(Adds details, share performance, comments throughout)
By Guillermo Parra-Bernal
SAO PAULO, Feb 2 (Reuters) - Plans by Itaú Unibanco Holding SA to boost loan-loss provisions faster than rivals this year drove its shares down sharply on Tuesday, as Brazil's deepest recession in more than a century and sluggish activity across Latin America bite hard.
The provisions could rise as much as 38 percent to 25 billion reais ($6.9 billion) this year, with over 95 percent of that being set aside in Brazil, Itau said on Tuesday. The bank's loan book could even shrink this year, the grimmest outlook for Itau, Latin America's No. 1 bank by market value, has issued in years.
The warnings underscore Chief Executive Roberto Setubal's efforts to strengthen Itaú's balance sheet to offset soaring defaults and protect earnings. Slumping activity and fallout from a sweeping corruption probe into state companies are driving a record number of companies and households into insolvency in Brazil.
"We are prepared to cope with an increase in defaults, but we are proactively working towards mitigating that impact," Setubal said at a news conference to discuss fourth-quarter results.
Still, shares tumbled the most in 4-1/2 years on concern the overly cautious tone of guidance could pose downside risk for Itaú, which is also expecting slower interest income growth than are rivals. Investors are closely watching results and guidance to gauge how the recession may affect profitability.
Non-voting shares of São Paulo-based Itaú, which released its results earlier in the day, fell 7.5 percent to 23.55 reais, a price last seen in November 2012. Itaú's drop also helped spark a widespread decline in Brazil bank stocks and the benchmark Bovespa stock index.
"Concerns over asset quality outlook, the transfer of bad loans and the high provisions guidance could undermine market sentiment," said Philip Finch, a strategist with UBS Securities in London.
The burden of a 27 percent increase in provisions and borrowers' reluctance to accept higher borrowing costs on new loans hurt profit at the bank in the fourth quarter. Profit excluding one-off items came in at 5.773 billion reais in the quarter, the lowest in a year and down 5.6 percent from the prior three months.
The number, however, topped the profit estimate of 5.510 billion reais in a Reuters poll of analysts.
The result was driven by resilient net interest margins - a measure of the average cost of borrowing - as well as robust fee and insurance income growth in the quarter and a declining tax burden. Net interest income fell almost 5 percent in the quarter, but not as much as the 8.5 percent the poll estimated.
According to Marcelo Telles, an analyst with Credit Suisse Securities, the quality of Itaú's loan book worsened materially in the fourth quarter. Bad loan formation, or a measure of the pace at which new defaults are piling up, would have jumped last quarter if it were not for an unexpected sale of a pool of bad loans.
Itaú also transferred 2.2 billion reais worth of toxic loans - signaling an increasingly strained loan book. While corporate loans in arrears fell slightly, consumer delinquencies jumped and fanned worries of future defaults.
"In our view, this discrepancy between cost of risk and bad debt formation metrics is unsustainable," Telles said.
Renegotiated loans, including overdue and amended credit not in arrears, rose 5 percent to 23 billion reais last quarter.
Return on equity, a gauge of profitability for banks, slipped to 22.3 percent last quarter, from 24 percent in the third quarter and 24.7 percent a year earlier.
Many analysts are expecting ROE, as the indicator is commonly known, to decline toward levels near 18 percent this year.
$1 = 3.9601 Brazilian reais Editing by Jason Neely, W Simon and Steve Orlofsky