New Zealand banks had their most profitable year in more than three decades in 2017, driven mostly by a sharp fall in bad debt as the dairy sector emerged from its slump, KPMG said in its latest banking survey.

Together banks produced a 7.35 per cent, or $355.11 million, increase in net profit after tax to $5.19 billion - the highest in the survey's 31-year history - and reversing the previous year's $316.4m profit fall, KMPG said in its Financial Institutions Performance Survey review.

"The year's result highlights the relatively stable economy combined with continued strong loan growth and improved asset quality, albeit with a continued decrease in margin," KMPG said.

The increase in profitability was largely attributable to the combined impact of a $281.9 million (61.3 per cent) reduction in impaired asset expense and a $268.6 million (10 per cent) increase in non-interest income, KPMG said.

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"The reduction in impaired asset expense is largely a result of an improved sector credit quality and a relatively stable economy over the past 12 months," KPMG said.

Favourable gains in banks' financial instruments further helped increase non-interest income for the majority of the survey participants, it said.

The big four - ANZ, BNZ, Commonwealth Bank of Australia (ASB) and Westpac - collectively contributed $451m of the growth in net profit.

Conversely, the fifth major bank - Kiwibank - reported a 57.2 per cent fall in net profit - which was significantly impacted by a $65m software impairment charge.

The three Chinese banks operating in New Zealand had the most impressive profit growth in percentage terms, KPMG said, with the Bank of China lifting its profit by 73.6 per cent, China Construction Bank by 138 per cent and Industrial and Commercial bank of China by 139 per cent.

JP Morgan Chase Bank and Southland Building Society produced the next biggest net profit increases among the non-major banks, with a 36.9 per cent and 37.4 per cent respectively, as fee and commission income increased for both participants.

KPMG partner John Kensington said that in the first half, revisions to Australian prudential standards led to intense competition for deposits, resulting in banks refinancing and altering internal policies while slowing the growth in their lending books.

"Meanwhile the second half of the year saw lending growth accelerate again, although more slowly than historic levels," Kensington said.

One aspect that continues to underpin the banking sector's performance was the strength of the balance sheet, he said.

In contrast to 2016, the banking sector produced an impressive increase in profitability.

The banking sector's interest rate margin decreased by 9 basis points from 2.17 per cent to 2.08 per cent, mostly through increased competition on the lending side.

"Asset quality is going from strength to strength, with the ratio of total provisions to average gross loans decreasing 5 basis points.

"This reduction, combined with a significant decline in impairment expense due to banks tightening their selection criteria, has resulted in the positive outcome of better asset quality. KMPG said it looked like higher interest rates lay ahead.

It said low cost, easily accessible funding has become scarcer than before, following revisions to the Australian prudential standards , which resulted in a reduction of funding able to be provided by the big four Australian banks to their New Zealand subsidiaries.

"Funding costs also may be pressed upward in the future given the inflationary pressures across the globe and in New Zealand, and a rise in interest rates probably will not come as a surprise," it said.

The combination of these costs and supply pressures makes it appear as though the liquid cash of retail depositors is the 'kingmaker' as far as funding is concerned, especially in the low current low-yield environment," KMPG said.

"Many survey participants espoused the notion that, since the historic love affair with looking after the borrower may be over, depositors may be the ones that now start to 'feel the love'," it said.