New Zealand bank profits rose 8.6 per cent in the first three months of the year as lenders honed costs while lending margins fell.

KPMG's quarterly Financial Institutions Performance Survey (FIPS) shows the New Zealand banking sector lifted net profit to $1.25 billion in the three months ended March 31 from $1.15 billion in the December quarter, when earnings dropped 8.3 per cent.

Net interest margins across the sector shrank five basis points to 2.29 per cent as banks fought for residential mortgage customers, forcing them to improve earnings from other forms of revenue and by clamping down on costs.

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"Growth in other income, together with a reduction in operating and impaired asset expenses, were the main drivers for the industry-wide increase in NPAT (net profit after tax), which outweighed the decline in the net interest income and increase in income tax expense," KPMG said in its report.

"In an intensely competitive environment with a growing trend of new banks and other finance providers entering the market to chase the lure of growing profitability, the incumbents have shown a shift in focus towards cost cutting as a way to maintain competitive advantage."

In May, the Reserve Bank said the country's financial system was still sound, though escalating Auckland house prices were a key risk that prompted governor Graeme Wheeler to announce new loan restrictions targeting the city's property investors to stifle some demand.

Today's KPMG survey shows gross loans rose 1.9 per cent to $336.9 billion and were 6.1 per cent higher than a year earlier, owing to a combination of increased business and consumer confidence, low dairy payouts putting stress on farmers, and increased house sales. Of that, agriculture lending rose at an annual pace of 6.9 per cent and business credit expanded 6.6 per cent.

Banks have increased their use of mortgage brokers, with Bank of New Zealand using them again for the first time in 12 years, while ANZ Bank New Zealand is now sourcing 38 per cent of loans through brokers, up from 32 per cent two years ago.

Heartland Bank reported the biggest loan book growth, with a 4.1 per cent quarterly increase to $2.25 billion, for an annual gain of 16 per cent. Of the big four, ASB Bank lifted gross loans 2.8 per cent in the quarter for an annual increase of 6.9 per cent, to $67.88 billion.

A deterioration in lenders' asset quality was obscured by TSB Bank's write-off in an earlier period of its Solid Energy bonds. Stripping that out, the impaired asset expense was at the highest quarterly level since December 2012 in the latest survey.

"This is due to write backs continuing to decrease and provisioning continuing to reach more normalised levels," KPMG said. "Looking at the growth in impairment expense over gross loans and advances, they appear to be slowly increasing at a similar rate compared to the prior three quarters."

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KPMG said banks with high agricultural sector exposure may feel some concern over asset quality with Fonterra payouts to farmers slashed for this season compared to last and with prospects for a relatively weak 2015/16 payout.

The Reserve Bank has said another year of low payouts would be a concern for the New Zealand economy, especially for some 25 per cent of dairy farmers currently trading with negative cashflow.

See more from the KPMG report here: