This is why Australian banks should watch the mining sector closely

A crash will deal quite a blow.

Fitch explained in a new report that while Australian banks' direct exposure to the mining sector is limited at less than 1% of total lending, "a significant slowdown in mining would still affect banks indirectly through its impact on the broader economy."

"A major slowdown in the mining sector would have negative implications for the broader economy, most likely leading to higher unemployment and ultimately weaker asset quality and increased provisioning for Australian banks," said Tim Roche, Director in Fitch's Financial Institutions group in a release accompanying the report titled "'Australian Bank Mining Exposure - Direct Exposure Minimal, Risks Stem from Broader Economy."

"The states of Western Australia and Queensland are the most exposed to the mining sector and are likely to bear the brunt of any mining driven downturn. Western Australia, in particular, exhibits some bubble characteristics, with mining accounting for over a quarter of the state's economy and property prices increasing significantly since 2004," said Fitch.

"It is important to note that a sharp slowdown is not Fitch's base case - the agency expects the Australian economy to grow at 3.3% in 2012, 3% in 2013 and 3.2% in 2014 - but rather represents a potential risk for the banking system."

Fitch recognises that there are a number of buffers that exist under such a scenario. Both fiscal and monetary policy could be eased substantially, while the Australian dollar would likely depreciate significantly from its current high level, providing some stimulus to export oriented and import competing industries.

The banks themselves have built sizeable buffers over the past four years, leaving them better placed to deal with a slowdown in the Australian economy.

"Nevertheless, the banking system retains a reliance on wholesale funding, particularly from offshore sources, which may leave it vulnerable to weaker global investor sentiment toward Australia. While such reliance is declining, Fitch expects it to remain prevalent given structural issues in Australia," Fi