The Reserve Bank has warned that unemployment could rise to 18 per cent and house price could halve if New Zealand faced further lockdown periods.
The central bank's six-monthly report on Financial Stability delivered these worst-case scenarios but added that the financial system is in a solid position to weather the economic impact caused by Covid-19.
Reserve Bank governor Adrian Orr said at the start of the pandemic the banking system had significant capital and liquidity buffers built up.
"These buffers can now be used to support their customers' long-term economic future. Our economic stress test analysis suggest banks can continue to lend and prosper through a broad range of adverse scenarios."
Orr said banks had a critical role in supporting customers who were facing short-term income declines.
"Maintaining the flow of credit to financially sound customers also contributes to the long-term profitability of the banking sector, by avoiding unnecessary defaults and disorderly corrections in asset markets," he said.
But outside the banking system some parts of the financial system had entered the downturn in a vulnerable position.
Deputy Governor Geoff Bascand said some non-bank deposit takers had low profitability and were operating with low buffers.
"There has been consolidation in this sector in recent years and this is expected to continue. Resilience could also be boosted by seeking operational efficiencies, asset sales, and additional capital."
Some life insurers had also been operating with low solvency buffers while others had experienced investment losses and/or rising credit insurance claims.
"We are continuing to work with insurers to see them build better resilience and maintain a strong focus on long-term customer outcomes."
In its report the central bank noted that Covid-19 had caused an unprecedented shock to economic activity.
"Economic activity has now restarted domestically as we have moved to alert level 2 and a number of other countries have made moves to open up their economies.
"However, economies are operating well below capacity and general economic conditions will remain weak as losses of income in directly affected sectors flow into a decline in overall demand."
Unemployment was expected to rise significantly.
In response the Reserve Bank cut the official cash rate to 0.25 per cent in March and had begun purchasing central and local government bonds in large scales to reduce interest rates.
It had also provided funding to banks when markets were volatile to ensure banks remained able to support customers.
But while the employer wage subsidy and easier monetary policy had cushioned the near-term financial impact some household and business borrowers would come under stress.
"Despite the broad range of support measures, some households and firms will face a significant loss of income. Firms in the tourism, accommodation and hospitality sectors are particularly affected, and will face longer recoveries as border restrictions and social distancing measures affect sales and operating models."
Household incomes would also come under pressure as staff cutbacks and firm failures lead to rising unemployment, it noted.
That loss of income would mean some borrowers had difficulty paying their loans and banks were likely to see more loan defaults and losses.
The central bank's stress tests suggested the banks could withstand loan losses under a broad range of scenarios.
"However, there remains considerable uncertainty about the future trajectory of the pandemic, and how this will affect the New Zealand economy. Under severe enough scenarios, the viability of banks would come into question."
The RBNZ looked at a second stress scenario which assesses the impact of further economic lockdowns that resulted in unemployment rising to 18 per cent and house prices falling by almost half.
Under this modelling and without significant and timely mitigation, banks would fall below minimum capital requirements.
"The Reserve Bank is working with industry to better understand the impacts that these scenarios would have on banks and to assess appropriate mitigating actions."
