MADRID--Santander, the euro zone's biggest bank, reported a sharp drop in annual profit after it set aside money against foreclosed Spanish property, anticipating government demands that lenders recognise heavy real estate losses.

Spanish banks have hundreds of billions of euros of unsaleable land and property and unrecoverable loans to bankrupt developers sitting on their balance sheets, four years after a housing and construction crash. Santander's grim outlook for the property sector on Tuesday comes a day after data showed Spain's economy looked set to slip into recession after contracting for the first time in two years in the last quarter of 2011.

The Spanish bank took advantage of the European Central Bank's offer of cheap loans in December, Chief Executive Alfredo Saenz said at a press conference, and had used the cash as a "buffer" rather than lending it on. Group net profit fell by 35 percent to 5.35 billion euros ($7 billion)in 2011.

In Britain, where Santander is the fifth-largest bank, profit fell by 40 percent to 993 million pounds, due to a weak economy, rising funding and regulatory costs and a big hit from compensating customers for mis-sold insurance, the lender said.

Santander made 3.2 billion euros of provisions, of which 1.8 billion euros would allow the lender to recognise losses on repossessed Spanish properties at 50 percent of book value, up from 31 percent. The bank's writedown on repossessed property is now in line with Ireland's 2009 state-driven cleanup after a similar boom and bust.

"They are sacrificing the present to develop a better future," said Alejandro Varela, Madrid-based fund manager at Renta 4, who owns Santander shares and has around 300 million euros under management. "The quicker they recognise them, the quicker we'll see a recovery in the next few quarters," he added.

The government is expected to announce this week new rules forcing banks to recognize losses on loans to developers and reclaimed property with the aim of cleaning up balance sheets and increasing credit flow to the economy. Some analysts were disappointed that Santander had not marked down loans to bankrupt property developers to the same degree as foreclosed property. Credit Suisse had expected a 3.9 billion euro upfront cost, including writedowns on bad loans.