Australia's banking sector is at risk of a mass credit rating downgrade as Standard & Poor's warns surging debt and home prices are creating potential economic imbalances.

Key points: 25 Australian financial institutions put on negative ratings outlook

25 Australian financial institutions put on negative ratings outlook "Risks of a sharp correction in property prices could increase": S&P

"Risks of a sharp correction in property prices could increase": S&P A sharp drop in Sydney or Melbourne home prices "could precipitate a crash in the rest of the country"

S&P has put 25 Australian financial institutions on a negative credit outlook, largely due to growing risks from the housing sector.

The negative outlook ranges from larger institutions - such as AMP Bank, Macquarie, Bendigo and Adelaide, and Bank of Queensland - through to smaller credit unions, building societies and mutual banks.

It follows S&P's move several months ago to lower the credit outlook for Australia's major banks when it lowered the outlook for the Federal Government to negative.

While S&P maintained a benign "base case" outlook on Australia's economy and financial outlook, it warned that there is a one-in-three chance that continued strong property price rises in Sydney and Melbourne could set the nation up for a crash.

The ratings agency pointed to a rise in Australia's private sector debt-to-GDP ratio from 118 per cent in 2012 to 139 per cent in June 2016 as a key concern, especially since inflation-adjusted home prices have risen at 5.3 per cent per annum.

"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 the 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."

Sydney, Melbourne property bust would sink nation

S&P said a "sharp fall in property prices remains unlikely in the next two years" and is a "stress-case scenario".

It remains of the view that growing imbalances in the economy caused by the latest east coast residential property boom will "unwind in an orderly manner, as has generally been the case over past property cycles."

However, if prices and debt continue to grow strongly, 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," the ratings agency cautioned.

"This would ultimately result in lower income levels.

"In such a scenario, financial stresses would be widespread across the country, including the corporate, small-to-midsize enterprises, and household sectors.

"We believe that this would significantly increase defaults by borrowers and losses on such defaults."

The news is no better outside the potential bubble markets of Sydney and Melbourne, if S&P's worst case scenario came to pass.

"If a sharp fall in house prices in Melbourne or Sydney were to occur, we believe that most financial institutions in Australia would be adversely affected even when they do not have significant direct exposure to these properties," the ratings agency warned.

"This is because we believe that a sharp drop in house prices in these two cities would likely be accompanied by weakening in other macroeconomic factors, including GDP, employment, business and consumer sentiment, and consequently, could also precipitate a property price crash in the rest of the country."

While the risks in a worst-case scenario are enormous, S&P rates the chance of crash as being low and Australia's banks as being relatively well placed to ride out a financial storm.

"Notwithstanding increasing economic risks, we believe that Australia remains among the lower-risk banking systems by global standards," S&P concluded.

In its negative scenario, S&P foresees cutting the ratings of most Australian banks by a notch, including the big four.

Seven financial institutions escaped being put on a negative watch, mostly subsidiaries of large foreign banks which would be able to financially support them in the event of an Australian economic crisis.