Releasing his financial stability report yesterday, Dr Bollard said while economic forecasts tended to be more positive than negative, risks to the economy remained from an inflated exchange rate, poor quality bank loans and an over-reliance on offshore credit and property investment.
The report said Australian and New Zealand banks had withstood the recession better than most, but their asset quality had deteriorated during the recession, reflected in the provision for bad debts in profit results.
The bank's deputy governor, Grant Spencer, said trading banks remained cautious with their credit and funding decisions, which could be at a cost to business.
"While generally supporting this approach, we have continued to emphasise that the banks should not overly restrict lending to the business sector."
Dr Bollard said New Zealanders needed to live more within their means to reduce vulnerability to adverse events offshore.
"While we see some progress to recover savings and reduce our current account deficit, there is still a considerable adjustment needed to reduce our vulnerability to external shocks.
"To assist this, we need to ensure there is no return to a debt-fuelled housing cycle which would likely bring with it further exchange rate pressure and erosion of competitiveness."
Dr Bollard said financial market pressure had eased, equity markets were recovering and confidence had returned, leading to economic forecasts being revised upwards.
But much of that was driven by fiscal and monetary stimulus which could not continue indefinitely.
He was concerned the rising exchange rate could hinder a recovery.
Mr Spencer said further rationalisation and closures were expected within the non-banking financial sector, even with the Government extending by a year the deposit guarantee scheme.
Businesses had to adhere to the Reserve Bank's new prudential regime, which he said could result in some companies failing.
The Minister of Finance, Bill English, said the Reserve Bank's report showed the world was recovering from the credit crisis and that New Zealand's financial sector was fundamentally sound.
"It is heartening banks are showing a renewed willingness to lend to one another, but the data shows the credit-fuelled boom of recent years is well and truly over, with lending growth continuing to slow.
"That means future economic growth will be more dependent on savings and investment."
Mr English said the report also showed banks' net interest margins had stabilised at low levels when compared with margins over the past 10 years.
