SYDNEY (Reuters) - Australia’s top central banker on Tuesday rapped the country’s scandal ridden banks for their errant behavior, saying strong penalties were required to punish misdeeds, but cautioned over regulation risks crimping much-needed credit to the economy.

FILE PHOTO: A man smokes next to the Reserve Bank of Australia headquarters in central Sydney, Australia February 6, 2018. REUTERS/Daniel Munoz

In a dinner speech in Melbourne, Reserve Bank of Australia (RBA) Governor Philip Lowe said banks should consider correcting their internal incentive system that focuses on sales and short-term objectives.

Lowe's speech comes as Commonwealth Bank CBA.AX CEO Matt Comyn testifies under oath for a second day at a powerful government-mandated inquiry that has exposed widespread financial sector misconduct since the start of this year.

“The vast bulk of the people who work for Australia’s financial institutions do want to do the right thing, and they do want to serve their customers as best they can,” Lowe said in the speech titled “trust and prosperity”.

“But, like everybody else, they respond to the incentives they face.”

Australian banks have been accused of predatory lending and poor financial advice as they amassed huge profits at the cost of customers’ interest.

In response to the allegations, they have slowed mortgage lending, their biggest source of revenue.

Lowe said banks need to take risks and manage them well.

“If they become afraid to lend simply because of the consequences of making a loan that goes bad, our economy will suffer. So a balance needs to be struck here,” he said.

“Strong penalties can play an important role in incentivising good behavior, and this is an area we should be looking at. But we do need to get the balance right as there can be unintended consequences.”

The banks have tightened lending standards in the face of pressure from regulators. That has exacerbated weakness in Australia’s once-hot housing market.

HOUSING DOWNTURN

Lowe sounded comfortable about the softening in the property sector though that comes after “very large run-ups” in Sydney and Melbourne, the two biggest markets.

He also noted the downturn in home prices comes against the backdrop of a strong world economy, robust domestic activity, falling unemployment, record low interest rates and rapid population growth.

“This is a reasonably favorable backdrop against which to be having an adjustment in the housing market.”

“But we do need to watch things closely,” he said.

Lowe also touched upon stagnant real wage growth since 2012 that has hurt living standards even as Australia’s A$1.8 trillion economy has outperformed its global peers by extending its recession-free run for 27 straight years.

Weak wage growth has been the single biggest factor restraining the RBA from raising borrowing costs. It has left its policy rate at a record low 1.50 percent since last easing in August 2016.

Lowe expects a pick-up in household incomes as the labor market continues to tighten, though the gains are expected to be gradual.

The RBA has become more optimistic about the economy but minutes of its Nov.6 policy meeting released earlier in the day revealed policymakers were in no hurry to jack up rates just yet.

In his speech, Lowe repeated that there was no strong case for a near-term change in rates as it awaits a pick up in inflation, although the next move will likely be up, than down.