Report says institutions well placed after record profits but dairy lull and housing correction risk pose threats.

New Zealand's banking sector notched up another record year of returns in 2015, but is facing challenges, including the impact of low dairy prices on rural borrowers and the threat of a sharp correction in the housing market, according to a new report.

KPMG's latest Financial Institutions Performance Survey found this country's banks posted a combined profit of $5.2 billion last year - a 6.9 per cent increase on 2014.

Impaired asset costs, however, rose by $173 million, or 65 per cent, which the report said reflected a "normalisation" of bad debt charges.

John Kensingston, head of financial services at KPMG, said the sector had strengthened its position through operational efficiencies and lending growth of 7.1 per cent, despite volatility in global financial markets.


It was well-placed to continue its growth this year, he said, although headwinds were emerging.

Kensington said the dairy industry's situation was not yet "dire", but would become more serious if prices remained low for a sustained period.

"[Were you] to have two more years of sustained low dairy prices, with no relief in any other areas [such as increased production or a lower Kiwi dollar] ... then I think you would see banks starting to make provisions against loans and having to make special arrangements with farmers on potentially ... a wide proportion of their books," Kensington said.

The risk of a sharp correction in house prices is therefore still a concern given the banking sector's significant exposure to the property market.


The report said loan-to-value ratios introduced by the Reserve Bank had not been strong enough to combat the market forces driving Auckland property prices higher.

"The risk of a sharp correction in house prices is therefore still a concern given the banking sector's significant exposure to the property market," the report said.

KPMG's comments echo those of ratings agency Standard & Poor's, which said this week that rising house prices and the dairy slump posed a threat to New Zealand's banks.

Meanwhile, global fears about credit risks are increasing the cost of credit default swaps, essentially insurance policies against debt default.

Last week, the cost of protecting the bonds issued by Australia's big four banks - ANZ, Westpac, National Australia Bank and Commonwealth Bank - rose to 29 basis points more than the average for the four biggest US banks, the widest gap on record in credit default swap prices going back to 2004, Bloomberg reported.

Kensington said funding markets had been favourable for local banks last year, but the situation had taken a turn for the worse in early 2016.

"I think banks that are now looking to refinance will be doing so at rates that are less favourable than they were previously," he said. "As banks start to feel the impact of higher pricing, they will be forced to raise their mortgage rates slightly."

The report said competition in the lending market remained fierce, with some survey participants reporting that the resulting margin squeeze meant they were edging below return-on-assets and return-on-equity requirements for some lending.

See the latest FIPS report here: