The woes of the dairy sector are well-known, with declining global milk prices creating significant financial pressure on dairy farmers.

About one half of the dairy sector is currently experiencing a second consecutive season of operating losses.

Last week Fonterra last week cut its farmgate milk price forecast for this season to $3.90 a kg of milk solids.

This was down from its previous forecast of $4.15, and is in comparison to the average breakeven point for most of $5.25.

As a result, concerns about the economic impact of the dairy sector’s downturn are widespread and growing.

But severe stress tests of the five largest dairy sector lenders showed New Zealand’s banking system is robust enough to handle this, the Reserve Bank announced today.

The tests assessed how the banks are prepared to deal with the situation if conditions do not improve.

Two scenarios were tested.

In the first scenario, the dairy payout recovers to $5.25 per kilogram of milk solids by the 2017/18 season. This scenario sees a 20% fall in dairy land prices.

In the second scenario, the dairy payout falls to $3 in 2015/16 and remains below $5 until the 2019/20 season. This scenario sees a 40% fall in dairy land prices.

Both scenarios assume the dairy payout remains lower for longer than was assumed in the economic projections in the Reserve Bank’s March Monetary Policy Statement.

Reserve Bank head of macro financial Bernard Hodgetts said that, on average, banks reported losses under the two scenarios ranging between 3 to 8% of their total dairy sector exposures.

“Bank lending to the dairy sector stands at around $38 billion, which is approximately 10% 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.”

The test results suggested that, in the shorter term, banks would increase their dairy lending to support existing borrowers facing negative cash flow.

However, if the dairy sector downturn was prolonged, the banks would face a longer term rise in loan losses.

Further, a prolonged downturn, could mean it would take longer for foreclosed dairy farms to sell.

This means banks could be left with the costly management of a large portfolio of foreclosed dairy assets for an extended period of time.

The Reserve Bank said that, under these circumstances, banks would have to hold additional capital for confidence.

This is because losses on written-off loans could increase if ongoing management costs and forgone interest income were larger than initially provisioned for.

The Reserve Bank’s announcement comes hot on the heels of Labour leader Andrew Little’s call for banks to pass on the full 25 basis point OCR cut to customers and, particularly, struggling dairy farmers.