peers.
Since April, President Dilma Rousseff has demanded private-sector banks boost lending and cut rates to help revive an ailing economy. State lenders led by Banco do Brasil , the nation's largest, did so to force rivals to follow suit.
ERA OF PAIN?
Rousseff's plans to drive down the cost of credit in Brazil, where banks for years charged the world's highest lending rates, coupled with deteriorating asset quality and an economic downturn could hurt Santander Brasil's profitability for years.
Return on equity, a gauge of profitability among banks, dropped to 11.5 percent in the second quarter from 14.2 percent the prior three months.
"We continue to see above-average execution risk in light of the continued inability to improve operating performance in recent years," a team of JPMorgan Securities analysts led by Saul Martínez wrote in a client note after the release.
Net interest income, the sum of revenue from lending transactions plus gains or losses from trading financial securities, rose 3.7 percent to 8.379 billion reais from the first quarter. That was the slowest pace of sequential growth in a year.
Net interest income jumped 23.9 percent from a year earlier, helped by higher spreads charged on most consumer credit lines. JPMorgan's Martínez said that "suggests that a turn in the credit cycle could eventually benefit Santander Brasil disproportionately."
Fee income fell 4.2 percent, signaling that Santander Brasil, as opposed to Bradesco and Itaú Unibanco, was unable to compensate for lower lending rates with higher charges on financial services. The decline in rates, however, helped trim the cost of funding for Santander Brasil, the filing showed.
Administrative expenses fell 4.2 percent on a sequential basis, helping offset the impact of higher provisions and slower revenue generation. Taxes fell too, helping bolster profit on both on a quarterly and annual basis.
Santander Brasil's loan book grew 3.2 percent in the quarter to 205.632 billion reais, the same pace at which Itaú expanded its credit portfolio on a sequential basis, but a bit less than Bradesco's.