The threat to the banking system from a collapse in house prices has receded, according to the Central Bank. In its annual Financial Stability Report, published yesterday, the bank concludes that the banking system is well-placed to deal with financial shocks, in the short term.

Speaking at the launch of the report the Central Bank governor, John Hurley, said: "The Irish banking system is currently in a good state of health. Our central expectation is that this leaves it reasonably well-placed to withstand pressures. Despite this benign conclusion, we still have to consider a variety of risks."

The report repeated warnings that the rising level of personal indebtedness could threaten the economy and the banking system in the longer term, and it warns that if house price growth were to reaccelerate, the risk of a future "correction" would increase.

"The household sector is becoming increasingly indebted, with the ratio of personal-sector credit to disposable income estimated to increase from approximately 112 per cent of disposable income by end-2004 to 133 by end-2005," driven by strong demand for housing, the report says.

Mr Hurley added: "The main vulnerability here is the high and growing level of indebtedness. This poses dangers because, notwithstanding current robust economic growth in Ireland, there are domestic and external risks to the economic outlook. This increased debt burden will still have to be serviced should these risks be realised."

The report says that present debt levels are justified by fundamentals, but warns that the economy is increasingly exposed to the possibility for future interest rate rises. "Average retail mortgage interest rates in the medium term could be significantly higher than the current rate. Borrowers and lenders need to carefully consider these kinds of issues in their decisions," the report says.

It argues that increased borrowing is partly justified by growth in the value of Irish banks' assets, which are growing at 24.6 per cent, over twice the level in the euro area as a whole.

The report's findings follow the publication last week of a report by Goodbody stockbrokers, predicting that the level of personal debt will rise to 160 per cent of personal disposable income by 2006.

The bank said that it would work with domestic banks to continue regular "stress-testing" exercises to measure their ability to cope with shocks, such as interest rate increases or slower economic growth.

High energy prices and so- called global imbalances are identified as the main external risks to the economy, while an overdependence on the construction sector and falling competitiveness are the domestic risks, the report says.

"The threat to financial stability in Ireland comes from the interaction of such shocks with existing vulnerabilities, which could then lead to systemic weakness," said Mr Hurley.

The governor welcomed the recent slowdown in the growth of house prices, which increases the probability of a soft landing in the property market. He pointed out that there was tentative evidence that this moderation may not have persisted to the extent that was anticipated some months ago.

If house prices were to reaccelerate, this would again increase the risk of a sharp correction in house prices in the future, he said.