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China's city commercial banks - the single city-based lightweight lenders in the country's banking sector - are headed for a reshuffle within the next three years.

The central message from top regulators at a summit last week was quite clear - if city commercial banks cannot come up with better asset quality, sufficient capital and sound management by the end of 2006, when restrictions on foreign banks are lifted under China's World Trade Organization commitments, they face the possibility of being shut down.

"We cannot wait and make them exit (the market) only after they become insolvent," Liu Mingkang, chairman of the China Banking Regulatory Commission (CBRC), told a conference attended by chiefs of all the 112 city commercial banks.

"For those who go from bad to worse and do not correct their mistakes, we'll be quick to remove them," he added.

Said a participant who did not want to be named: "What impressed me most in his remarks was that regulators will protect depositors' interests, instead of protecting shareholders' interests. That showed their determination with the market exit mechanism."

Participants said the CBRC aims to "basically" dissolve financial risks in small and medium-sized financial institutions by 2006 and "actively and prudently" complete the exit of high-risk financial institutions.

City commercial banks are required to bring their overall non-performing loan (NPL) ratio down to 15 per cent by the end of 2005, from 16.53 per cent at the end of June.

That is far lower than the average NPL ratio for the four largest State-owned commercial banks, but still no easy task. According to standards set by the Chinese central bank, city commercial banks currently need to set aside some 70 billion yuan (US$8.4 billion) in bad loan provisions.

"But only 6 billion yuan (US$720 million) was set aside," the president of one city commercial bank said.

Keenly aware of the difficulty in tackling existing bad loans, some participants said their banks are increasingly choosing to issue more new loans to dilute their NPL ratios.

That is dangerous, analysts have warned, as the banks' capital adequacy ratios, which measure their risk resistance capacity, are fairly low - averaging 5.92 per cent at the end of June, far below the 8 per cent minimum requirement.

Only 66 of these lenders, which were created in restructuring of credit co-operatives, meet the 8 per cent minimum.

City banks got assurances at last week's conference that the ways they are planing to replenish their capital base are supported by regulators. Tang Shuangning, vice-chairman of CBRC, said:"The China Banking Regulatory Commission supports any enterprise that meets legal requirements to buy into city commercial banks.

"(The commission) supports banks, when mature, to list on the stock market and establish a market mechanism for supplementing capital."

A number of city commercial banks are already in talks with foreign or individual Chinese investors for possible share transfers. Among them is Beijing City Commercial Bank, which has entered a crucial stage of talks with HSBC and is expected to usher in a few private Chinese enterprises as new shareholders.

"Meeting the 8 per cent capital adequacy requirement is no problem for us at all," said an official surnamed Wang with the bank.

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