SYDNEY (Feb 17): Australia and New Zealand Banking Group Ltd said on Friday the credit environment was improving after reporting a 31 percent rise in first-quarter cash profit driven in part by lower-than-expected bad debts.

The surprise improvement in credit quality suggests new Chief Executive Shayne Elliott's strategy of reducing the size of its institutional lending book and weighting itself more toward retail banking may be starting to bear fruit.

This in turn is raising hopes Australia's third-biggest bank can boost profitability and catch up with its major peers. The biggest institutional lender of the "Big Four" banks typically reports higher bad debts and lower return on equity.

"They have always been a bit riskier. They have taken on loans others have walked away from. That's why bad debts have always been higher," said Omkar Joshi, Regal Funds Management senior analyst.

ANZ said unaudited cash profit stood at A$2 billion ($1.54 billion) for the quarter ended Dec. 31, including strong income from trading and gains from the sale of its old Melbourne head-office building.

Total provision charges for bad debts stood at A$283 million, well below the near A$500 million quarterly average reported in the previous financial year. The Melbourne-based bank had guided for flat bad debt provisions, after a major decline in unperforming loans in the institutional division.

"The outlook on provisions is ... a little more positive," Elliott said in a statement, although he also cautioned the first quarter typically had the lowest provisions of the year.

ANZ shares were up 1.66 percent to A$30.70 in a flat overall market.

Over the past few years, large Australian banks have been hit by bad debt charges from loans to companies that suffered from the end of a mining boom, but a recent rebound in commodities prices has helped to improve credit quality.

MARGIN FALL

Morningstar analyst David Ellis said ANZ's bad debts were "a lot lower" than he had expected, although a fall in the net interest margin of "several basis points" was disappointing.

Rival Commonwealth Bank of Australia on Wednesday reported a slight decline in its net interest margin while National Australia Bank last week said its margin had been "broadly stable".

Australian bank margins have been under pressure from higher wholesale funding and deposit costs.

Adjusted to remove the impact of certain one-off items, such as impairment and restructuring charges, ANZ's first-quarter unaudited cash profit rose 20 percent.

ANZ reported a Tier 1 capital ratio of 9.5 percent as of Dec. 31. ($1 = 1.2995 Australian dollars)