Reserve Bank Governor Alan Bollard has issued a warning to banks about the perils of approving high-risk mortgages.

Dr Bollard warned of the need to avoid a return to a "debt-fuelled housing cycle", as the bank published its six-monthly Financial Stability Report today.

The report said there had been signs of an easing in lending standards for residential borrowers in recent months, with some banks prepared to offer housing loans at relatively high loan-to-value ratios.

"The housing market is currently strengthening, but we believe house price growth will slow after the current recovery phase," the report said.

"We would encourage the banks to avoid any return to riskier mortgage lending practices."

House prices still looked relatively high compared to history, and were still higher as a share of income than at any time before 2005, the report said.

Despite the pick up in housing market activity, household credit growth had continued at low and steady rates.

Slow credit growth may reflect some highly indebted sellers repaying mortgages, as well as households accelerating principal repayments now interest rates were low.

"Overall, the housing market recovery is likely to be limited, and subject to downside risks as interest rates start to rise from very low levels," the report said.

"Continued weakness in the labour market, along with falling agricultural incomes, could also weigh on the housing market."

Current low levels of interest rates made mortgages look relatively affordable compared to recent history, particularly if the loan was financed using a floating mortgage, the report said.

But floating mortgage rates would eventually rise as the economy started to recover, possibly placing stress on some first-time home owners who had entered the market at very low interest rates.

Longer term fixed mortgage rates, which were significantly higher, were likely to be a better guide to medium term mortgage affordability.

Dr Bollard said the New Zealand economy and financial system had improved in the past six months as international conditions stabilised, but some risks and challenges remained.

Global recovery had been fuelled by stimulatory fiscal and monetary policy settings which could not be kept in place for ever, he said.

The global banking system also remained vulnerable to further shocks.

"The New Zealand economy needs to live more within its means to reduce its vulnerability to adverse developments in offshore markets," Dr Bollard said.

While some progress had been made to recover savings and reduce the current account deficit, considerable adjustment was still needed to reduce this country's vulnerability to external shocks.

Deputy Governor Grant Spencer said further loan losses for banks were likely as unemployment continued to rise through into 2010.

Banks' recent provisioning and profit results reflected the deterioration in their asset quality during the recession, he said.

The banks remained "very cautious" in credit and funding decisions, and while the Reserve Bank generally supported that approach, it continued to emphasise that banks should not overly restrict lending to the business sector.

In the non-bank sector, further rationalisation and closures were expected as the sector faced the challenge in the coming year of meeting the requirements of the Reserve Bank's new non-bank prudential regime.

- NZPA