Standard & Poor’s recently warned that the nation’s banking sector is at risk of a massive credit downgrade due to surging private-sector debt and rising home prices. The credit-rating agency placed 25 Australian financial institutions on a negative credit outlook, mainly due to growing risks from the housing sector.

The negative credit outlook encompasses larger financial institutions (such as AMP Bank, Macquarie, Bendigo and Adelaide Bank, and Bank of Queensland), as well as smaller credit unions, building societies, and mutual banks.

While S&P maintains a benign “base case” outlook on Australia’s economy and financial outlook, it warned there’s a “one-in-three” chance that continued property price rises in Sydney and Melbourne could precipitate a crash.      

S&P highlighted the rise in Australia’s private sector debt-to-GDP ratio from 118% in 2012 to 139% in June 2016 as a key concern, particularly since inflation-adjusted home prices have risen at 5.3% per year.

"Consequently, we believe the risks of a sharp correction in property prices could increase and, if that were to occur, credit losses incurred by all financial institutions operating in Australia are likely to be significantly greater; with about two-thirds of banks' lending assets secured by residential home loans," S&P warned in its official report.

"The impact of such a scenario on financial institutions would be amplified by the Australian economy's external weaknesses, in particular its persistent current account deficits and high level of external debt."

While S&P said a sharp fall in property prices remains unlikely in the next two years, it is a "stress-case scenario". It is probable that growing imbalances in the economy due to the latest property boom in the east coast will "unwind in an orderly manner, as has generally been the case over past property cycles."

On the other hand, if prices and debt continue to grow, S&P warned that Australia’s economy and financial system have "external weaknesses" that could "amplify the impact."

"We expect that the cost of external borrowings would rise, domestic credit conditions would tighten, the currency may depreciate sharply (damaging confidence and potentially limiting monetary policy flexibility), and economic growth would slow," S&P cautioned.