The smaller banks were being squeezed by competition and their falling profits were largely the result of increased pressure on margins and lower increases, or even decreases, in lending growth rates, the survey said.
The report said TSB's net profit fell 14.3 per cent to $12 million in the first quarter. Kiwibank's net profit dropped 10.7 per cent to $25 million and SBS Bank's profit fell 25 per cent to $3 million.
Banks have been offering flat-screen televisions, cash for groceries, iPads and even free legal advice to customers to sweeten home loan deals in an increasingly competitive lending market ahead of an expected rise in interest rates either later this year or in early 2014.
"The big banks are using their size and ability to borrow money from offshore markets - perhaps more easily than some of the smaller local banks - to offer some very competitive rates to their customers," said KPMG's head of financial services, John Kensington.
"Those larger banks are doing everything they possibly can to try and get as much growth in market share at a time when, for the first time in a long time, there hasn't been a huge demand for borrowing."
Kensington said the overall rise in profit shown in the survey was a strong result for the sector.
"New Zealand banks continue to have solid performance reflecting the early signs of growth in the domestic economy," he said. "This, combined with improved results from business confidence surveys, points to an improving economic situation."
While big bank profits draw a fair amount of cynicism from the public, Kensington said it was important that the country had stable, profitable banks.
"The engine of the economy is the agri-sector in New Zealand but the banks are the fuel or the oil in that engine, and if either of those things are missing the engine doesn't run too well," he said, adding while the big lenders' profits often seemed huge, banks' return on equity was much lower than other large companies.
The survey said the sector's net interest margin - the difference between what it costs banks to borrow money and what it lends it out at - had decreased by 4 basis points to 2.24 per cent, which showed margins were being impacted by the competitive environment.
BNZ was the only bank to experience a lift in margin during the quarter, rising one basis point to 2.35 per cent.
The survey said gross loans and advances were showing good growth in the March quarter, rising 1.08 per cent and 4.87 per cent, respectively.
"The quality of the banks' loan portfolios continues to improve as legacy impaired loans from the global financial crisis have been realised or returned to good book," KPMG said.
Kensington said banks were likely to face even more competition in the lending market in the near term, while other challenges included government regulation, such as the introduction of loan-to-value ratios on home loans and anti-money laundering legislation.
