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* Recurring profit down 5.5 pct but tops expectations
* Bank sees loan book expanding 10 percent this year
* Provisions and defaults jump, offset lower expenses
* Results come a day after bank names Zabalza as CEO
By Guillermo Parra-Bernal and Aluísio Alves
SAO PAULO, April 25 Banco Santander Brasil SA expects to grow lending by at least 10 percent this year, less than rivals, as the bank, Brazil's largest foreign lender, struggles with flagging demand for credit, low interest rates and a jump in defaults.
Santander Brasil, a subsidiary of Spain's Banco Santander SA , grew its loan book by 6 percent in the 12 months ended in March, one-third the average pace of Brazil's banking system. Growth is expected in segments where clients pay less interest but are less likely to default, such as mortgages, Chief Executive Marcial Portela said.
"This reflects our strategy of migrating toward credit lines of better quality," Portela, who will be replaced by Jesús Zabalza around July as CEO, told reporters in São Paulo. "However, we still feel that demand for credit is not strong."
Santander Brasil is implementing the risk-off approach taken on by rivals such as Itaú Unibanco Holding SA amid government pressure to cut interest rates, a reluctance among consumers to borrow and two years of weak activity. Defaults at Santander Brasil jumped in the first quarter, triggering a 5.5 percent drop in earnings, the lender said on Thursday.
First-quarter recurring profit -- a gauge of net income excluding one-time items -- fell to 1.518 billion reais ($755 million), down 14.4 percent from a year earlier, as stringent cost-cutting failed to offset falling interest income and soaring loan delinquencies.
Shares fell 2 percent. Investors balked at Santander Brasil's strategy of aggressively trimming bad-loan provisions to bolster profit, saying it is preventing the lender from catching up with its rivals in terms of profitability.
"The quality of results was very poor and leads to downside risk to our earnings forecast this year," Marcelo Telles, an analyst with Credit Suisse Group, wrote in a client note. "We think that management has to rethink the bank's strategy for the future, as Santander has not been able to deliver the long-promised return-on-equity convergence with private peers for a long time now."
Return on equity, a gauge of profitability for banks known as ROE, fell to 12 percent in the first quarter from 12.8 percent at the end of last year. ROE, also a measure of how well banks spend shareholder money, was 14.6 percent a year earlier.
Interest income fell to the lowest level in two years, fee income rose less than expected, and defaults climbed to the highest level since at least 2010. The results illustrate how low interest rates are weighing on bank profits in Brazil, and highlight Santander Brasil's struggles with defaults as Latin America's top economy enters a third year of sub-par growth.
Portela said that loans in arrears for 90 days or more, which rose in the first quarter to the equivalent of 5.8 percent of Santander Brasil's loan book, are expected to fall in coming quarters.
The so-called default ratio was 5.5 percent in the fourth quarter of last year. Analysts expected a so-called default ratio of 5.6 percent.
Even as banks in Brazil have consistently failed to accurately predict default trends in the past two years, investors have been particularly stingy with Santander Brasil because of Portela's reluctance to hike provisions as asset quality deteriorated.
The spike in defaults made management at Santander Brasil extra cautious. The bank's loan book fell 0.1 percent to 211.7 billion reais on a quarterly basis.
Bad-loan provisions rose 9 percent to 3.371 billion reais, the highest level in four quarters. Portela had cut such provisions, the amount set aside to cover credit-related losses, by more than 700 million reais since the second quarter of last year.
Santander Brasil probably will cut provisions as defaults recede, Portela said.
Despite the drop in profit, the first-quarter earnings did top average estimates in a Thomson Reuters poll, in part because analysts underestimated the extent of cost cuts implemented by Portela, 68, in his 3-1/2 years as chief executive.
Near record-low interest rates in Brazil drove the bank's net interest margin, an average measure of how much Santander Brasil charges on loans, down to 7.1 percent in the first quarter from 7.2 percent three months earlier and 10.3 percent a year earlier.
Interest income fell 2 percent on a quarter-on-quarter basis, while fee income -- revenue from banking transactions other than lending -- rose 2.3 percent. Expenses dropped 5.8 percent to 3.891 billion reais, the lowest level in a year, and taxes were unusually low for a second quarter.
Santander Brasil's results weighed on earnings at its beleaguered parent. Banco Santander, Europe's largest bank, posted a 26 percent drop in net income as slowing growth in some South American markets added to the gloom at home in Spain.
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