It all adds up to increasing pressure on the major banks.
The current scenario continues to fall within models the Reserve Bank ran last year which showed the banks should be strong enough to withstand this downturn.
The banks have so far taken a positive view of the milk price outlook.
But the Reserve Bank notes some analysts are starting to forecast that payouts in the 2016-2017 season will remain below break-even.
"If the banks begin to take a more pessimistic view of the sector they may force a larger number of troubled farms to be sold, which could create a negative feedback loop," the Financial Stability Report says.
This would put further downward pressure on farm values, particularly as sales volumes are low.
"There haven't been a lot of transactions but if, for example, you did get into an extreme situation with a lot of foreclosures, there is the potential for that price to fall significantly in a distressed situation," Reserve Bank governor Graeme Wheeler said.
Deputy Governor Grant Spencer said the dairy outlook was still in line with the more optimistic out of two scenarios modelled late last year.
That scenario assumed dairy payouts would recover to $5.25 per kilogram of milksolids by 2017/18 and an eventual fall in dairy land prices of 20 per cent.
But Spencer said there were "significant potential losses" for farmers in this scenario.
If milk prices stay low longer and farmers do not break even in the 2017/18 season, banks would then face the worst-case scenario in the Reserve Bank's modelling.
That would see about 25 per cent of dairy loans resolved through some forced sale processes and could cause farm prices to fall by up to 40 per cent. The major banks should "be prepared to increase their provisioning against loans in the dairy sector to ensure that they are able to absorb potential losses," the Bank warns.
Local banks remain strong relative to comparable banking systems. After-tax profits were up 1.4 per cent in the year to March.
