Around 11 per cent of dairy debt is owed by such farms, while farms with relatively high loan to value ratios account for 27 per cent of sectoral debt.
"It is likely that the number of foreclosures among these indebted farms will eventually increase if weak cash flow persists for multiple seasons," the report said.
"Bank losses associated with these foreclosures would be exacerbated if land values fall alongside weaker farm incomes."
Fonterra will late this month release its milk price forecast for 2015/16 and indications are that it will be towards $5 a kg of milk solids, compared to last season's record price of $8.40 a kg. The current season's forecast is for a milk price of $4.50 a kg.
A high degree of uncertainty surrounds the global dairy trade because of world oversupply, Russia's dairy import ban, increased production from the European Union, and slack demand from China.
Despite many farms being in a position to manage down working expenses, around a quarter have negative cash flow for the 2014-15 season, the Reserve Bank said.
The sector's vulnerability to reduced incomes is increased by elevated indebtedness, despite moderate growth in borrowing since 2009, it said, adding financial stress in the dairy sector could rise markedly if low global milk prices persist beyond the current season.
Cash flow in the 2014-15 season will be boosted by around $1.50 per kg due to deferred payments from the strong 2013-14 season, but deferred payments from the current season will be lower at about 25c.
The Reserve Bank said financial stress would be exacerbated if low milk prices led to falling land prices.
The ensuing reduction in equity buffers could prevent indebted farmers from drawing on credit lines and result in a rise in loan defaults in the sector.
As at March 2015, rural land prices were flat on an annual basis, suggesting that low interest rates and a reasonable longer-term outlook were supporting demand.
Some recovery in global milk prices is expected in the 2015-16 season, although there is considerable uncertainty over the timing and extent of the recovery, the bank said.
"Recovery in Chinese milk demand, following its large build-up of inventories in 2013, will be critical to supporting demand," it said. "Assessing the balance of these global forces is difficult, but there is a significant risk that milk prices remain low for an extended period."
Reserve Bank Governor Graeme Wheeler told a parliamentary hearing after the report's release that another year of low prices would be a worry for the economy.
Prices for whole milk powder dropped an average of 1.8 per cent to US$2386 a tonne in last week's GlobalDairyTrade auction, extending its decline over the past five auctions to 27 per cent.
Wheeler told Parliament's finance and expenditure select committee that the bank estimates prices will return to an equilibrium price over the medium term of between US$3200 and US$3800 per tonne, although market pricing only suggests it will rise to about US$2700 per tonne by the end of the year.
Wheeler said: "If you saw the dairy price just remain at low levels for a considerable period - one, that negative cash flow problem intensifies, two, you'd probably start to see dairy farm prices fall which would compound the situation."
Dollar back up after early fall
The New Zealand dollar fell in a knee-jerk reaction to the Reserve Bank's financial stability report, then made up for lost ground.
News from the central bank that it planned to tighten loan-to-value ratios on Auckland property market lending initially drove the currency about 30 basis points down to US73.20c, before it rebounded to US74.13. Late on the local trading day, the currency was at US73.90c.
The shift lower in the minutes after the statement was on the perception that tighter macro-economic policy would allow more leeway for the Reserve Bank to cut interest rates.
Then, some in the market chose to play up the lack of the word "unjustified" in reference to the currency's relative strength - a word usually restricted to the bank's comments on monetary policy - to bid the currency back up. Most in the market didn't see it that way.
"In fact, given that we feel today's announcements should continue to see the market more comfortable about the prospects for Reserve Bank policy easing, we remain of the opinion that the NZ dollar will decline from here," ANZ Bank said.
Bank of New Zealand currency strategist Raiko Shareef said there was no "smoking gun" to be taken from the statement in terms of the prospect of near-term interest rate cuts.
"I think that is the theme the market has been trying to play for the past week."
The Reserve Bank's official cash rate sits at 3.5 per cent.
