What are the key risks to Australian banks' asset quality?

A sharp interest rate increase is one.

Fitch Ratings believes Australia's regional lenders are likely to maintain their solid performance relative to their current ratings in the next year or two, and their strong asset quality should continue to be supported by the country's broadly stable operating environment.

Here's more from Fitch:

A sharp increase in unemployment or interest rates could threaten the lenders' asset quality. Australian household debt levels continue to rise, and are high relative to other developed economies.

Australia's household debt-to-disposable income had risen to a record 186% at end-June 2016. High household debt, combined with strong residential property price growth, remain key risks to the financial system.

Fitch believes the regional banks will maintain their conservative risk appetites despite the competitive pressures in the mortgage market. The banks have a greater weighting of household exposures within their loan books, and underwriting criteria that are broadly conservative.

The banks' risk controls continue to improve, but the rate of improvement has been greater at larger regional banks, which have invested more in risk systems and technology. We expect further tightening in underwriting standards and processes, reflecting regulatory concerns, especially of certain mortgage products, such as investor mortgages and interest-only mortgages.

Fitch expects the Australian regional banks to maintain their small and limited franchises in the mortgage and deposit markets, given the strong dominance of the major Australian banks. Fitch believes that a significant improvement in mortgage market shares is likely to reflect a weakened risk appetite, which would increase negative rating pressure.