* Profit of 2.66 billion reais excluding items beats forecasts
* CFO Monteiro expects lower expenses, provisions for bad loans
* Bad loan provisions come in slightly above forecast
By Guillermo Parra-Bernal and Aluísio Alves
SAO PAULO, Nov 8 (Reuters) - Banco do Brasil SA does not expect expenses and provisions for bad loans to decline until next year, after rampant credit-related losses at a unit hurt third-quarter earnings at Brazil's biggest lender, executives said on Thursday.
The state-controlled bank said it would still set aside 3.5 billion reais ($1.7 billion) to 3.7 billion reais in the fourth quarter to cover credit-related losses. Provisions should fall next year, Chief Financial Officer Ivan Monteiro said at a news conference.
Higher-than-expected provisions and expenses, coupled with lower revenue after an aggressive reduction in borrowing costs, led to an 11 percent drop in profit at the bank in the third quarter. Excluding special items, earnings came in at 2.66 billion reais, slightly above the average estimate of 2.63 billion reais in a Reuters poll of seven analysts.
Lending-related and operational expenses rose faster than revenue, underscoring the strain Banco do Brasil faces as it expands its loan book almost twice as fast as rivals. Loans in arrears rose slightly, yet within expectations, in the third quarter.
"We believe third-quarter results should generate a meaningful reduction in Wall Street estimates for next year, which are still over-optimistic," Credit Suisse Group analyst Marcelo Telles said in a client note.
The higher provisions came after Banco do Brasil had to tighten risk assessment controls at Banco Votorantim SA, in which it holds a 49.99 percent stake. Votorantim lost money for the fourth straight quarter as delinquencies in its auto loan book spiked.
"We are implementing a very conservative approach to credit risk assessment in Votorantim," Monteiro said. "We expect that to bring about good results, including a return to profit at Banco Votorantim, within the next two quarters."
An imminent "new normal" marked by tougher oversight, margin compression and lower profits has weighed on shares of Brazilian lenders this year. The Bovespa stock exchange's financial sector index has shed 13 percent since April, when President Dilma Rousseff began a crusade to force banks to cut lending rates.
Shares of Banco do Brasil dropped for the second straight day, shedding 2.2 percent on Thursday to 21.97 reais. Expectations of weak quarterly results were behind a 2.5 percent decline in the stock over the past month, analysts said.
The quarterly results that Brazil's top three private-sector banks announced this week have reinforced investors' concerns that profits at the nation's lenders are sinking. Return on equity, the industry's most widely followed gauge of profitability, looks set to tumble further in coming quarters, industry executives and analysts said.
Banco do Brasil's return on equity tumbled to 18.6 percent in the third quarter from 21.4 percent in the second quarter and 22.6 percent a year earlier. It still beat the average estimate of 16.8 percent in the Reuters poll, though.
The bank forecasts ROE at between 17 percent and 20 percent for 2012. Credit Suisse's Telles said he expected ROE at Banco do Brasil to "continue to decline, making the operating outlook still gloomy."
Interest income, or revenue from lending and trading of securities before provisions, fell 3 percent to 11.51 billion reais from the second quarter as trading income slumped 18 percent. Revenue from lending-related transactions declined 7.3 percent.
"We don't wake up every morning and come to work thinking about how good trading-related results will be," Monteiro said.
Banco do Brasil's asset quality indicators were within expectations, but underperformed those of private-sector rivals like Itaú Unibanco Holding SA and Banco Bradesco SA .
Banco do Brasil set aside 3.76 billion reais to cover bad loans in the quarter, more than it had forecast, because of growing auto loan-related losses at Votorantim.
Payroll, administrative and general expenses rose on both an annual and a quarterly basis, weighing on earnings and driving the company's so-called efficiency ratio to 46 percent from 44 percent in the second quarter. The lower the ratio, the more cost-efficient a bank is.
Loans in arrears for 90 days or more, the most widely watched gauge of delinquencies in Brazil's financial system, rose slightly to 2.17 percent of the bank's total in the third quarter from 2.15 percent in the second quarter. A year earlier, this default ratio was at 2.11 percent.
Banco do Brasil's domestic loan book rose to 439.28 billion reais at the end of the third quarter, up 3.9 percent from the prior quarter. Annual growth of 18 percent came within the company's credit expansion estimate of 17 percent to 21 percent for 2012.