Commonwealth Bank of Australia said profitability declined in the bank's first quarter as European sovereign debt concerns and restrained consumers at home led to "challenging" conditions.

The group's underlying net interest margin fell "marginally" in the three months ended September 30 as the bank increased holdings of liquid assets, Commonwealth Bank said yesterday.

Competition and higher funding costs continue to squeeze margins, the Sydney-based lender said.

Market volatility is driving up the cost of money on which the bank relies to finance its lending business, Commonwealth Bank said yesterday as it posted a 9.4 per cent increase in quarterly cash earnings to A$1.75 billion ($2.3 billion).

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The bank and its three largest rivals including Westpac face the worst domestic market for home loans in three decades, and stock indexes worldwide are fluctuating as investors bet on the outcome of Europe's debt crisis.

"Operating conditions remain challenging," New Zealand-born chief executive Ralph Norris said.

"Whilst the Australian economy continues to perform relatively well, consumer and business confidence remains fragile, most noticeably reflected in subdued system credit growth."

Shares in Commonwealth Bank dropped 71c to A$49.15 on the ASX yesterday, ending two days of gains.

Westpac was steady, ANZ Banking Group rose 6c while National Australia Bank was little changed.

Westpac, Australia's second-largest lender, on November 2 posted a 13 per cent decline in second-half profit as lending growth slowed and debt market turmoil triggered a drop in earnings.

National Australia said last month that profit in the period rose 31 per cent as it won a bigger slice of the nation's mortgage market with discounted loans. ANZ Bank's profit rose 4.3 per cent, the lender said on November 3.

ANZ Bank, Westpac and Commonwealth Bank lowered their variable mortgage rates this month by the same amount as the central bank's reduction.

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National Australia reduced its variable rate by 0.2 per cent.

Commonwealth Bank's Tier 1 capital ratio, a key measure of financial health, was 9.85 per cent as of September 30, it said yesterday.

The bank's total impairment expense was lower at 0.19 per cent of total average loans, or A$256 million in the quarter, the bank said.

- Bloomberg