KEY POINTS:
The fiercely competitive home loan market leaves banks increasingly vulnerable to loan defaults if there is a major economic downturn, the Reserve Bank warns.
New Zealand's financial system was found to be "sound and stable" in the RBNZ's six monthly Financial Stability Report released yesterday.
But in "looking through the markets, the institutions and the payment and settlements parts of the systems," the central bank had identified concerns, Governor Alan Bollard said.
Bollard has previously warned households of the risks in concentrating their wealth in housing, but yesterday highlighted the problems banks may face should that market soften.
While banks were well capitalised, he noted they were competing "quite aggressively", particularly on mortgage lending.
"To the extent that this competition leads to credit quality slipping, overall financial system risks will rise."
As households were already "quite heavily saddled" with debt, any increased strain in servicing mortgage payments had the potential to hit bank balance sheets.
Home mortgage lending was now at a historic high of $122 billion as at the end of June despite a slowing economy and high household debt.
"This cocktail exposes banks to potential losses stemming from lower growth and higher risk new lending in this area."
Deputy Governor Adrian Orr said banks' high concentration of lending in the housing market, now about 44 per cent of their total assets, left them vulnerable to the "low probability" but "high impact" eventuality of "dramatic shifts in house prices and/or unemployment simultaneously".
"We're working closely with the banks to ensure that they're adequately capitalised for those sorts of events to be able to buffer through it."
While the level of non-performing loans was at historic lows, "the issue we always have to think about is if things turn bad they can go quite quickly and you can have quite significant turnarounds from these levels," said Orr.
The report again outlined the risk that house prices may yet decline as the increases over the past five years had run ahead of household incomes and population growth.
Should households be unable to meet debt repayments they may be forced to sell houses in a weak market and take a loss. Banks were likely to sustain a financial loss if the amount outstanding on a loan exceeded the price they could get for the house.
Bollard and Orr said the bank was encouraged that corrections to global economic imbalances were starting to happen with signs of lower US domestic spending linked to the slowing housing market there.
The bank saw the domestic economy rebalancing through declines in household spending and an improvement in the current account balance.
"However, we do note that New Zealanders do continue to be heavy users of foreign savings, particularly to finance housing, and therefore as a country we continue to be vulnerable to international perceptions of our creditworthiness," Bollard said.
"We will watch that those perceptions don't worsen because if they did they could have a significant impact on our long term interest rates, forcing a tougher sort of rebalancing scenario.
"These effects could lead to an abrupt slowdown in economic growth, with the end borrowers - predominantly domestic residential mortgage borrowers - likely to be most affected."
Meanwhile, the report also found that companies' debt levels had increased over the past year.
That was partly explained by merger and acquisition activity driven by firms' quest for earnings growth in more challenging conditions.
"Anecdotal evidence suggests that recent acquisitions by private equity financiers could also be increasing corporate sector leverage,"
The sector's balance sheets were strong enough to weather a period of slower earnings growth.
