* Recurring profit slumps 8.5 pct to 1.5 bln reais
* Portela sees changes in sector within two years
* Profitability to hinge on efficiency, not revenue
By Guillermo Parra-Bernal
SAO PAULO, Oct 25 (Reuters) - Brazil's banking sector will undergo profound changes over the next two years as government efforts to keep interest rates at record lows translate into lower credit costs and more competition, the head of the nation's largest foreign lender said on Thursday.
Banks in Brazil, which have for years charged some of the world's highest lending rates and fees for services, will at some point come to terms with a new reality in which their pricing power will remain under frequent scrutiny, said Marcial Portela Álvarez, chief executive of Banco Santander Brasil SA.
Government pressure on banks to cut rates and boost access to credit is being overshadowed by a change in the mindset of consumers and corporations, which are demanding better service and lower prices, he said. Brazilian lenders have entered a new phase in which profitability will be linked more to cost efficiency than interest income.
"Brazil changed. This is not a government issue, it is Brazilians urging banks to normalize the cost of credit," Portela said at a news conference to discuss third-quarter earnings. "These changes will take place in Brazil within the next two years, not the 15 years they took in other nations."
The imminence of a "new normal" for Brazilian lenders marked by tougher oversight, margin compression, and lower profits has weighed on shares in the sector this year. The Bovespa stock exchange's financial sector index has shed 11 percent since April, when President Dilma Rousseff began a crusade to force banks to cut lending rates.
Borrowers in Latin America's No. 1 economy recently listed interest rates for the first time as the main consideration before taking out a loan, signaling that behavioral changes in the credit market are taking place faster than previously thought.
Rates replaced loan maturities early this year as the foremost issue in borrowers' minds when requesting a loan, according to a poll by credit recovery company NovaQuest. For years, clients have used maturities, not the cost of credit, as a key tool to calculate their monthly debt-servicing costs.
Quarterly results for Brazil's top three private sector banks, which were unveiled this week, have reinforced the view among investors that profits at the nation's lenders are sinking. Return on equity, the industry's most widely followed gauge of profitability, is expected to tumble further in coming quarters.
Santander Brasil reported an 8.5 percent decline in third-quarter profit, after rising delinquencies forced management to boost bad loan provisions. Recurring net income, or profit excluding one-off items, fell to 1.501 billion reais ($743 million) from 1.643 billion reais in the third quarter of 2011.
However, recurring profit rose 2.5 percent from the second quarter as a jump in fee income and a 30 percent cut in bad loan provisions helped offset the impact of higher operating expenses and plummeting revenue. Investors in Brazil follow quarter-on-quarter results more closely than annual comparisons.
Previously, Itaú Unibanco Holding SA and Banco Bradesco SA reported disappointing third-quarter results. Executives at Itaú told investors on Wednesday that expense and provision cuts should help mitigate a decline in profitability as government pressure on the industry weighs on the lender's ability to generate revenue.
Units of Santander Brasil, a blend of the bank's common and preferred stock, were up 0.3 percent on Thursday as global risk-taking gained traction. Thursday's gains, which bucked a run of seven straight daily declines, came even after some analysts said flagging profits may lead to a cut in earnings estimates.
"Sluggish results continue to weigh on the stock and compromise the bank's guidance, in our view. After the third quarter of 2012, we see 5 percent to 10 percent downside risks to our 2013 forecasts," said Jorg Friedemann, an analyst at Bank of America Merrill Lynch in São Paulo.
Weaker earnings at Santander Brasil contributed to a tumble in third-quarter profit at parent company Banco Santander SA on Thursday. The Spanish behemoth has weathered a banking crisis at home better than rivals because it makes most of its profits elsewhere - half of earnings come from Latin America.
Portela said the situation facing Santander Brasil's parent in its home market "will have no impact at all" on earnings. The unit remitted 2 billion reais in dividends to Banco Santander this year, down from 2.4 billion reais a year ago, Chief Financial Officer Carlos López Galán said.
Return on equity sank at Santander Brasil to 11.7 percent from 14 percent a year earlier. ROE, as the indicator is known, was 11.5 percent in the second quarter
Unlike its counterparts in Brazil, Santander Brasil suffered a deterioration in asset quality in the quarter as more consumers and companies fell behind on their loan installments.
Loans in arrears for 90 days or more, the benchmark for delinquencies, rose to the equivalent of 5.1 percent of its loan book, compared with 4.9 percent in the second quarter.