Bad debts waiting to hit bank profits, says KPMG

New Zealand banks' profitability is set to decline this year as bad debts rise and house prices fall, according to KPMG's annual survey of the sector.

The banks' combined profit for the 2008 year was $3.27 billion, a modest 1.6 per cent improvement on 2007. However that was affected by changes to financial reporting standards.

A normalised measure of the banks' underlying performance showed a 5.1 per cent improvement or 3.7 per cent in the case of the big four: ANZ National, Westpac, Bank of New Zealand and ASB.

Underpinning that was growth of 19 per cent, or $4.6 billion, in net interest income, reflecting an expanded loan book and an increase in average interest rates.

KPMG expected the major banks' earnings for the six months to March 31 would also prove to be relatively strong, despite increasing bad debts.

"However, these earnings will not be sustained and impaired asset expense is likely to increase in the next few quarters," it said.

"The outlook for bank earnings appears negative in comparison with earnings achieved the previous year."

Banks' loan books continue to be dominated by residential mortgages. Property prices have fallen over the past 15 months and continue to drop.

"As a result, the largest single driver of bank growth over the past decade has stalled," KPMG said, though it added that to date the effect had been mitigated by strong agricultural and business lending growth.

During the second half of the 2008 financial year bad debts written off jumped to $636 million from $239 million a year earlier.

But that represented less than a quarter of 1 per cent of loans outstanding and was at a very low level by international standards, KPMG said.

Meanwhile, the sector faces uncertainty about what happens when the retail deposit guarantee scheme, which the Government introduced last October, expires in October 2010.

"Will the scheme be extended to match the the Australian guarantee scheme or will it mature and investors suddenly have to reassess the relative riskiness of the entity holding their hard-earned money?" asked KPMG's head of financial services, Godfrey Boyce.