S&P Global warned the risk of a sharp fall in New Zealand property prices is high and were that to occur, the risks to the banks would be heightened by a debt-ridden economy.
This warning comes just as the Reserve Bank of New Zealand has flagged another round of macroprudential tightening to further curb house price growth - the introduction of a debt-to-income limit.
"If this measure is added to the toolkit and the RBNZ decided to use them in the future, debt-to-income limits would limit the share of home loan borrowers able to obtain large loans relative to their income," said the ratings agency.
For a debt-to-income limit to be introduced, the Governor of the RBNZ and the Minister of Finance both need to sign-off on the deai and the banks would also need to upgrade their systems so they can report on ratios.
In a report, S&P has concluded that the country's banking sector's funding profile remains a weakness despite a modest strengthening of banks' customer deposits and a slight reduction in banks' dependence on external borrowing.
Debt levels risky
External debt still funds about 27 per cent of domestic customer loans and support from core customer deposits remains limited, at about half of domestic customer loans, according to the ratings firm.
The problem is that even though the repricing of home loans will likely cut some demand from the white-hot housing market, the challenge of being saddled with too much debt is risky for the country.
Aside from the persistent current account deficits which S&P expects to stay at around 3 per cent to 4.5 per cent of GDP for the next few years, New Zealand has a high level of external debt compared to other banking systems.
External debt is currently running at an ominous 46 per cent of GDP.
“This heightens the risk of a sudden shift in foreign investors' willingness to fund New Zealand's external borrowing.
"If this occurred, the cost of external borrowings would rise, domestic credit conditions would tighten, the currency may depreciate sharply, and economic growth would slow markedly.
Plunge in house prices
"These would ultimately result in lower income levels and a potential plunge in house prices."
Importantly, S&P considers the key drivers in the slowdown in house prices and credit growth to be tighter macro-prudential tools introduced by the central bank as well as higher lending rates due to an increase in funding costs.
Currently, temporary restrictions on high loan-to-value residential mortgage lending is the only tool in use by the RBNZ and has been in place since October 2013.
A third round of temporary LVR restrictions were introduced in October 2016 and included limits on bank lending to investors with LVRs of greater than 60 per cent to no more than 5 per cent of investor lending.
“In our view, this limit has been effective in stemming some house price and loan growth recently,” said S&P after noting that the timing of the new proposed new ratio might coincide with a house price drop.
Capital requirements examined
The central bank is also conducting a review of the minimum capital requirements that apply to locally incorporate registered banks, focusing on the type on financial instruments that should qualify as bank capital.
“We are of the view that the review is likely to result in capital requirements increasing and the definition around additional tier one instruments further tightening, which will pose an additional headwind to credit growth.”
The ratings agency thinks that the major banks will have limited scope to improve capital efficiency such as changing their exposure at default mix or capital modelling changes.