A commercial bank should limit its interbank borrowing to less than a third of its liabilities, while its lending to another financial firm shouldn’t exceed 50 percent of its Tier 1 capital, according to a statement on the People’s Bank of China’s website. Financial institutions need to better manage the maturity of interbank funding and control liquidity risks, the PBOC said.

Borrowing between financial institutions on the interbank market more than tripled in the past five years as part of a web of underground finance that evolved to sidestep government lending restrictions and capital requirements. Estimated by JPMorgan Chase & Co. to be worth $7.5 trillion as of September, shadow banking has made it harder for the government to curtail debt and shield state banks from rising defaults as the economy cools.

“Given that interbank financing has been important in funding the business of some lenders, the rules will limit overall lending in the economy, not just in the market,” Dariusz Kowalczyk, a Hong Kong-based strategist at Credit Agricole, wrote in an e-mail. “While much needed to control the risk in the banking system, they are a medium-term negative for the growth outlook.”

Asset Surge

The statement was jointly issued by the central bank, the China Banking Regulatory Commission, the China Securities Regulatory Commission, the China Insurance Regulatory Commission and the State Administration of Foreign Exchange.

The transactions between banks have allowed them to circumvent regulatory requirements on capital, risk provision and loan-to-deposit limits, the central bank said in its stability report. The complex structure through layers of intermediaries had inflated the assets of the industry and is extremely likely to spread risks, the PBOC said.

Interbank assets surged to 21.5 trillion yuan ($3.4 trillion) by the end of last year from 6.2 trillion yuan at the beginning of 2009, the PBOC said in its 2014 financial stability report. The increase was almost double the gain of China’s banking assets during the same period.

Transactions in the interbank market include loans to other financial institutions and resale agreements, or pacts between two banks under which one borrows from another by using assets as collateral and agrees to buy them back at a later date.

Make Provisions

The resale agreements shouldn’t involve more than two parties and their underlying assets must be limited to highly-liquid financial assets with “fair value” such as bankers’ acceptance, bonds and bills, the regulators said. Borrowers through the agreements are banned from moving the underlying assets off their balance sheets.

Financial firms need to make provisions and capital charges on the assets they invest in, and use accurate accounting treatment on their interbank business, the regulators said. The maturity of interbank borrowing shouldn’t exceed three years, while other types of interbank financing should be limited to one year, they said.

The Chinese Academy of Social Sciences, a state-run research institute, in May described the interbank market as a “critical link” that could exacerbate financial-system risks during periods of liquidity shortage.

Cash Crunch

The risks associated with interbank lending were underscored last year after a cash crunch in China’s money markets in June forced two branches of China Everbright Bank Co. to delay repaying 6.5 billion yuan of short-term interbank loans after they failed to receive proceeds from counterparties.

The incident helped drive interbank borrowing costs to a record 10.77 percent on June 20 as other institutions struggled to obtain funds and the central bank refrained from helping.

Smaller Chinese banks, such as China Minsheng Banking Corp. and Industrial Bank Co., are more active in the interbank market, with Minsheng’s exposure accounting for 24 percent of total assets at the end of 2013, according to an April 14 report from Barclays Plc. That’s the most among the eight largest Chinese banks listed in Hong Kong and compares with 5 percent to 10 percent at the four biggest, Barclays said.

Financial regulators acted after the State Council in December imposed limits on shadow banking in the government’s highest-level effort so far to control off-balance-sheet lending. They included a ban on transactions designed to avoid regulations such as moving interbank lending off balance sheets.

The China Banking Regulatory Commission stepped up in April supervision of the trust industry by tightening the approval process for companies seeking to enter new businesses and offer new products. It also told smaller rural banks to limit investment in assets that aren’t traded on any exchanges using proprietary or interbank funds.