China’s banking regulator has asked the country’s lenders to make preparations for a “big rise” in non-performing loans as part of Beijing’s efforts to brace its financial system for shocks from the coronavirus at home and a hostile environment abroad.

Runs on China’s small banks have become more frequent amid the current turmoil, while the loan repayment capabilities of Chinese companies and households have been undermined by the impact of the coronavirus.

Beijing has made efforts to avoid a broader financial crisis, but it is now facing fresh challenges, the China Banking and Insurance Regulatory Commission said this week.

China has to “prevent the cold ash of shadow banking from burning again”, while avoiding “a resurgence of chaos in real estate financing”, said a statement summarising a working conference held by China’s banking regulator this week.

It has to also “make full preparations to counter changes in the external environment over the long run”, the statement added.

But Qu Qiang, a researcher at Renmin University’s International Monetary Institute, said China is unlikely to see a broad financial meltdown as Beijing has kept credit and liquidity risks in check.

“Banking sectors worldwide are facing an extra test from the pandemic. Like overseas peers, some Chinese banks could run into difficulty because of their operations, but it’s quite normal and won’t endanger the overall system,” said Qu.

China’s official statistics paint a picture of a sound financial system as the non-performing loan ratio of all Chinese commercial banks edged up by a mere 0.05 percentage point to 1.91 per cent at the end of March.

But it is increasingly evident that the banking system has started to show cracks at a grass-roots level, especially rural and smaller regional banks, as well as lenders in poorer regions.

Official data showed that the non-performing loans ratio at rural banks stood at 4.09 per cent at the end of March, more than double the national average.

“It is worth keeping a close eye on this because the impact of the coronavirus on asset quality will eventually show up in the second half of 2020 and early next year,” said Wang Jun, chief economist at Zhongyuan Bank in Henan province.

China’s banking system is also a hotbed for corruption. In a recent case, three former top officials at the Shanxi provincial rural credit cooperative, the backbone financial institution in charge of rural financing in the coal-rich province, were placed under investigation for corruption. Jing Hui, who had been the top financial regulator in the province until June 2020, was also found to have 400 million yuan (US$57 million) in cash stored at his home.

China’s prosecutors also recently charged Cai Guohua, the former chairman of the Shandong-based Hengfeng Bank, with embezzling 10.3 billion yuan (US$1.5 billion). Cai denies the charges.

Last year, China was forced to bail out several lenders, including Baoshang Bank in Inner Mongolia and Hengfeng Bank, which were the first bank failures in China in more than 20 years, but more weak banks could follow, according to Wang.

Alicia Garcia Herrero, chief Asia-Pacific economist at French investment bank Natixis, said China’s banking sector faces a catch-22 situation, given it has vital responsibilities but contradictory goals, including increasing lending to weak links in the economy in line with government policy while maintaining sound asset quality as required by bank supervisors.

Chinese banks, largely controlled by governments at various levels, extended a record 12 trillion yuan (US$1.7 trillion) worth of new loans in the first six months of the year, responding to Beijing’s call to help support the real economy.

Many of the loans were given out to smaller, private sector businesses, which were generally viewed as high risk before the coronavirus outbreak.