Australia's big bank oligopoly is not enjoying the best of times lately.

The June quarter results were solid enough, but were largely overshadowed by the need to raise billions of dollars more capital to keep their regulator APRA happy.

No sooner had investors started digging around for the money to pump into the banks' capital reserves, then global markets had a collective panic attack about China and the Australian economy started to look decidedly wobbly.

GDP for the quarter was only saved from going backwards by an ABS "statistical discrepancy" which added $619 million or 0.2 per cent to growth.

The economy has hardly shaken off its funk this quarter either.

Retail sales have gone into reverse, business investment is still at "recessionary" levels and a marginally improved trade performance was propped up by another fortunate one-off, this time gold exports.

The jobs market is holding up despite drifting up to a 13-year high of 6.3 per cent.

However, average nominal wages have slipped over the past two quarters and are now growing at an anaemic annualised 0.4 per cent, compared to the long-term average closer to 4 per cent.

As UBS bank analyst Jonathan Mott pointed out recently, weak wages growth is a better outcome for the banks than rising unemployment, but it is still a drag on consumption.

This on-going weakness — and an uptick in unemployment — could start driving up consumer arrears and bad debts.

Banks' asset quality 'deteriorating'

There is growing consensus among the banks' analysts that the banks' provisioning for bad debts will start rising from their current historic lows.

Credit Suisse's Jarrod Martin said isolated pockets of asset quality stress were emerging.

Mr Martin's "hot-spots" include unsecured personal loans, mortgages in mining towns and mining regions more generally — as well as the "big four's" exposure to agriculture, and in particular, New Zealand's dairy industry.

Morgan Stanley's Richard Wiles also published a note recently arguing the banks' bad debt provisioning was too optimistic.

In Morgan Stanley's "bear case" scenario — which does not include a recession — banks shares were significantly overvalued and provisioning for bad debts and impairment charges could double in a downturn.

"However, we think loss rates would materially exceed these levels if there was a recession," Mr Wiles said.

UBS's Jonathan Mott said the previous month's lead indicators showed early signs of a "deterioration" in the banks' asset quality.

He cited a tick-up in arrears at Genworth Mortgage Insurance, especially in the 2012-13 vintage of home loans.

However it was ANZ's third quarter update that was the greatest cause for concern.

ANZ flagged to the market that its total provision charge for bad debts was up 13 per cent to $877 million for the nine months to June 30 on the back of increased loan growth and higher risks in the resources and agricultural sectors.

"While updates from other 'majors' have not yet shown this deterioration, the improvement in stressed exposures appears to be at an end," Mr Mott said.

Corporate credit growing

So far most of the attention about lending risk has been in the banks' mortgage books, given the debate about soaring house prices and the fact that almost two-thirds of Australian debt is parked in housing.

However, Mr Mott pointed out, "it is corporate losses which have caused the banks the most pain over the last 30 years".

"During the GFC the Australian economy dodged a bullet, however ... corporate exposures to Allco, Babcock and Brown, ABC Learning and Centro and other commercial properties cost the banks dearly," he said.

The big banks have grown corporate credit by 24 per cent over the past five years, while maintaining more subdued growth in small business lending.

While the corporates have been reining in debt since the GFC and the bank' underwriting standards have generally improved, it should be noted recently released ASIC figures have shown that bankruptcies are on the rise again, and are now above their long-term trend.

Can dividends be maintained in a downturn?

Given the headwinds of a slowing economy, the need to build up higher capital buffers and the early signs of a deterioration of asset quality, debate has switched to the sustainability of the banks' generous dividends and what it would take for payouts to be cut.

"There is no crystal ball of future economic outlook, nor is there any formulaic relationship between GDP, unemployment, bad debt charges and dividends," Mr Mott said.

At the first sign of trouble, banks would most likely reprice their books, with a lot of the pain borne, again, by depositors.

The banks could also take a knife to their cost base, which has been rising at a compounded 4.5 per cent a year for the past decade, from around $24 billion in 2005 to $37 billion today.

As Mr Mott argued, the banks have become inefficient, and their cost bases bloated, because benign conditions have allowed it to happen.

"Risk averse management and boards have not been prepared to make tough decisions on costs given the risk of upsetting their customers and disturbing revenue momentum," he said.

UBS modelled two scenarios — a weak economy and a mild recession — to see if dividends would be affected.

The "weak" economy scenario, where the economy continues to grind down, assumes slow GDP growth of between 1 to 2 per cent, unemployment rising to 7 per cent, flat to falling house prices and the RBA cutting official rates to 1.5 per cent.

Mr Mott said under this scenario CBA, NAB and Westpac were "unlikely" to cut dividends, while it is "possible" ANZ would.

The "moderate" recession — that is not as severe as the early 1990s — assumes Australia endures two to three consecutive quarters of contraction, a hard landing in Asia, GDP growth between 0 to 1 per cent, unemployment heading up to 8.5 per cent and the RBA pushing rates down to 1 per cent.

"Western Australia and Queensland are assumed to suffer harshly from this slowdown, while NSW and Victoria also enter a mild downturn," Mr Mott said.

"In New Zealand, the Auckland economy slows sharply, while the dairy and rural sectors suffer a more severe slowdown.

"House prices nationally are assumed to fall 10 to 15 per cent, with larger falls assumed in Perth and regional areas.

"Given the patchy economy over the last years and lower levels of corporate leverage, we believe the banks would be less likely to suffer significant single name — such as Babcock and Brown and Centro — exposures than the last cycle."

Mr Mott said under this scenario, bank share prices would continue to fall sharply and all banks would be forced to cut dividends.

There is an uglier, "hard landing" scenario, where China and Asia experience a significant contraction that spreads to a full-blown Australian recession.

While UBS has not modelled this outcome, Mr Mott suggested that if you believe it likely to happen, do not fret about dividend cuts — just avoid the banks altogether.