A sharp fall in house prices remains a risk to households' balance sheets, which have yet to be truly tested, the Reserve Bank warns in its latest financial stability report.

The report - couched in tones ranging from sober to downright grim - focuses on the risks to the financial system and the real economy from the turmoil in Europe.

But it also notes that fundamental measures such as house prices relative to incomes and rents remain high.

Households' ability to service debt has been bolstered since 2007 by higher incomes, slow growth in debt levels and lower mortgage rates.


Because of this, people have devoted a higher proportion of their incomes to paying off mortgages.

Consequently, households' vulnerability to a further slowdown in the economy "appears to have declined slightly over the past few years", the bank says.

"However, in many ways the economic environment of the past three years has not provided a true test of household balance sheets.

"Debt-to-income ratios remain at historically high levels and house prices, although they have declined relative to incomes, still seem somewhat overvalued.

"A significant decline in house prices, particularly if coupled with a rise in unemployment or interest rates, would be likely to create larger credit losses for the banking system than seen in recent years."

It is less worried about the risk in the other direction - another property boom.

"We are not concerned at this point," deputy governor Grant Spencer said.

"There has been some relaxation of lending standards but the volumes are still very low."


The bank sees the greatest risk of another global recession which would put New Zealand households under pressure as coming from Europe, where concerns about sovereign debt have made access to overseas funding markets "more challenging" for New Zealand's banks.

"At present they are sitting back and saying, let's wait and see if things cool down," Spencer said. "But the longer this goes on, the likelier it is there will be impacts in terms of reduced credit and/or a higher cost of credit."

However, he is more optimistic than International Monetary Fund head Christine Lagarde, who has spoken of the risk of a "lost decade" for the world economy.

Spencer says that "even if the European situation takes a year or two to resolve, I don't see it causing global weakness for an extended period".