* Spanish banks' stock of bad loans starting to drop
* Tough provisioning has helped banks cut ratio
* Not expected to boost earnings in the near term
* Drop unlikely to accelerate, due to fragile economy, ECB stress tests
By Sarah White
MADRID, April 30 (Reuters) - Bad debts at Spanish banks are falling compared with overall lending for the first time since the financial crisis, signalling the start of a slow return to normality for a sector once viewed as a trip wire for the Spanish economy and wider euro zone.
Spain's banks were forced by the central bank and the government to set aside billions of euros in provisions in 2012 and 2013 for soured property loans after years of denial about the size of their problem. Now they are starting to reap the benefits of that harsh medicine.
Most of Spain's major lenders, including Santander and BBVA, cut their stock of domestic bad debts in the first quarter compared with the end of last year. Their high level of provisions made it easier for them to write off some soured loans and move them off their balance sheets.
Some lenders even reported declines in the ratio of bad loans to their total credit as a decline in lending slowed. Barcelona-based Caixabank said its bad-loan ratio fell in the first three months of 2013, the first decline in six years.
Bad loans as a proportion of overall credit dropped to 13.5 percent and 13.4 percent in January and February from a peak of 13.6 at the end of last year.
Analysts said this was the start of a turnaround that should leave lenders much better off. Many Spanish banks had been suspected for years of rolling over loans to ailing companies to keep them going and avoid pain. They were forced to address this problem last year, when the Bank of Spain made them treat refinanced loans more harshly.
"A great deal of the refinanced debts have been reclassified as non-performing and have been recognized," said Carlos Peixoto, a banking analyst at BPI. "It's still something we look at, but it has stopped being a risk."
A tentative return to economic growth last year has helped reduce Spanish bad-debt ratios, but the main driver has been their own clean-up operation.
"On the one hand, new entries of bad debts are falling, only a little, but they are falling month by month," Juan Maria Nin, chief executive of Caixabank, told a news conference last week. "Channelling out the failed loans is helping," he added, referring to written-off debts being taken off balance sheet.
In a note this week, rating agency Standard & Poor's said Spain's banks had absorbed most of their credit losses, and with economic activity starting to pick up and real estate prices expected to bottom out this year, the economic risks facing Spanish banks had eased.
"We therefore expect banks' credit provisions to decline in 2014 and 2015 and to approach more-normalized levels by 2016," S&P said.
However, the Spanish economy is still hamstrung by sky-high unemployment, and banks are preparing for stress tested by the European Central Bank (ECB) this year. Bankers and analysts do not expect the first quarter drop-off in bad-loan ratios to accelerate this year.
"It will be a mixed year, and perhaps we will not see falls of the same magnitude next quarter," said Peixoto at BPI. "But the long-term trend is there, for this year and the next."
Many debt-laden companies still need to be restructured or are trying to cut borrowings, meaning the cycle of losses and write-offs is not yet over.
Some of Spain's banks were also still putting up buffers against bad loans in the first quarter, as they prepare for the ECB health checks this year. That could delay any benefit they may feel from falling bad debts on their earnings.
Bankia, Spain's biggest bailed-out bank, posted a lower bad-debt ratio in March compared with December, and said it had shaved 842 million euros off its bad-debt stock in the period, after selling a 300 million-euro portfolio of failed loans. But the lender nearly tripled net provisions in the first quarter, to 47 million euros from a year ago.
"We are still strengthening the bank more in terms of provisions," said Jose Sevilla, director general at Bankia. "We will probably see something similar next quarter." (Writing by Carmel Crimmins; Editing by Larry King)