China's banking regulator ordered some of the nation's smallerlenders to set aside more funds to avoid a cash shortfall, threepeople with knowledge of the matter said, signaling rising concern that defaults may climb.

China Banking Regulatory Commission (CBRC) branches asked somecity commercial banks and rural lenders to strengthen liquiditymanagement this year, the people said, asking not to be identifiedbecause the matter is confidential. Different requirements arebeing instituted by province, such as quarterly stress tests, afterCBRC studies last year showed increasing risks at those lenders,the people said.

The People's Bank of China (PBOC) signaled on Feb. 8 thatvolatility in money-market interest rates will persist,underscoring investors' concerns that financial stresses could dragdown growth in the world's second-biggest economy. The bailout of a3 billion-yuan ($495 million) high-yield investment product daysbefore it matured last month highlighted challenges for authoritiesseeking to rein in an unprecedented credit boom.

“Smaller banks are the weakest link of China's financial systembecause their lack of a stable deposit base would force them toseek more expensive funding and offer more risky loans,” said LiuJun, a Wuhan-based analyst at Changjiang Securities Co. “They willbe hardest hit when borrowing costs are elevated and the economyslows.”

The requirements add to steps taken to protect against souredloans weighing on China's economy, which included speeding upbad-loan write-offs and limiting local government debt sales.

The benchmark seven-day repo rate, a gauge of interbank fundingavailability, surged to a record 10.77 percent on June 20 asinstitutions struggled to obtain funds amid a PBOC crackdown onshadow finance and more than doubled in December to 8.84 percent aslenders hoarded cash to meet year-end regulatory requirements. Itwas fixed at 5.3 percent yesterday.

Some of the banks were asked by their local CBRC branches to setaside reserves to ensure cash supply for 30- to 45-day periods, thepeople said, declining to identify the banks. Press officers at theCBRC's headquarters in Beijing didn't return three calls seekingcomment yesterday.

'Decisive' Role

China's money markets are playing a greater role in creditallocation and borrowing costs as the central bank has moved toliberalize interest rates and make the economy less reliant onbanks for funding. The PBOC abolished controls on bank lendingrates in July, and the Communist Party said in November it wantedmarkets to play a “decisive” role in pricing capital.

“When the valve of liquidity starts to tame and curb excessivecredit expansion, money-market rates, or the cost of liquidity,will reflect that,” the central bank said in a Feb. 8 report. “Themarket needs to tolerate reasonable rate changes so that rates canbe effective in allocating resources and modifying the behavior ofmarket players.”

One or two small Chinese banks may fail this year as they getabout 80 percent of their funding from interbank markets andhigher-cost deposits in savings vehicles known as wealth managementproducts, Fang Xinghai, a bureau director at the Office of theCentral Leading Group for Financial and Economic Affairs, said inNovember. The group is the highest-level agency within theCommunist Party for financial and economic policies.

China's five biggest state-owned banks and 12 national lenderscontrolled more than 60 percent of the nation's 148 trillion yuanof banking assets at the end of 2013, according to CBRC data. Otherfinancial institutions including 144 city commercial lenders, 337rural banks, and more than 1,900 rural cooperatives owned therest.

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