As at June, total dairy debt reached $37.9billion, or 10% of total bank lending.
While the Reserve Bank concluded losses for the banking system "as a whole would be manageable'', it painted a bleak and challenging picture for dairy farmers.
The Reserve Bank continues to have the five major banks "stress-testing'' their respective dairy portfolios.
In its December bulletin, the Reserve Bank yesterday updated its assessment of "dairy sector vulnerabilities'', using financial data collated by DairyNZ.
Because of the lower sustained milk prices, the bank said farmers faced "significant cash-flow pressures'', following a record 2013-14 season.
Subsequently, Fonterra's payout had fallen considerably and farmers were now expected to face consecutive payouts below $5 per kilogram of milk solids.
"The impact of the low payouts is amplified by an increase in average break-even payouts since the 2006-07, reflecting increases in debt levels and a shift to more cost-intensive operating structures''.
The latest Federated Farmers banking survey was released, separately, yesterday and showed unchanged levels of farmer support for banks during the past three months of low dairy prices: 80.5% were satisfied with banks regarding mortgages compared with 80.7% in August.
Federated Farmers national president Dr William Rolleston said it had been a difficult few months for farmers, particularly in the dairy industry, so it was "extremely pleasing to see the banks are standing by them.''
"We're staring down the barrel of an El Nino summer and it seems there are more difficult months ahead for the dairy industry, so we need these high levels of support to continue,'' he said in a statement yesterday.
The survey also found a slight drop in satisfaction with the communication from banks over their mortgages, from 81% to 78.8%, while the percentage of farmers feeling they had come under undue pressure from their bank increased from 5.5% to 6.4%.
Despite the cash-flow pressures, the Reserve Bank said dairy farmland values had been supported by low-interest lending rates and a "largely positive'' long-term outlook for the annual payout.
However, there was a risk land values could fall if cash-flow pressures persisted, especially if confidence in the longer-term milk price outlook deteriorated.
Downward price movements could be amplified by reduced liquidity in the farm market, if demand to purchase farms fell alongside the increased risk of rising, stressed sales.
"The extent of financial system losses in this scenario hinges critically on how debt is distributed within the dairy sector,'' the bank said.
While the Reserve Bank said the proportion of loan defaults was "highly uncertain'', it gave an estimate if all the non-performing loans were to default.
"Loss rates for the banking system are estimated to be 2% of the system's dairy portfolio under the base scenario, and 14% under the severe scenario.''
The Reserve Bank had requested the five largest dairy lenders to undertake stress tests of their dairy portfolios.
The Reserve Bank was in discussions with the five banks, to ensure they were setting aside realistic provisions to reflect the expected rise in problem dairy loans.
The Reserve Bank estimated that for the 2014-15 season, 49% of dairy farmers were in negative cash flow, while for 2015-16 about 80%; representing 90% of the dairy debt, were expected to be below break-even.
"With a large portion of the sector making losses in 2014-15 and 2015-16 seasons, demand for working capital has increased markedly,'' the Reserve Bank said.
The banks had supported the sector by expanding lending by more than 10% during the year, on the basis most farms would be profitable in the medium term.
"Despite some farms with high debts facing considerable difficulties, most farms are expected to remain viable over the medium term,'' the Reserve Bank said.
