(Refiles to change "see" to "sees" in headline and first paragraph)
By Marcela Ayres
BRASILIA, May 8 (Reuters) - Brazil's central bank sees risks that a regional bank may have given excessive loans to its controlling shareholder, the state of Rio Grande do Sul, whose ability to honor its debt could be impaired if Brazil goes into recession this year as expected.
Banrisul has lent 7.7 billion reais ($2.5 billion) to Rio Grande do Sul, one of Brazil's most indebted states, from a bank fund made up of deposits in court, according to internal central bank documents seen by Reuters.
Deposits in court consist of payments made to a court officer as a precaution while litigation is pending over who is entitled to the funds.
Brazilian legislation allows state governments to borrow against court deposits, but the size of the bank's loan to Rio Grande do Sul is larger than Banrisul's net assets of about 5.7 billion reais, and this has raised red flags among central bank auditors.
"The state's delicate financial situation ... raises doubts about its ability to honor its obligations over time, indicating growing risks to the (financial) institution," the central bank report said.
A central bank spokesman declined to comment on the report.
Banrisul said there is no risk to its operations as it is merely a depositary of the court-deposit funds, which it does not consider to be part of its assets.
The government of Rio Grande do Sul acknowledged its financial hardship but maintained that Banrisul is safe. It said borrowing against court deposits is a "necessary evil" in the current economic environment.
"The government understands that, given the extreme situation in public finances, deposits in court are an important and accessible source (of financing) for times of emergency such as those we are experiencing," the state said in a statement.
The Banrisul case highlights the risks incurred by companies that do business with Brazilian states, which are running into budget problems after years of overspending.
Many states have suspended payments to suppliers, while freezing billions of reais earmarked for services and infrastructure projects, in a bid to clean up their finances as revenues fall as Brazil heads toward a likely recession.
Rio Grande do Sul estimates it will post a budget deficit of 5.4 billion reais this year.
Risks to Banrisul are magnified because Rio Grande do Sul has more lax legislation allowing the government to borrow as much as 85 percent of total deposits in court. Federal legislation imposes a 70 percent limit on borrowing from court deposits related only to tax disputes.
The discrepancy between federal and state laws is being questioned in the Supreme Court by the Brazilian bar association, which argues that Rio Grande do Sul's legislation should be considered unconstitutional.
Such a decision could force the state to return a large part of the financing it received. Failure to do so could give rise to an illegal situation in which a financial institution provides credit to its controlling shareholder, the central bank said in the report.
To avoid an extreme situation that could put Banrisul's operations at risk, the central bank is considering filing a "friend of the court" brief with the court, a position that allows it to share its point of view without being directly involved in the case.
Rio Grande do Sul said in its statement that a Supreme Court ruling that its legislation is unconstitutional is "unimaginable" and would "certainly have huge impact on its ability to provide the most essential services to the population".
$1=3.03 reais Writing by Walter Brandimarte; Editing by Todd Benson; and Peter Galloway