Chinese banks' loans to local governments are about 3.5 trillion yuan ($540 billion) more than the national auditor's estimate, and the industry's credit outlook could decline, Moody's Investors Service said.

"The Chinese audit agency could be understating banks' exposure to local governments," Yvonne Zhang, a Moody's analyst in Beijing, said in the report today. The "apparent absence of a clear master plan to deal with this issue" is likely to exacerbate problems and lenders may be left to manage a portion of the souring loans on their own, it said.

Bank shares fell and bond risk rose on concern that the banks will be unable to absorb losses on defaults should property prices drop. Moody's estimates that local governments' debt is about a third more than the audit office's findings last week of 10.7 trillion yuan. Non-performing loans could reach as much as 12 percent of total credit, it said.