By Paulina Duran

SYDNEY (Reuters) - Commonwealth Bank of Australia dashed investor hopes for capital handouts and posted its second consecutive annual profit fall on Wednesday, missing expectations as rising costs and falling rates ate into margins.

CBA's first back-to-back profit decline in more than a decade shows Australia's banks are struggling to grow earnings in an environment with intense regulatory scrutiny and subdued economic and credit growth.

They are also struggling to meet investors' expectations on yield in the face of mounting costs, including legal bills linked to misconduct revealed by a public inquiry into financial-sector wrongdoing last year.

"Clearly, we've seen some softening conditions," CEO Matt Comyn told analysts at an investor briefing in Sydney. "The reality is, in a softer income environment, we have to do more work and we will on cost in future periods."

Australia's largest bank declared an unchanged fully-franked final dividend of A$2.31 per share, disappointing those investors who had anticipated a special dividend or a buyback, according to analysts.

Comyn said it was reasonable to expect that a "good proportion" of its A$6 billion in surplus capital would be returned to shareholders. The bank would update investors about its capital plans before the end of September, he said.

CBA shares fell as much as much as 2.9% in morning trading before recovering to be 1% lower in the afternoon, while the broader market was 0.7% higher.

Cash profit from continuing operations, a measure that excludes non-cash accounting items and sold-off units, fell to A$8.49 billion in the year ended June 30, missing a A$8.73 billion profit forecast from analysts polled by Reuters.

HOUSING PICKUP

While home loan and business-lending growth was up 4% for the year, margins suffered amid strong competition and falling rates.

Net interest margin (NIM), a key gauge of profitability that measures the difference between interest paid on deposits and earned on loans, fell five basis points to 2.10%.

Expenses unrelated to remediation were also higher, with the cost to income ratio rising to 46.2% from 44.1% last year, far from a self-imposed target of less than 40% "in the medium term".

Overall, it was "a disappointing result given the expectations that had been built in the market around costs and capital management that now appear delayed," Credit Suisse analysts told clients in a note.

Australian bank earnings are getting squeezed by the central bank's move to cut the cash rate to a record low 1%, as it gets harder to reduce deposit rates to offset the cheaper mortgages they must now offer borrowers.

With an eye on its margins, the Sydney-based lender last month resisted public pressure to pass on a central bank interest rate cut in full.

CBA said it expected official rate cuts so far to eat about 4 basis points off its NIM in the current fiscal year, but this would be offset by significantly lower funding costs in the bond market.

Expected further rate cuts would intensify pressure on margins, but they may also boost the struggling housing market. Comyn said CBA expected a slight pickup in house prices and credit growth.

While home loans and credit card loan arrears improved, loan impairments grew 11% to A$1.2 billion, driven by losses from a small number of large clients and weakness in the retail, construction and agriculture sectors.

CBA also said it had joined U.S. rapper Snoop Dogg as an owner in Europe's most valuable fintech startup Klarna, an online payment company, with a $100 million investment.

($1 = 1.4795 Australian dollars)

(Reporting by Paulina Duran in Sydney, and Nikhil Kurian Nainan and Rushil Dutta in Bengaluru; Editing by Stephen Coates)