The Reserve Bank has given the New Zealand finance system a pass mark while warning some risks remain.
On the eve of Budget 2014, the Reserve Bank's Financial Stability Report says the country's financial system remains sound and well placed to support expansion in the economy.
Governor Graeme Wheeler said the banking system was well capitalised, funding and liquidity buffers were comfortably above required minimums and non-performing loans continued to decline.
However, several risks to the financial system required continual focus.
Debt in the household sector remained high relative to incomes and house prices were overvalued on several measures.
''As a result, financial stability could deteriorate if there is a sharp correction in house prices, particularly if accompanied by a reduction in debt repayment capacity.''
The central bank introduced a restriction on high loan-to-value (LVR) lending in October to help reduce the risk, he said.
Debt was also elevated in the dairy sector, although incomes were strong due to high export prices.
A reduction in farm incomes and an associated fall in land prices could place pressure on some highly leveraged borrowers.
One risk to farm incomes was a disruption to China's economic growth, which could result from vulnerabilities in the financial system.
A disruption to the Chinese economy could also affect international capital markets and impair funding conditions for New Zealand banks, Mr Wheeler said.
ASB chief economist Nick Tuffley said the list of risks sounded familiar but he believed the FSR had no implications for the Reserve Bank's official cash rate.
On several of the risks, the Reserve Bank had already taken action.
The treatment of high-LVR loans had been tightened up and capital requirements for agriculture lending were lifted several years ago.
''We expect a degree of adjustment in the overvaluation of house prices will take place, though the adjustment won't start in Auckland and Canterbury until higher interest rates and stronger construction rein in price growth further.
''We expect the reduction in overvaluation will be gradual, driven by steady rises in incomes that outpace fairly static house-price growth.''
Household credit growth appeared to have peaked and the ratio of household debt to income should resume a gentle decline, Mr Tuffley said.
The ratio, although well below the pre-global financial crisis peak, would remain relatively high.
The ratio of agriculture debt to dairy and meat exports had fallen considerably from its peak, assisted by higher dairy prices enjoyed over the past years.
Reduced prices would constrain further reduction but dairy production had been exceptional in recent years, he said.
''We expect a further lift in dairy output of around 4% next season, even after an estimated 11% growth for this season. Meat prices are also relatively firm, also assisting returns for this sector.''
Anecdotally, dairy farmers were using some of their strong earnings to either reduce debt or build up cash reserves.
Current agricultural credit growth was running at a ''very subdued'' annual pace of 2.3%.
Farmer behaviour at present was best described as prudent, Mr Tuffley said.
Bankers Association chief executive Kirk Hope said recently reported bank profits were a sign of both the industry's strength and the buoyant economy, especially compared with other parts of the world.
''That's good for us at home and our reputation overseas. Maintaining a successful banking sector is important because it supports economic growth by helping fund the needs of businesses and households and providing a safe place for us to save and invest.''
Bank lending was not driving house prices, Mr Hope said. It was the lack of housing supply in some parts of the country that was the problem.
The Government's steps to address supply issues would help.
The association also welcomed the Reserve Bank's move to review its bank and non-bank regulations to help improve efficiency, consistency and clarity, he said.
The risks.
• High household debt
• Overvalued house prices
• High farm debt levels
• Vulnerability of agricultural earnings to a fall in commodity prices and a slowdown in Chinese growth
