UPDATE 2-Santander Brasil's Q3 net profit falls 12.5% but NII set to improve

(Rewrites throughout)

SAO PAULO, Oct 25 (Reuters) - Brazilian lender Santander Brasil on Wednesday reported a 12.5% decline in third-quarter net profit but pledged to improve some key metrics in coming quarters as it believes the worst is behind it when it comes to net interest income.

The unit of Spain's Banco Santander reported a net profit of 2.73 billion reais ($547 million) for the July-September period, down on an annual basis and shy of the 2.75 billion reais expected by analysts polled by LSEG, but up 18.2% from the previous quarter.

Santander Brasil has been trying since last year to be more selective in its lending as credit conditions deteriorated, but reported some poor results while still implementing the strategy.

By the third quarter, asset quality had improved and the cost of credit was at the lowest since March 2022, the bank said, with loan-loss provisions also reaching their lowest since that time even as the credit portfolio expanded.

"Our net interest income (NII) declined by 1.2% in the quarter, still affected by our increased selectivity," Chief Financial Officer Gustavo Alejo said in a statement, referring to the key metric that measures the difference between interest revenue and interest expenses.

"However, we attained volume growth and a solid performance in the funding NII and we have a positive outlook for the upcoming quarters," he added, noting that lower interest rates in Brazil have been helping with markets NII.

JPMorgan analysts led by Yuri Fernandes said good asset quality was offset by some expense misses and weaker NII, which came in 6% below their forecast.

"All in all, a mixed quarter, but we believe the market may welcome good non-performing loan trends, which can point to a turn in the cycle," they wrote in a note to clients.

Santander Brasil's provisions for loan losses fell 9.5% to 5.62 billion reais, while the cost of credit eased 0.2 percentage points to 3.6%. Its consolidated loan book, meanwhile, rose 10.5% to 625.49 billion reais.

Return on average equity (ROAE), a gauge of profitability, was 13.1%, a rise of 1.9 percentage points from the previous three months and the highest level since the third quarter of last year, when it hit 15.6%.

($1 = 4.9924 reais) (Reporting by Gabriel Araujo; editing by Jason Neely and Kirsten Donovan)