New Zealand's banking system is robust enough to handle the current dairy sector downturn, the Reserve Bank said.
However, even the Bank's best case scenario sees farm prices fall by 20 per cent, while the worst case scenario would see a fall in land prices of 40 per cent.
Low global milk prices are generating "significant financial pressure" for dairy farmers, with around half of the dairy sector currently experiencing a second consecutive season of operating losses, the bank said its latest Reserve Bank Bulletin.
Fonterra last week cut its farmgate milk price forecast for this season to $3.90 a kg of milksolids from a previous forecast of $4.15, compared with an average breakeven point for most of $5.25.
In recognising the weak environment, the Reserve Bank last year asked the five largest dairy dairy sector lenders participate in a "stress test".
The Reserve Bank tested two scenarios, with the first one assuming that the dairy payout recovered to $5.25 per kilogram of milksolids by the 2017/18 season and a fall in dairy land prices of 20 per cent.
Under the second scenario, the dairy payout was assumed to fall to $3 in 2015/16 and remain below $5 until the 2019/20 season with a fall in land prices of 40 per cent.
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The head of macro financial at the Reserve Bank, Bernard Hodgetts, said both scenarios assumed the dairy payout remained lower for longer than was assumed in the economic projections contained in the Reserve Bank's March monetary policy statement.
On average, banks reported losses under the two scenarios ranging between 3 to 8 per cent of their total dairy sector exposures.
"On average, banks reported losses under the two scenarios ranging between 3 to 8 per cent of their total dairy sector exposures," Hodgetts said in a statement.
Bank lending to the dairy sector stands at around $38 billion, which is about 10 per cent of the banking system's total lending.
"We would expect losses of the order seen in the stress scenarios to be absorbed largely through lower bank earnings rather than through an erosion of bank capital," Hodgetts said.
The test results suggested that in the shorter term, banks would increase their dairy lending in order to support existing borrowers facing negative cash flow, before facing a longer term rise in loan losses if there were a prolonged dairy sector downturn.
Hodgetts said stress testing was an important part of the bank's prudential supervision as it helped the bank to identify and assess financial system risks and helped the commercial banks to assess their risks.
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