* Adds to views that Brazil's banks headed for rough patch
* Itau's expense, provision cuts may help stem profit drops
* Profit at 3.41 bln reais vs 3.48 bln reais in poll
* Return on equity posts steeper-than-expected slump
By Guillermo Parra-Bernal
SAO PAULO, Oct 23 Expense and provision cuts will help mitigate a decline in profitability at Itaú Unibanco Holding SA, a senior executive said on Tuesday, as government efforts to drive down borrowing costs are weighing on the Brazilian lender's ability to generate revenue.
There is room to spend more efficiently in payroll and administrative items now that Itaú is undertaking technology investments worth 10.4 billion reais ($5.2 billion) through 2015, Rogerio Calderón, senior vice president for risk management and compliance, said on a conference call to discuss third-quarter earnings.
Itaú's results, released earlier on Tuesday, reinforced the view that Brazilian banks are headed for a period of declining profitability. As record-low interest rates keep revenue under pressure, banks will have to use expense controls and faster loan growth to sustain profitability, analysts said.
"There is scope for improved efficiency, because we know that profitability will now hinge on efficiency rather than revenue," Calderón said.
Recurring profit, or net income excluding one-time items, fell 4.8 percent to 3.412 billion reais in the third quarter from the prior three months, according to a securities filing on Tuesday. The result fell short of the 3.480 billion reais estimate by nine analysts in a Reuters poll.
Weak growth in loan disbursements, a focus on less-risky kinds of credit that charge lower interest, and a rapid narrowing of banking spreads drove third-quarter profit down for Itaú. Provisions fell less than expected, helping intensify the decline in earnings.
Since April, President Dilma Rousseff has pressed commercial banks to increase lending and cut borrowing costs, which she says remain "excessively high." Spreads are the difference between the interest rate charged on a bank loan and the lender's cost of funds.
As a result, profitability as measured by a gauge known as return on equity sank to 17.7 percent - a multi-year low, missing the 18.2 percent ROE predicted in the Reuters poll.
Preferred shares of Itaú fell for a fifth day, shedding 3.3 percent to 28.37 reais in early afternoon trading. The stock is down 12 percent this year.
Bad loan provisions will be reduced as loan delinquencies ease, helping bolster profit, Calderón added. Brazil's largest private sector lender said on Tuesday that third-quarter profit slumped to the lowest level in five quarters, leading to Tuesday's stock drop.
Results at Itaú came a day after smaller private sector lender Banco Bradesco SA narrowly beat profit estimates as smaller provisions for bad loans helped offset lower revenue and flagging lending growth.
"We still see the glass as half-full," Deutsche Bank Securities Mario Pierry said of Itaú's results in a client note, adding that "earnings in 2013 should benefit from an expected economic recovery and stable market rates."
Itaú's bond and stock traders earned the bank 850 million reais, the least since the second quarter of 2011. A decline in the benchmark Selic overnight rate to a record low in the quarter helped subtract 113 million reais from Itau's so-called financial margin, or profit stemming from lending transactions, the bank said in the filing.
Itaú also booked a 100 million-real nonrecurring loss from the sale of a stake in financial bourse operator BM&FBovespa .
Net interest income, the equivalent to revenue from lending and trading of financial securities, fell 4.8 percent to 12.820 billion reais, the lowest since June 2011. Fee income fell 1 percent from the second quarter, primarily due to lower fees from loan-related transactions.
Net bad loans provisions, or total provisions expenses excluding credit write-offs, fell to 4.781 billion reais from 4.852 billion reais in the second quarter. On an annual basis, provisions surged 31 percent.
The current 21-month credit market downturn that has hampered Itaú and peers through a surge in loan defaults is the longest in Brazil since 2000, Thomson Reuters data showed. The July-September period has so far been the first in seven straight quarters that banks experienced a decline in nonperforming loan ratios.
Loans in arrears for 90 days or more fell to 5.1 percent of Itaú's outstanding loans in the quarter from 5.2 percent in the prior quarter, the filing said. At the same time, Itaú stepped up the refinancing of overdue loans with many of its clients between July and September - renegotiated loans rose to 5.4 percent of total lending from 5.2 percent in the period.
The bank also highlighted an improving trend in short-term defaults, in an indication that asset quality is about to improve in coming quarters. Loans in arrears between 15 days and 90 days fell to 4.2 percent of total loans, the lowest since the first quarter of last year, driven by both individuals and companies.
Itaú's loan book rose 1 percent to 417.6 billion reais from the second quarter, and 9.3 percent on an annual basis. The bank expects to increase lending 10 percent this year.