ANTIQUES SHOPS

* Itaú to also help fund BMG payroll loan operations

* Pact comes as mid-sized banks show signs of strain (Adds details, analyst comments in paragraphs 2-10)

SAO PAULO, July 10 (Reuters) - Itaú Unibanco Holding , Brazil's largest private-sector lender, formed a 1 billion real ($493 million) joint venture with smaller rival Banco BMG to offer payroll-deductible loans, the fastest-growing personal loan segment in Latin America's largest economy.

The venture, named Banco Itaú BMG Consignad o, will be 70 percent-controlled by Itaú Unibanco, which will name most of the management team, according to a securities filing on Tuesday. BM G will control the remainder 30 percent. The venture expects to originate about 12 billion reais of payroll loans wit h in two years.

The deal comes amid speculation that Banco BMG, under strain after the purchase of rival Banco Schahin last year and a surge in the cost of funding in its segment, could be bought by Banco Bradesco or investment bank BTG Pactual.

Itaú has about 11 billion reais in outstanding payroll loans, compared with BMG's 27 billion reais in similar credits. Th e filing did not specify what the impact on Itaú Unibanco's earnings would be in the short term.

Under the deal, Itaú Unibanco will also provide BMG with as much as 300 million reais per month in funding for new payroll loans outside the joint venture, indicating the giant lender is looking for further synergies with BMG beyond the association. Deta ils on the cost to BMG of the funding line, wh ich was agreed upon for a period of five years, were not disclosed.

"The joint venture enhances Banco BMG's credit quality by addressing one of the two structural pressures on the payroll business operated by small and mid-sized banks in Brazil: namely, the high cost of funding available for some of these institutions," wrote Alexandre Muller, a corporate debt analyst with BTG Pactual in São Paulo.

Payroll-deductible loans, formally created in September 2003 by former President Luiz Inácio Lula da Silva, charge lower borrowing costs than traditional loans because monthly installments are deducted from the borrower's paycheck. The average interest rate for payroll loans was 24.7 percent in May, compared with 41.4 percent for standard consumer loans.

"The transaction is another step to help Itaú Unibanco operate with less risky assets that charge smaller lending spreads," the bank said in the filing. Spreads are the difference between the interest rate banks charge for their loans and the yield they pay depositors for their savings.

That newfound prudence will be tested in coming months as President Dilma Rousseff pushes lenders to offer more financing to consumers in a bid to jumpstart Brazil's economy.

With defaults hitting an all-time high, some investors worry that Rousseff's strategy is poorly timed and may foment irresponsible lending among lenders wary of losing market share to state-controlled banks such as Banco do Brasil.

" For Ita ú Unibanco, this transaction seems like a good way for the bank to e xpand its presence in a market where it lags competitors," Goldman Sachs Group analyst Carlos Macedo said in a note to clients. "Ris ks seem li m ited given funding recourse, and the combination would make Ita ú Un ib anco's balance sheet more defensive."

RAPID CREDIT GROWTH

Loans in arrears for 90 days or more, the most widely followed gauge of bank defaults, rose to 6 percent of outstanding loans in Brazil in May, compared with a revised 5.9 percent in April.

Preferred shares of Itaú Unibanco fell 2 percent to 28. 6 7 reais Tuesday, the second decline in as many days, on concern the association with BMG will hamper profits, traders said. Shares of Itaú Unibanco are down 14 per cent this year.

The yield on the Banco BMG bond due in August 2020 fell to 10.95 percent, the second straight decline. Falling yields often indicate an ease in risk perceptions among investors.

Years of rapid credit expansion in Brazil, which drove credit as a share of gross domestic product to 50 percent this year from about 26 percent at the start of 2003, have resulted in tougher funding and liquidity conditions as well as a relaxation of risk assessment and auditing controls among smaller lenders.

The central bank has seized control of three mid-sized lenders over the past 18 months, partly because of accounting fraud. Yet, more than fraud, investors are worried about the inability of regulators and bankers to fix the funding gap at the core of mid-sized banks' woes.

Lenders in the segment are too dependent on revenue from bond offerings, securitizations of their own loans and even sales of parts of their own loan book to raise funds.

Shares in mid-cap banks are down 2.4 percent in dollar terms this year, according to the MSCI Brazil Small and Mid Financials Index, following a 15 percent slump last year.

($1 = 2.03 Brazilian reais) (Reporting by Guillermo Parra-Bernal and Aluísio Alves; Additional reporting by Sergio Spagnuolo in Rio de Janeiro and Silvio Cascione and Brad Haynes in São Paulo; Editing by Gerald E. McCormick, Jeffrey Benkoe and M.D. Golan)