The Reserve Bank of New Zealand says the five banks exposed to more than NZ$38 billion of dairy loans could cope with a sustained period of milk payouts below operating costs.The banking regulator reported back from stress tests of ANZ, Westpac, National Australia Bank's BNZ, Commonwealth Bank of Australia's ASB and Rabobank New Zealand, saying the banks faced losses of up to an average of eight per cent of their dairy loans in the most extreme scenario. Dairy lending makes up about ten per cent of total lending in New Zealand and the five banks tested control 98 per cent of dairy loans.But the RBNZ said the banks were able to handle the losses through lower profits, rather than having to eat into their capital.The tests included two scenarios: one where the milk payout recovered to NZ$5.25 a kilo by 2017/18 from NZ$3.90 a kilo this year and land prices fell 20 per cent; and a second scenario where the payout was NZ$3 a kilo this year and remained below NZ$5 a kilo until 2019/20. The second scenario generated land price falls of 40 per cent, given average break-even levels for dairy farmers of NZ$5.30 a kilo."On average, banks reported losses under the two scenarios ranging between three to eight per cent of their total dairy sector exposures," said RBNZ head of macro-prudential Bernard Hodgetts."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," Hodgetts said.The Reserve Bank reported the results of the stress conducted by the banks on their dairy loan portfolios in October and November in a Bulletin article."Consistent with earlier work, the scenarios generate significant increases in loss rates that are manageable for the banking system as a whole," RBNZ economist Ashley Dunstan wrote in the article."There is a risk that the time taken to resolve stressed dairy exposures could be longer than reported in the tests, creating an ongoing source of uncertainty for banks," he said.The Reserve Bank said the tests showed that most of the impact on bank profitability would occur in the first three years of the scenarios.The Reserve Bank warned the scale of loans written off would likely result in "very challenging conditions in the market for dairy farms, particularly in the last two years of the scenario," given the number of farms the could be sold would be larger than the number of buyers with sufficient capital."This analysis suggests that banks should plan for the possibility that the time taken to write off stressed dairy exposures could be significantly longer than assumed in the tests," the bank said."Under these circumstances, banks could be left needing to manage a large portfolio of foreclosed assets for an extended period of time. This would mean that uncertainty about the scale of eventual write downs would persist for longer, potentially requiring the banks to hold additional capital to boost confidence," it said.