* ANZ annual profit down 5 pct, second profit fall in three years
* Hurt by customer compensation costs, drop in net interest margin
* Bad loan charges tumble to lowest level in 11 years (Recasts and writes through with analyst comment)
By Paulina Duran
SYDNEY, Oct 31 (Reuters) - Australia and New Zealand Banking Group ANZ.AX said on Wednesday that second-half profit tumbled 13 percent, hit by costs to compensate customers hurt by the bank's misconduct as well as increases in the cost of funding.
The country's Big Four lenders are reeling from the revelations of a powerful inquiry into financial sector behaviour that has forced them to lay off staff, compensate customers and earmark funds to deal with legal and compliance costs.
Cash profit for Australia's No. 3 lender, which excludes one-off items, fell to A$2.99 billion ($2.1 billion), slightly higher than analyst estimates as charges for bad loans slid to a 11-year low.
For the full-year, cash profit was down 5 percent, the second annual decline in three years.
"This has been a challenging and confronting year," Chief Executive Shayne Elliott told a conference call for analysts, adding that the lender had to accept that failures highlighted by the Royal Commission had hurt its standing in the community.
The inquiry showed that the country's banks often sold products to people who did not need them or could not afford them. ANZ and its three main rivals also charged customers for services not rendered. the wake of the inquiry, ANZ has fired 200 staff for wrongdoing including senior executives. Compensation charges for refunds to customers and related costs in the second half were A$374 million.
"It is a messy result as expected," said David Ellis, banking analyst at Morningstar but he added that ANZ was making good progress on simplifying its business model.
Charges for non-performing loans fell 43 percent to A$688 million, representing just 0.12 percent of loans. The decline reflects ANZ's focus on less risky products such as owner-occupied home loans, the bank said.
Another plus for ANZ was 3 percent growth in loans and advances to A$603 billion, primarily driven by growth in home loans in Australia and New Zealand, as well as corporate loans.
"[Revenue growth] is going to be much harder to come by." Elliott said. "I don't want people to think that it's terrible out there in terms of the opportunities. But it's much harder than we've been used to."
The cost of raising money to lend to customers rose during the second half on higher short-term interest rates while a public backlash - exacerbated by the inquiry - and intense competition have curbed their ability to raise mortgage rates.
Net interest income fell two percent to A$14.51 billion, driven by a slide of 12 basis points in net interest margin - the difference between what a bank pays to borrow money and what it charges customers for loans - to 1.87 percent.
($1 = 1.4086 Australian dollars)