Easing lending criteria and higher loan-to-value ratios could potentially see the country return to a debt-fuelled housing cycle and dampen the recovery seen thus far, warns Reserve Bank Governor Alan Bollard.
While banks tightened their lending standards for residential borrowers during the financial crisis, there have been signs of an easing in recent months, with some banks prepared to offer housing loans at relatively high loan-to-value ratios, the Reserve Bank's six-monthly stability report says.
The bank is worried the increased risk to both banks and borrowers with higher LVRs will dampen the growth seen in both the housing market and economy as a whole.
House prices are historically still extremely high, pushed up over recent months as a result of a shortage of listings and increased demand.
"The housing market is currently strengthening, but we believe house price growth will slow after the current recovery phase," the bank said. "Continued weakness in the labour market, along with falling agricultural incomes, could also weigh on the housing market.
"We would encourage the banks to avoid any return to riskier mortgage lending practices."
Also contributing to the warnings are rising mortgage rates. Currently, historically low floating rates are extremely attractive, but are set to rise in the near future as the economy recovers further and there are concerns some borrowers will be caught out by the increase in repayments.
"Overall, the housing market recovery is likely to be limited, and subject to downside risks as interest rates start to rise from very low levels," the report said.
The report also reinforces how vulnerable the New Zealand economy, banks and households are to stress emanating from global financial markets.
"The New Zealand economy needs to live more within its means to reduce its vulnerability to adverse developments in offshore markets," Bollard says.
"The lesson here is that a more cautious approach to credit expansion is warranted during the next economic upswing."
However, there is an extremely fine balancing act for the banks to walk, as continuing economic growth depends on their willingness to lend to new borrowers, both for private loans and businesses.