"Most dairy farms have been profitable for the past three seasons as dairy prices and production have been good," the report says.
"But some farms struggle to make profits at current prices, particularly those with large debts."
Around 35 per cent of dairy farm debt is to farms that have more than $35 of debt per kilogram of milk solids produced annually, it says.
On average, it says those farms require a $6.20/kgMS just to break even while Fonterra is forecasting a milk price of $6.30-6.40/kgMS for the season ending this month.
Fonterra is forecasting a price of $6.25-7.25/kgMS for the season starting next month.
"Vulnerable farms must reduce their debt to improve their resilience to further downturns," the report says.
"However, options for addressing problems at financially stressed farms appear constrained at the moment as demand for dairy farm land is low."
The report notes that lending to horticulture grew 19 per cent in the year ended March while lending growth to dairy farms was less than 1 per cent.
"Diversification reduces risks to banks by lowering their exposure to downturns in individual sectors. But rapid lending growth to a sector could be a sign of overly fast expansion and should be monitored by banks," it says.
Farm lending accounts for about 14 per cent of total bank lending while loans to households account for about 60 per cent of bank lending and most of that is mortgages.
The report notes that tighter lending standards, helped by its loan-to-valuation restrictions, have meant a decline in riskier mortgage lending.
"The proportion of new mortgage lending to households with DTI (debt-to-income) ratios above five is large but has declined in the past two years. Fewer new mortgages are now provided on interest-only terms and the share of mortgages going to investors has been fairly flat for the past two years," the report says.
It notes house prices grew about 2 per cent in the year ended April and says RBNZ expects house price growth to remain subdued.
But the vulnerability of households remains elevated and "must continue to be closely monitored and managed."
Orr said similar challenges existed globally given high public and private debt levels and stretched asset prices in many of New Zealand's trading partners.
"The capacity for some foreign governments and central banks to respond to unanticipated negative events is also limited by their current high government debt and low nominal interest rates.
"It is imperative to improve New Zealand's financial system resilience while conditions are conducive."
Orr said increasing financial institutions' capital position was central to ensuring they could withstand shocks.
The Reserve Bank has proposed increasing capital levels for the banks and is in the process of reviewing submissions on the proposals.
Orr said there was also a need for some insurers and non-bank deposit takers to improve their capital buffers and the bank would be reviewing insurer solvency standards in the months ahead.
"Financial resilience also includes service providers taking a long-term customer outcome focus, to both maintain confidence and promote sound resource allocation.
"We will ensure banks and insurers respond to the issues identified in our recent review of their conduct and culture."
Orr said a longer-term focus was needed for financial firms to adapt to the changing competitive, regulatory, and natural environment.
He said insurers were already changing how they manage their exposure to natural disaster events which is changing affordability.
"Risks associated with climate change are also impacting on the accessibility of insurance, with potential flow-on effects on bank lending.
"These risks must be appropriately identified and priced, so as to best ensure a stable transition over coming years."
The central bank also confirmed there would be no change to the loan to value ratios which control how much banks can lend to low deposit borrowers.
Orr said the LVR settings were appropriate for now.
Any further easing would be subject to continued subdued growth in credit and house prices and banks maintaining prudent lending standards.
-additional reporting BusinessDesk.
