The Reserve Bank has dashed hopes that it would ease home lending restrictions, warning banks that their behaviour around risk needed to improve.
On Wednesday the Reserve Bank released its six-monthly Financial Stability Report, which found that New Zealand's financial system was stable, but risks were increasing.
Some observers had predicted that the release could see the central bank ease loan to value ratio (LVR) restrictions, but governor Adrian Orr warned that "persistent, low long-term interest rates" could be starting to lead to problems.
"Low interest rates can encourage excessive debt, can encourage excessive risk-taking and it can lead to over-heated asset prices," Orr said.
The bank was "not particularly" close to easing LVR restrictions, Orr said and while it welcomed house price inflation falling below income growth, there would need to be signs of improved bank behaviour before it would do so.
"What we've seen to date is they [banks] like to fill their boots as soon as the LVR is eased, taking up the full slack."
The report said that household indebtedness remained high and some households faced particularly large debt burdens.
"The risk of large housing losses has reduced somewhat over the past three years. House price inflation has slowed, particularly in Auckland, reducing the likelihood of a future sharp house price fall."
But it warned that vulnerabilities may increase in the low-interest rate environment.
"...there are early signs that housing lending risk may be increasing again."
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The central bank noted that house price growth had strengthened in recent months even with the restrictions and it was unclear how long this strength would persist.
"There are also early signs that banks are easing mortgage lending standards in response to the low interest rate environment."
Data shows high LVR lending - those borrowing more than 80 per cent of the value for their own home or more than 70 per cent for an investment property - was the highest it has been in the three months to September 2019 compared to the same period in the prior three years.
The report said household sector debt remained the largest single vulnerability to New Zealand's financial system with household debt making up 60 per cent of bank lending and it growing at a rate of 6 per cent a year.
Low interest rates have allowed people to service bigger mortgages and servicing ratios currently remained around the 20-year ratio average.
"However, there is a risk that prolonged low interest rates will encourage new borrowers to take on excessive debt, exposing them to financial stress if they experience a loss of income, or if interest rates rise in the future."
The Reserve Bank report noted that a resurgence in the housing market would be particularly concerning if it came with an easing in bank lending standards and a rise in high-risk lending.
While mortgage lending standards had been tightening at the banks that may be changing with Australian regulator APRA relaxing its rules on debt servicing test rates.
"APRA regulations directly affect the four Australian-owned banks, and indirectly affect other banks through competition. This has contributed to a loosening of bank lending standards in New Zealand in the past few months, which has the potential to increase
the supply of credit to the housing market."
The report said in the low interest rate environment it was not unreasonable that banks should adjust their lending standards.
"...but the effects of these changes will need to be monitored closely to ensure that they do not lead to an increase in vulnerabilities."
Overall, the Reserve Bank said the risks to New Zealand's financial system remain elevated and more was required to ensure they were resilient over the longer term.
Reserve Bank governor Adrian Orr said the international risks to the financial system had increased.
"Global growth has slowed amid continued uncertainty about the outlook for world trade."
Orr said this had resulted in reductions in long-term interest rates to historic lows, including in New Zealand.
The central bank was also committed to bolstering the resilience of the financial system and said bank capital buffers were key to helping banks absorb losses when faced with unexpected developments.
The Reserve Bank is due to announce its final decision on increasing bank capital on December 5.
More scrutiny of compliance by banks and insurers
Deputy Governor Geoff Bascand said good governance and robust risk management of financial institutions was also important.
"Our recent reviews of banks and life insurers, and the number of recent breaches in key regulatory requirements, reinforces the need for financial institutions to improve their behaviour."
"We are engaging with industry to ensure that they strengthen their own assurance processes and controls."
Bascand said it had also reviewed its own supervisory strategy and would be taking a more intensive approach, which will involve greater scrutiny of institutions' compliance.
"Some life insurers have low solvency buffers over minimum requirements. Recent falls in long-term interest rates are putting further pressure on solvency ratios for some of these insurers."
Bascand said affected insurers were preparing plans to increase solvency ratios and were subject to enhanced supervisory engagement.
"This highlights the need for insurers to maintain strong buffers, and insurer solvency requirements will be reviewed alongside an upcoming review of the Insurance (Prudential Supervision) Act."