China's Cabinet-level financial regulatory body called for tightened regulations on local financial institutions to mitigate risks and curb excessive business expansion, according to a key meeting on Thursday.

Local financial institutions, which play a crucial role in serving small and medium-sized enterprises, should further improve institutional governance and financial regulations as some are exposed to risks.

"Great importance needs to be attached (to the problem)," said the Financial Stability and Development Committee under the State Council in a statement.

Vice-Premier Liu He, who is also head of the regulatory committee, presided over the meeting. The statement said that local financial institutions should focus on their core businesses and prioritize services for local SMEs and residents.

The meeting urged the institutions to enhance risk management, conduct prudent operations and avoid excessive expansion. In addition, it said more efforts are needed to restrain chief executives. The role of government should be separate from market forces, it added.

This year, China is likely to tighten credit supply after adopting an expansionary monetary policy to mitigate COVID-19 risks last year. Total social financing is also likely to increase at a slower pace to meet the requirements of controlling overall leveraging levels. That may increase pressure on local financial institutions, said Li Chao, chief economist with Zheshang Securities Co Ltd.

Default risks may also affect financial institutions, especially local State-owned enterprises, private firms and local government financing vehicles, Li said.

"Strengthening micro governance and financial supervision over local financial institutions will enter the fast lane and become an important direction to prevent financial risks," he added."The policy also reaffirms the direct responsibility of local governments."

With China's economy undergoing structural transformation and still in the process of recovering from the impact of the pandemic, the State Council decided in late March to extend the deferred debt-repayment policy to the end of 2021 to support SMEs and save jobs.

The extension of the policy will delay the credit risk exposure of some loans to small, medium and micro enterprises, but it may put additional pressure on the asset quality of municipal and rural commercial banks over the longer term, said analysts from Fitch Bohua, which is wholly owned by Fitch Ratings.

The amount of loans that have applied for deferred repayment accounted for 4.5 percent of total loans granted by the banking sector, Fitch Bohua said. And if banks continue with their current write-off policy, this will lead to a 10 to 69 basis point increase in the nonperforming loan ratio of commercial banks, leading to a negative impact on lenders' asset quality.

The policy extension will also support the profitability of regional and local banks, as this means that eligible banks can continue to enjoy subsidies from the central bank's supportive policy instruments, said Li Yan, an analyst with Moody's Investors Service.

Policy tools mainly include providing incentive funds and purchasing 40 percent of the new inclusive credit loans to small and micro enterprises issued by qualified regional banks, Li said.

The high-level meeting also highlighted the need to maintain a prudent monetary policy and keep the renminbi exchange rate stable. The priority of the macroeconomic policies is to secure jobs and market entities, with strong support provided to smaller and private firms, it said.

As Beijing is committed to "make no sharp policy shift", the impact on liquidity, funding costs and economic growth from the moderate slowdown in credit growth should be limited, said Lu Ting, chief economist in China with Nomura Securities.

The People's Bank of China, the country's central bank, is expected to conduct open market operations using instruments such as the medium-term lending facility to dismiss market concerns about short-term illiquidity, Fitch Bohua added.