Issues ranging from weak transparency standards, slow consolidation and eroding profits are hampering investor confidence in the sector. Shares of Brazil's mid-cap banks are down 14 percent in dollar terms since January, according to the MSCI Brazil Small and Mid Financials Index.

At the core of such worries lies the segment's inefficient funding structure in which cash flow mismatches are frequent, making mid-cap lenders vulnerable to a downturn in credit markets.

Concerns over the industry's fragile position were fuelled last week in a local newspaper report that Banco Cruzeiro do Sul sought support from the banking deposit insurance fund FGC. Although executives at both Cruzeiro and the FGC denied the story, investors continue to look for signs of weakness.

"Funding continues to be the structural weakness of small- and mid-sized banks and their high liquidity position suggests their cautious view in the short term," said Frederic de Mariz, a banking analyst with JPMorgan Securities in Sao Paulo.

At stake is the credibility of a model for the industry based on broader access and rapid disbursements that was for years labelled as "risk-free" by government officials.

Despite the promising outlook for consumer and middle-market corporate lending in Brazil, so-called mid-cap banks are showing signs of strain following a rapid expansion of credit over the past eight years.

Moody's Investors Service downgraded Cruzeiro do Sul's ratings to "Ba3" on Friday three levels below investment grade citing doubts over the sustainability of its revenue and funding. The yield on Cruzeiro's bond due in 2016 soared almost one percentage point to 15.50 percent as a result.

Cruzeiro and its peers rely more than larger peers on funding that is pegged to market interest rates and usually bears short maturities, Moody's said. As markets remain wary of a potential worsening of Europe's debt crisis, sources for fresh cash are likely to remain scarce next year.

Mid-cap banks have sold more than $10 billion of dollar bonds since mid-2009, and much of those debts bear maturities of five years or less. The tight repayment schedule means that a dearth of capital could get even worse, analysts said.

Revenue streams remain poorly diversified in the sector and there is little that can be done to improve it. Mid-cap banks rely on credit and trading income for about 88 percent of revenue, compared with 70 percent for the largest Brazilian banks, according to JPMorgan data.

As Brazil embarks on an interest-rate cutting cycle to fend off the impact of market turmoil, these lenders will have to turn more aggressive to retain clients and obtain cheaper, longer sources of funding. The sector is now too fragmented to fully capture the benefits of lower rates while remaining vulnerable to difficult market conditions.

"Conditions could change marginally but the outlook won't turn less worrisome just because of the rate-reduction cycle," said a Sao Paulo-based bond investor who spoke on condition of anonymity. Mid-cap lenders were severely punished by central bank steps earlier in the year to arrest red-hot credit growth in the auto, payroll and consumer segments.

Capital requirements and policy measures could also bring in more headwinds for the sector, de Mariz said. New capital rules based on the Basel III accord could depress solvency ratios for some of these lenders, he said.

More problems could arise if liquidity dries up as the central bank phases out a program to guarantee certain deposits. The so-called DPGE program was implemented two years ago to shore up deposits after the collapse of Lehman Brothers.

The future of the mid-cap bank sector is core to the development of Brazil's banking industry not only because of the systemic risk their weakness could pose, but also for their ability to foster competition in a market that is becoming more concentrated.

But the fortunes of the industry, which grew at a break-neck pace once former President Luiz Inacio Lula da Silva allowed lenders to deduct monthly loan instalments from workers' pay-check in September 2003, have soured since the bailout of Banco PanAmericano exactly a year ago.

Brazil's privately owned deposit guarantee fund lent about 4 billion raise to PanAmericano's then-controlling shareholder to back up deposits. The lender, which booked heavy losses following a series of accounting problems, was sold to banking powerhouse BTG Pactual early this year.

The limited visibility and scant information about the circumstances of the PanAmericano rescue made it harder for investors to gauge whether peers were conducting similar accounting inconsistencies.