By Sameer Manekar and Praveen Menon

SYDNEY (Reuters) -Commonwealth Bank of Australia on Wednesday warned of downside economic risks building in Australia from continued high interest rates and persistent inflation, as the country's largest lender posed a drop in its first-half profit.

The bank's profit, which still beat expectations, came a day after mortgage lending challenger Macquarie Group (OTC:MQBKY) said it was gaining market share and signals a tough year for Australia's "Big Four" banks as they enter an environment of lower margins and fees.

"As cash rate increases have a lagged impact on households and business customers, we expect financial strain to continue in 2024, with an uptick in our arrears and impairments," CBA CEO Matt Comyn said in a statement.

Shares of CBA fell 2.4%, with the broader Australian index down about 1% as of 0255 GMT.

Comyn said in a briefing after the results that the rising cost of living was being felt an increasing number of households and businesses, and as a consequence customers had reduced their spending.

"Inflation is falling but still remains too high," Comyn told analysts and investors on the call.

"And we expect economic growth to fall below 1.5% this year. Our base case remains a soft landing, and we're expecting these pressures to ease as inflation and interest rates start coming down later this year," he said.

CBA's profit reflects the earnings challenges Australian banks are facing from higher costs and a contraction in net interest margins (NIM), Daniel Yu, Vice President for Moody’s Investors Service said in a note.

"We expect these headwinds to persist in 2024 as tight competition for both lending and, deposits weigh on banks’ NIMs and operating costs increase further as the effects of elevated inflation linger," he said.

CBA's primary competitors are Westpac, National Australia Bank (OTC:NABZY) and ANZ Group.

SHARES RALLY

For the six months ending Dec. 31, CBA's cash profit fell 3.1% to A$5.02 billion ($3.24 billion) from A$5.18 billion a year earlier as intense mortgage competition and higher expenses due to inflation squeezed margins.

Despite that, the cash profit came in above a Visible Alpha consensus of A$4.95 billion.

Before the result, CBA's shares had jumped more than 20% since November, outshining a 12% rise in the wider market on the back of some investors fleeing China's battered markets and others switching to equities on expectations of interest rate cuts.

Comyn, however, said the bank's valuation was driven by consistent profitability and by the fact that it was very large and had by far the strongest deposit base in Australia.

UBS analyst John Storey said in a note that CBA had needed to deliver a strong set of results given the recent share price rally.

"Despite not living up to expectations, CBA  delivered $5B in cash NPAT, at a point in time when the bank has endured extreme levels of pricing pressure in mortgages &  deposits. If the mortgage market rationalizes, CBA is well placed," Storey added.

CBA's home loan portfolio shrank to A$582 billion at December-end from A$584 billion at the end of June, while Macquarie's grew to A$117.9 billion at end-December from A$114.2 billion at the end of June.

CBA's net interest income from continuing operations on a cash basis slipped 2% to A$11.4 billion as its net interest margin declined 11 basis points to 1.99% versus the prior year period.

The bank's common equity tier 1 capital ratio stood at 12.3% as at December-end, slightly above 12.2% as at June-end. It declared an interim dividend of A$2.15 per share, up from A$2.10 last year.

($1 = 1.5504 Australian dollars)