* New Zealand financial system sound - RBNZ
* Flags high household and dairy sector indebtedness as key risks
* Main international risk is rapid increase in global rates
* Holds off on easing mortgage lending restrictions further (Updates with comments to parliamentary committee)
By Charlotte Greenfield and John Mair
WELLINGTON, May 30 (Reuters) - New Zealand's central bank said the country's financial system is better prepared to weather any unforeseen global shocks that could push up borrowing costs, but emphasised that more needed to be done to reduce high household and dairy sector debts.
Reserve Bank of New Zealand Governor Adrian Orr said that while financial risks had lessened as both lending and house price growth slowed, there would be no further easing of mortgage lending restrictions for now.
The report named three key vulnerabilities to the financial sector - household sector indebtedness, dairy sector indebtedness, and exposure to international risks.
"Ultimately, continued stabilisation, or a further reduction, in the growth rates of household debt and house prices, will be required before the risk to the financial system is normalised," the bank said in its semi-annual Financial Stability Report.
Appearing before a parliamentary committee, Bernard Hodgetts, the head of the RBNZ's macro-financial department, said the central bank had done stress testing that showed banks would remain solvent even when house price fell "upwards of 40 percent".
Hodgetts said "it's certainly not a pretty picture," adding it would put the broader economy under pressure.
"That is a risky situation, but we do believe the banking system could withstand a reasonably significant decline in house prices."
House prices have risen more than 50 percent nationally over the past 10 years, and almost doubled in Auckland, New Zealand's largest city, while household debt levels have soared.
GLOBAL RISKS
The central bank was monitoring the risks of higher international interest rates and risk premiums, which could increase funding costs for banks and ramp up borrowing costs, putting pressure both on banks and their customers.
Orr referred to Tuesday's jump in Italian bond yields as an example of sudden changes in market conditions.
"You've seen as recently as last week no one could ask us a question about the Italian bonds market, that's how quickly these things can arise," he told reporters.
"We are in a solid place. Does that mean that these events won't happen? No."
He said New Zealand banks had increased the share of domestic deposits and longer-term borrowing in their funding, thereby reducing their reliance on short-term offshore borrowing.
The New Zealand dollar NZD=D4 was largely steady in local trade on Wednesday, stuck in a narrow range near $0.69 after having fallen more than 0.5 percent overnight on depressed global risk sentiment.
MORTGAGE RULES REMAIN
At the previous review in November, the RBNZ said it would partially unwind loan-to-value ratios (LVR) restrictions to offset the impact of planned government curbs on the housing market. central bank noted that lending and house price growth had slowed in the past year, but said it needed further evidence of a cooling before loosening rules further.
Orr told reporters any changes are unlikely until "at least" the next review in six months time.
Some economists had thought that the central bank might ease the restrictions further.
"They could have easily tweaked them again but ... they're taking a very cautious approach there, they're still worried about the potential for the market to take off again," said Philip Borkin, senior economist at ANZ Bank.
Prices have recently cooled, slowed by an uncertain election period in 2017, the LVR restrictions and wider taxes on investment properties announced by the government.