The International Monetary Fund on Thursday warned of brewing risks in China's banking system as it found dozens of crucial lenders needed to beef up their defences against possible financial crises.
The IMF report comes a day after regulators in Beijing drafted new rules to strengthen bank funding, and follows a number of alerts about a ballooning debt problem in the world's number-two economy.
Near the top of the list in the IMF study on the stability of China's financial system is the need for banks to increase their capital to ward off risks from mounting debt.
China has largely relied on debt-fuelled investment and exports to drive its tremendous economic growth, but the Fund said this model has reached its limits.
Part of the problem lies in high growth targets, the IMF said, which incentivise local governments to extend credit and protect failing companies.
"We recommend the authorities to de-emphasise the GDP (growth)," Ratna Sahay, deputy director of the IMF's Monetary and Capital Markets Department, said during a news conference.
China should "incite local governments to strengthen supervision on risks", she added.
Abundant credit allows local governments to hit high growth figures but now each extra dollar of debt is producing diminishing returns.
The ballooning debt -- estimated at 234 percent of gross domestic product by the IMF -- adds financial risk and may weigh on China's future economic growth.
"Credit growth is an important indicator of future financial distress, because lending standards often fall in the rush to make more loans," IMF experts warned in a blog post.
- Zombie companies -
The Fund's experts carried out stress tests on dozens of banks.
China's big four banks had adequate capital but "large, medium, and city-commercial banks appear vulnerable", the IMF said.
It added that 27 out of the 33 banks tested -- accounting for three-quarters of China's banking system assets -- were "undercapitalised relative to at least one of the minimum requirements".
While the country's banking system meets the requirements of global banking rules known as Basel III, "current circumstances warrant a targeted increase in capital", the report said.
"This would create a buffer to absorb potential losses that can be expected during the economic transition as credit is tightened and implicit guarantees are removed."
China's central bank said it disagreed with "a few descriptions and views" in the report.
The China Banking Regulatory Commission on Wednesday released a draft of fresh rules to tackle related issues.
The latest regulations call for new indicators to monitor commercial banks' liquidity and set related requirements.
They will "strengthen management of liquidity risk for banks and protect the safety and stability of the banking system", the commission said.
In some cases local banks face pressure to lend to politically important companies, as local governments aim to maintain high employment even if that means cash-bleeding enterprises continue to operate.
These loss-making firms, often state-owned, have come to be known as zombie companies, and banks and investors fund many of them as if they will not be allowed to fail.
"Implicit guarantees and the government's desire to support growth encourage these firms to invest excessively, raising already-high leverage while weakening performance on profitability and debt service capacity," the Fund wrote in a recent report.
In October, it warned China's dependence on debt was growing at a "dangerous pace" and needed to act to avert a crisis.
That came weeks after the Bank for International Settlements -- dubbed the bank of central banks -- said the banking sector could be facing an imminent blowout, raising worries about its effect on the world economy.
The IMF's latest assessment said financial engineering helped banks obscure the potential losses.
"Implicit guarantees to SOEs (state-owned enterprises) need to be removed carefully and gradually," Sahay said.
"It would be wise to have a high-level committee to monitor the risks across all sectors."