UPDATE 2-Banco do Brasil sees lower ROE despite profit beat

* Net income falls 10.4 pct, beats poll estimates

* Cuts outlook on gross margin, return on equity

* Average lending spread jumps on consumer loans

* Delinquencies fall, bucking trend among rivals

By Guillermo Parra-Bernal and Aluísio Alves

SAO PAULO, Aug 14 (Reuters) - Banco do Brasil cut its estimates for profitability and interest income growth this year even as stricter lending standards helped the nation's largest bank beat second-quarter profit estimates and rein in loan defaults.

Banco do Brasil said on Tuesday it expects return on equity, a gauge of banking profitability known as ROE, to range between 17 percent and 20 percent this year, down from a prior estimate of 19 percent to 22 percent.

The new forecast signals profitability at the state-controlled bank could fall to the lowest level in at least four years.

The revision mirrors the impact of an economic downturn and a drive by Brazil's federal government, the bank's controlling shareholder, to use state lenders to push down the cost of credit in Latin America's largest economy. Brazilians pay the highest lending rates among the world's major economies.

The bank said gross financial margin, or revenue before bad loan provisions, may grow at a slower pace than previously thought: The indicator may rise between 10 percent and 14 percent, down from 11 percent to 15 percent.

Chief Executive Aldemir Bendine is stepping up Banco do Brasil's involvement in highly profitable, fee-oriented activities and growing loans faster than rivals to offset the lower ROE and margins.

"Average spread may narrow in coming years because of the process of decline in local interest rates and as we migrate toward less risky segments," Bendine told a news conference.

He sees a gauge of average spreads, or the difference between the rates that banks charge for their loans and what they pay to depositors, falling to 4 percent in coming years from about 7 percent currently.

The Brasilia-based bank brought down default rates in the second quarter, bucking a trend of rising delinquencies among rivals.

"In all, uncertainties still remain related to the implications of the spread discussion for Banco do Brasil, while asset quality seems now to be stabilizing, or even improving," wrote Fabio Zagatti, an analyst with Barclays in São Paulo.

Net income at the bank tumbled 10.4 percent from a year earlier as higher bad loan provisions and rising payroll and administrative expenses offset gains in interest income.

Banco do Brasil earned 3.008 billion reais ($1.49 billion) in the quarter, according to a securities filing. The number came in above the average estimate of 2.86 billion reais in a Reuters poll of five analysts.

Profit was 3.357 billion reais in the same period a year earlier and 2.502 billion reais in the first quarter.

ROE came in at 21.4 percent in the second quarter, above the average estimate of 16.9 percent. It was 18.1 percent in the first quarter and 27.5 percent a year earlier.

Loans in arrears for 90 days or more, the most widely used gauge of loan delinquencies in Brazil, slid to 2.1 percent of outstanding lending, down from 2.2 percent in the first quarter. Forward-looking default gauges also receded, indicating that borrowers are increasingly turning current on their obligations.

SHARES GAIN

Shares in Banco do Brasil gained as much as 1.6 percent to 23.81 reais on Tuesday, extending their jump for the past month to 16.1 percent.

Excluding one-time items such as charges and asset sales, quarterly profit totaled 2.986 billion reais. Analysts estimated recurring profit, as the indicator is known, at 2.78 billion reais.

Banco do Brasil's domestic loan book rose to 422.606 billion reais, within its 17 percent to 21 percent credit expansion estimate for 2012. Compared with the first quarter, the loan book rose 6.1 percent, versus the 2.5 percent estimate in the poll.

Bendine said growth in Banco do Brasil's loan portfolio could surpass estimates this year.

The riskiest pool of loans in the bank's loan book, commonly known as E-H loans and a proxy for non-performing credit, fell to 3.8 percent of outstanding lending from 4.3 percent in the prior quarter. Overdue renegotiated loans fell 3 percent from the first quarter.

Profit fell after non-interest expenses, composed mainly of payroll and administrative expenses, soared 21 percent on an annual basis. Expenses jumped thanks to higher-than-expected marketing campaigns, and despite a slower amortization of investments in Banco Postal, a unit it bought last year.

Revenue from lending and trading-related activities jumped 16.4 percent on an annual basis, as loan recoveries rose and the bank's traders made correct bets on the direction of bond and stock prices. The average spread on loans rose to 9.2 percent in the second quarter from 8.9 percent in the prior quarter after the cost of borrowing rose sharply for consumers.

Banco do Brasil will likely set aside less in bad credit provisions in coming quarters, Bendine said. Provisions reached 3.677 billion reais in the second quarter, within the bank's guidance.