According to a new report by the Australian Financial Review (AFR) it seems the banking regulator will actually force the banks to hold onto more of their earnings if capital ratios fall below a certain point.

And it will only take modest falls in equity to see the Australian Prudential Regulation Authority (APRA) require the banks to stop paying dividends, distributions on hybrid securities and staff bonuses.

As the AFR reports, if capital ratios fall below 8%, APRA will restrict 40% of major banks’ earnings from being used as dividends. Commonwealth Bank of Australia (ASX: CBA) current payout ratio is 76.5%.

Australia and New Zealand Banking Group (ASX: ANZ) CEO Shayne Elliot has already flagged lower dividends for its shareholders, down from the current range of 65% to 70% to 60% to 65% over the longer term.

National Australia Bank Ltd (ASX: NAB) had a payout ratio of 78.8% during the first half, while Westpac Banking Corp (ASX: WBC) reported a payout ratio of around 80% in the first half of the 2016 financial year.

It’s fairly clear to most analysts that the banks had reached their peak payout ratios already and needed to trim them back anyway.

But should the economy head into a recession and banks’ capital ratios fall below 5.375%, a formal stop on 100% of all payments to equity and hybrid securities kicks in. Banks typically experience declining capital ratios during recessions – hence the risk. During the last recession in 1991, both ANZ and Westpac reported losses and slashed their dividends.

That means zero dividends for shareholders, with the banks using the cash flow to shore up their balance sheets. And given the similarities between the big four and their exposure to Australia’s economy, investors could see all four banks cut back their payout ratios drastically or stop paying dividends.

Foolish takeaway

We’ve warned for some time that Australian retail investors need to diversify away from the big four banks. That doesn’t necessarily mean selling out completely – but it does mean having other sources of dividends.

You can’t say you haven’t been warned.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.