Reserve Bank Governor Graeme Wheeler said, when releasing the bank’s Financial Stability Report this morning, that the New Zealand’s financial system remains sound, and the biggest risk is the housing market.

“Banks are well capitalised and have strengthened their funding base, while non-performing loans continue to decline."

“The main threat to the financial system is the risk associated with imbalances in the housing market  The previously announced loan-to-value ratio (LVR) measures, starting from October 1, are intended to reduce systemic risk by slowing housing credit and house price inflation, and by reducing risk on bank balance sheets.

“The household sector has high and rising levels of debt relative to both historical and international norms. Both households and banks are highly exposed to the housing market. Further, we have a situation where house prices are rising from already-overvalued levels, particularly in Auckland and Christchurch. This is increasing the risk of a future house price correction that could result in significant financial system stress.

Wheeler said that several factors are contributing to the strength in house prices, including supply side constraints, a pick-up in net inward migration, relatively low interest rates, and relaxed credit conditions. “Dealing with the supply side issues is of primary importance. However, it is also important to avoid a prolonged build-up of excess demand while the supply issues are being addressed.”

Wheeler dismissed concerns raised from the new-build sector that the bank's policy had resulted in buyers decide not to build new houses.

He said new builds made up only two to three percent of lending volumes each month and housing start numbers were 50% higher than in housing market trough two years ago.

However, he did say the bank would "monitor the situation."

Wheeler said that the bank is closely watching the impact of the LVR policy. “The early evidence shows that banks have significantly reduced high LVR lending approvals, while increasing the cost of high LVR loans.  However, it is too early to assess the impact of the measures on house price inflation.”

Deputy Governor Grant Spencer said that other risks to financial stability were high levels of debt  in the dairy sector, and New Zealand’s high level of external indebtedness overall.