New Zealand's financial system is sound but housing market vulnerabilities remain a key risk and the central bank still wants to curb high debt-to-income lending if necessary, it said in its twice-yearly financial stability report.

Since the last report, house price inflation has moderated and banks are more resilient to a market downturn, but houses remain overvalued in many parts of the country and some homeowners are vulnerable to a potential fall in incomes or a rise in mortgage rates, it said. "A further resurgence in house prices would be of real concern, given existing affordability constraint," it said.

In response to the stability report, Westpac said they expect house prices to rise just 3 per cent this year compared to nearly 14 per cent last year.

New Zealand's housing market has been running hot, spurred by record high immigration and record low interest rates. Over the past several years, the central bank has introduced loan-to-valuation ratios on borrowing for housing in a bid to curb lending. The central bank said the LVRs have had an impact, with annual national house price inflation, as measured by the Real Estate Institute's house price index, at 8 per cent in April from around 14 per cent in October. However, while they have helped insulate the banking system from a housing downturn, low mortgage interest rates have encouraged an increase in high debt-to-income lending.


"Borrowers with high DTI ratios are typically more exposed to a rise in interest rates or a decline in income," it said. Earlier this year, Finance Minister Steven Joyce called for a full cost-benefit analysis on proposed debt-to-income home lending limits and said public consultation will be conducted by the Reserve Bank before any decision is made on the potential use of the additional macro-prudential policy tool.

In today's financial stability report, the central bank said it will shortly release a consultation paper proposing that DTI ratio restrictions be added to the Reserve Bank's macroprudential toolkit.

It said, however, if a DTI tool was available, the Reserve Bank would not apply it at this stage, given that LVR restrictions appear to be mitigating housing risks. However, "should high house price growth return and the proportion of housing lending at high DTI ratios remains high, a DTI restriction could be warranted."

The central bank also signaled bank funding pressures and dairy sector indebtedness as other key risks. While these risks have also moderated it said New Zealand banks have become more reliant on offshore funding to support new lending, exposing them to international risks that could disrupt global markets.

It said that global political and policy uncertainty "remains elevated" and debt burdens are high in a number of countries. "A sharp reversal in risk sentiment could lead to higher funding costs for New Zealand banks and an increase in domestic borrowing costs. Rising protectionism could also affect the trade-exposed sectors of the New Zealand economy," it said.

It reiterated it is currently undertaking a review of bank capital requirements and recently released an issues paper detailing the intended approach and scope of the review. It said principles underpinning the review include that capital requirements for New Zealand banks should remain conservative relative to international peers and that complexity in capital regulation should be reduced where possible.

Regarding dairy it said that after two years of low prices, whole milk powder prices increased by 45 per cent over the past 12 months and the majority of dairy farms are now expected to be profitable in the current season. However, "indebtedness in the sector has continued to increase, and the most indebted dairy farms remain highly vulnerable to lower dairy prices or an increase in costs," it said.

Banks should continue to closely monitor and maintain full provisioning against lending to high-risk farms, it said.