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UPDATE 2-Australia's Westpac scraps dividend as coronavirus crisis squeezes capital

* Scraps interim dividend, core capital falls slightly

* Westpac’s priority to remain strong - CEO

* Capital raises questions about final div - Credit Suisse (Recast, adds shares, CEO comment, analyst on capital, dividend)

SYDNEY, Aug 18 (Reuters) - Westpac Banking Corp scrapped its interim dividend on Tuesday, becoming the first major Australian bank to officially cancel a shareholder payout amid the coronavirus crisis, knocking its share price lower.

Australia’s banks have been grappling with record-low interest rates, higher default risk and loan holidays for struggling borrowers, as the country faces its first recession in nearly three decades.

With many investors relying on bank dividends for their retirement income, the pressure to maintain payouts is intense, but analysts flagged Westpac’s shrinking capital levels could lead it to cancel its final payout as well.

In a quarterly update on Tuesday, the country’s second largest lender said its core capital level had shrunk 1 basis point to 10.80% due to higher capital allocations to riskier exposures, a level close to the 10.50% baseline preferred by regulators.

Westpac said it booked A$826 million ($596 million) in credit impairment charges during the quarter, and increased provisions to cover for bad debts, as mortgage stress was emerging, customers were being downgraded and delinquencies were increasing.

“Westpac’s priority has been to remain strong so we can continue supporting customers through this challenging period,” Westpac’s CEO, Peter King said in a statement.

“While there have been some signs that the economy is performing better than early expectations, significant uncertainty remains.”

The bank reported third-quarter cash earnings of A$1.32 billion, above the first-half average as coronavirus-related impairment charges eased.

However, net interest margin, a highly watched measure of bank profitability measure, was 8 basis points below the first-half average, hurt by record low rates.

“While cancelling of the interim dividend was not a surprise the lower capital outcome will raise questions about a final dividend,” Credit Suisse analysts told investors in a note.

Westpac shares fell 3.5% in morning trade to A$16.97, in a slightly firmer broader market.

Westpac also said it had contacted 85% of the 135,000 customers receiving deferral plans, and around half of them were expected to resume regular payments. ($1 = 1.3866 Australian dollars) (Reporting by Paulina Duran; additional reporting by Rashmi Ashok in Bengaluru; Editing by Devika Syamnath and Richard Pullin)

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