Spain has instructed its banks to set aside capital to cover a funding gap of tens of billions of euros stemming from a decade of unsustainable lending to property developers during a real estate boom that went abruptly into reverse in 2008.

Santander said it would take the rest of the provisions throughout 2012.

With more Spanish householders and businesses defaulting on debt as the economy sinks back into recession, and nearly one in four workers unemployed, investors fear the scale of Spain's problem might ultimately require an international bailout as in Greece, Ireland and Portugal.

The International Monetary Fund, however, said on Wednesday that it believed the country's largest banks were sufficiently capitalized to withstand a decline in economic conditions.

Santander's domestic difficulties have been offset by its diversification into other markets such as Latin America, the United States, Britain and Poland, so Spain accounts for only about 12 percent of group profit.

The bank will book about 615 million euros ($811 million) in net capital gains on the sale of its Colombian unit in the second half, which will help offset property loss writedowns.

Santander made a profit of 1.6 billion euros after provisions of 3.1 billion euros during the quarter.

Profit in Brazil fell, despite strong revenue, due to a sharp increase in provisioning as more consumers defaulted on their debts in a slowing economy. The UK division also posted weak results, dragged down by weak economic growth, low interest rates and higher funding costs.

Santander is expected to face questions on the outlook for its Brazilian unit, which accounts for 27 percent of profit, later on Thursday.

The weaker performance in the bank's hitherto strong spots unnerved investors, driving its shares down 4.5 percent to 4.7 euros, underperforming its sector .SX7P.

Unlike Barclays (BARC.L) and Deutsche Bank (DBKGn.DE), which also reported first-quarter results on Thursday, it does not have significant investment banking income, which rebounded in the period for its peers.

Brazil's banks have cut their interest rates in recent days after the Latin American country's government called on lenders to reduce their spreads to stimulate the flagging economy.

Brazilian banks' spreads, or the difference between what they pay out in interest to depositors and charge in interest on loans, are among the world's highest.

Higher interest rates could eat into margins at Banco Santander Brasil (SANB11.SA). Berenberg Bank has cut its earnings estimates for Santander in Brazil by 12 percent and profits by 26 percent in the 2012 to 2015 period.

Its Mexico unit, however, showed strong profit growth.

The bank is considering an initial public offering of the unit, in what could be one of the largest IPOs out of Mexico, according to one banker cited by IFR, a Thomson Reuters news and market analysis service.

($1 = 0.7585 euros)

(Editing by Will Waterman)

• A Permanent Economic Emergency