By Roushni Nair

(Reuters) - Australia's biggest banks are expected to report lower annual earnings next week, with investors focused on whether intense competition in lending and the rising costs of deposits will outweigh gains in mortgage revenues.

The earnings will be closely monitored to see if the banking sector's share price surge by over a quarter since late 2023 is justified, with the sector posting its strongest rally in nearly two years in July.

Although margins are stabilising, Australian banks face rising costs as depositors move funds into savings accounts paying more attractive rates and borrowers struggling with loan repayments due to high interest rates.

"The banks hold large loan loss provisions to cover rising defaults, and borrowers struggling to service loans are remedying their financial situation by selling into a strong housing market," advisory firm Morningstar wrote in a client note.

The Reserve Bank of Australia has held rates steady at 4.35% since November 2023 after a rapid 425 basis-point hike since May 2022. Markets expect the RBA to ease policy by year-end, though the central bank has maintained the option to tighten.

Credit growth remains restricted, even as wages and the population grow, due to decreased borrowing capacity and high inflation. Meanwhile, fears of sustained high interest rates have discouraged discretionary spending.

As mortgage repayments rise, borrowers face greater difficulty qualifying for new loans or credit due to the impact on their debt-to-income ratio, a crucial metric for lenders assessing borrowing capacity.

Several lurking cost issues may also emerge this reporting season, Citi analysts said, including regulatory and compliance spending and investment in technology.

Westpac, Australia's second-largest mortgage lender by loans, is expected to report a 3% drop in annual cash earnings on Monday, according to market data aggregator Visible Alpha and other brokerages.

National Australia Bank ( NAUBF ) and ANZ Group ( ANZGF ) are also expected to tell a similar story with projected annual cash profit dips of 9% and 6%, respectively. NAB and ANZ, the second- and fourth-biggest banks by market value, announce annual earnings on Nov. 6 and 8, respectively.

Citi analysts anticipate challenges for ANZ's institutional bank as it faces "the negative impact from offshore rate cuts before more domestically focused peers".

ANZ has the biggest international footprint of the country's retail banks, including a dominant share of the Pacific banking market.

Commonwealth Bank of Australia ( CBAUF ), which holds a quarter of the country's A$2.2 trillion ($1.46 trillion) mortgage market, is expected to post a two-basis-point widening in first-quarter net interest margin when it reports on Nov. 13, with profit seen rising 6.3%, according to analyst estimates.

($1 = 1.5225 Australian dollars)