Orr said it was also seeing the impact of low global interest rates resulting in increased risk-taking and higher asset prices - a situation which was driving house prices higher in New Zealand.
Reserve Bank deputy governor Geoff Bascand said a high proportion of new lending had been done at high debt to income and loan to value ratios which made recent borrowers more vulnerable to a rise in mortgage rates and exposes households and the financial system to a fall in house prices.
"We will be watching how market conditions respond to the Government's recent policy changes. If required, we are prepared to further tighten lending conditions for housing using LVR requirements or additional tools that we are assessing," he said.
The Reserve Bank is assessing four policy options for addressing the issue of sustainable house prices; further LVR tightening, restrictions based on debt to income, restrictions on interest only lending and changes to sectoral capital requirements.
The report noted that if further tightening in policy settings was needed in the short term the easiest approach would be to tighten LVR restrictions further.
"However the marginal benefits are likely to decline as LVR restrictions tighten further while efficiency costs would rise."
Debt-to-income tool favoured
The Reserve Bank said it viewed the best option as a debt serviceability tool. This could come in the form of debt to income lending restrictions which would limit how much someone can borrow based on their income.
"Restrictions on interest-only lending would likely have less impact on overall lending conditions than alternative, while being challenging to implement."
The Reserve Bank already collects data on DTIs but said further work would be needed to finalise the design of the tool and update bank systems.
It estimates it would need a six month lead in to implement the tool.
The report noted that restrictions on interest only lending were unlikely to have a significant impact on credit availability as evidence suggested banks normally carry out credit assessments based on a principal and interest basis but it could deter credit demand from some higher risk borrowers.
It also warned that complex rules may be necessary to limit opportunities for avoidance.
"Our analysis of these options is still being completed. Additionally, the appropriate policy response depends on economic and financial conditions and may change with circumstances.
"Implementing new tools such as restrictions on debt serviceability or interest-only lending is complex and would take time to work through."
Bascand said government support and strong capital and liquidity buffers have meant the pandemic had a limited impact on the soundness of the financial system but further resilience was need.
Solid profitability and dividend restrictions had allowed banks to build their capital levels providing a buffer to absorb future loss and overall banks were in a strong position.
New capital rules will come in from October 1 this year with minimum requirements starting in July next year.
