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China bank regulator urges banks to control shadow-bank risks

Chairman of China Securities Regulatory Commission Shang Fulin attends the Asian Financial Forum in Hong Kong January 17, 2011. REUTERS/Tyrone Siu

By Hongmei Zhao and Gabriel Wildau

HONG KONG/SHANGHAI (Reuters) - China's banking regulator is pressuring banks to curb reliance on short-term borrowing and control risks from off-balance-sheet lending, according to a document obtained by Reuters, following two severe cash crunches in the last six months.

While China is pushing to reduce systemic risks posed by the rise of shadow banking, analysts say its focus is on curbing the riskiest off-balance-sheet lending practices rather than ending the practise altogether.

The China Banking Regulatory Commission (CBRC) has set up a leadership group on banking industry reform headed by its chairman Shang Fulin, according to a source close to the regulator.

"The CBRC is requiring banks ... to push forward reform in the two areas of wealth management and interbank business," the source told Reuters, requesting anonymity because he was not authorized to speak publicly.

"The commission will come up with a reform plan in the first quarter and preliminary results on these two focal points of reform should be evident by the end of June."

The document is the text of a speech delivered by CBRC Vice Chairman Zhou Mubing at the agency's annual work meeting on January 7. The 15-page speech was officially distributed as a circular to banks the following day.

Ratings agency Fitch issued a statement on Friday commenting on the regulator's approach to what many analysts see as potential time bomb ticking under the mountain of domestic debt.

"Recent developments highlight China's efforts at reforming and regulating - but not rolling back - the growth of shadow banking," Fitch said.

In the speech, Zhou warned banks against relying on interbank borrowing as a funding source for corporate loans.

"The key focus of interbank business reform is to restore its essential character as a temporary, short-term tool for banks for cash management, and to control the scale of interbank business and its share (of a bank's overall balance sheet)," Zhou said.

The interest rate that banks charge each other for short-term loans spiked to double-digit levels in June and again last month, raising concerns about excessive reliance on short-term funding, especially among smaller banks, which have limited access to customer deposits.

The regulator also called on banks to clearly separate their traditional deposit business from wealth management products (WMPs), which banks often market to customers as a higher-yielding substitute for deposits.

Dangers arise from customers typically assuming that WMPs are risk-free, just like deposits, even though WMP funds are used to make riskier loans and typically don't carry a bank's guarantee.

Zhou told banks that banks should strictly segregate these two funding streams.

The risks from short-term funding is related to WMPs because banks often borrow in the interbank market to finance cash payouts on maturing WMPs.

Such borrowing is necessary because of the maturity mismatch between WMPs -- which typically mature in under a year -- and the loans, bonds, and money market assets that often underlie such products. When payouts are due on WMPs, the underlying assets cannot be easily sold, forcing banks to raise cash from the money markets.

Zhou called for banks to centralize authority over interbank borrowing and lending within their head offices in order to prevent branches from conducting interbank business independently.

The regulator called for banks to establish a separate division for wealth management business to segregate it from the main deposit-taking business. As with interbank borrowing, Zhou said that banks should prevent branch banks from creating and selling WMPs independently from their headquarters.

"Recently the CBRC has raised the idea that wealth management business should be conducted with the a main operations office designing products, while other department and branch banks only handle sales," said a commercial bank executive with direct knowledge of the regulatory initiative.

(Editing by Simon Cameron-Moore)