* Net profit from South America falls 18 pct
* Santander's net interest income falls 14.3 pct
* Bad debts rise at Caixabank and Sabadell
* Santander shares biggest fallers among European banks
By Sarah White
MADRID, April 25 (Reuters) - Santander, the euro zone's largest bank, said stronger growth in Brazil should help underpin a gradual pick-up in earnings after flagging income there and recession at home in Spain dragged first-quarter profit down 26 percent.
The bank, which relies on South America for about half its profit, missed analysts' forecasts as lending in continental Europe shrank and low interest rates in both regions ate into lending margins.
Santander is one of Spain's healthier banks and survived a real estate market crash without state help, largely thanks to its overseas businesses. Spain was forced to seek 41 billion euros ($53 billion) of European aid for its ailing banks last year.
Chief Executive Alfredo Saenz said: "I don't see a quantum leap from these (income) levels but there will be a gradual improvement throughout 2013...practically in all geographies."
While Santander's emerging markets businesses have helped offset problems at home, earnings have come under pressure in Brazil, which contributes a quarter of group profit. The Brazilian economy is expected to grow by up to 3 percent this year compared with less then 1 percent in 2012.
Weaker quarterly net interest income, the profit made on loans, was particularly disappointing, analysts said. Group net interest income slid 14.3 percent from a year ago and was down 17 percent in Brazil.
Shares in Santander, Spain's largest bank by market capitalisation, were the biggest losers among European financial stocks on Thursday, down 2.4 percent at 5.48 euros.
Saenz said rising interest rates in Brazil, recently increased from an all-time low to 7.5 percent, could help its business, while bad debts were stabilising, though they still climbed.
Santander, like domestic rivals including rescued Bankia , is also suffering in Spain's deep recession which has reduced demand for loans and driven bad loans higher there too.
While the bank posted strong loan growth in some South American countries such as Mexico, lending in continental Europe, including Spain, shrank by 4.5 percent from a year ago.
Net profit fell to 1.21 billion euros, below the average estimate of 1.3 billion euros in a Reuters poll. Net profit from Latin America fell 18 percent and in Britain it was down by nearly a quarter.
Santander said it was in talks over selling a stake in its asset management business, which has 161 billion euros under management, a move that could help it bolster capital levels.
RECORD SPANISH UNEMPLOYMENT
Spanish banks wrote billions of euros off the value of their property loans after the government enforced a clean-up of their books last year.
They face rising bad loans as the economy keeps shrinking. Spain's unemployment rate rose to a new record of 27 percent in the first quarter, with 6.2 million people out of work, more than the population of Denmark.
Santander's Spanish bad debts rose to 4.12 percent at the end of March from 3.84 percent at the end of last year but that figure does not include all of the impact from soured property assets shifted to a different unit.
Barcelona-based Caixabank, Spain's third-largest lender and its biggest domestic lender, said non-performing loans as a percentage of its overall loan book rose to 9.4 percent at the end of March from 8.62 percent at the end of last year.
Mid-sized lender Sabadell posted a 36 percent drop in first-quarter net profit and a jump in bad loans to 9.7 percent from 6 percent at the end of December after it purchased some of the country's state-rescued lenders.
Bankia, which came to symbolise Spain's banking crisis after making a record 19.2 billion euros loss in 2012, said on Wednesday its bad debt ratio remained stable. It posted a 72 million euro first- quarter profit.