SHANGHAI/BEIJING (Reuters) - China’s banking and insurance regulator has told the country’s biggest distressed debt managers to prepare contingency plans to take over or invest in high-risk small and medium-sized Chinese banks, two sources involved in the discussions told Reuters.

Regulators are broadening out the framework for a rescue of the country’s highly-indebted smaller banks to contain financial risks amid the worst economic slowdown in almost 30 years.

The last time a state-owned asset management company (AMC) acquired a stake in a regional bank was in 2016.

In May, a shock government-led takeover of little-known Baoshang Bank revived concerns about the health of hundreds of small lenders as the slowing economy results in more sour loans, testing their capital buffers and draining their reserves.

On Thursday, the Bank of Jinzhou said it is in talks with multiple parties for possible investments. Sources told Reuters a day earlier that regulators recently met financial institutions to discuss measures to deal with liquidity problems at the bank.

“The regulator has asked about our opinions and plans. We’re studying the specifics - whether it should be in a form of takeover, M&A, or restructuring,” one of the sources in the discussions said, when asked whether AMCs are being tapped to participate in overhauls of smaller banks.

“The regulator wants us to be prepared,” the source added.

China's four biggest AMCs are China Huarong Asset Management Co 2799.HK, China Orient Asset Management Co, China Cinda Asset Management Co 1359.HK and China Great Wall Asset Management Co.

One of the four AMCs is assessing the idea of acquiring a small bank, the second source said.

China’s big state lenders first established the four asset managers in the late 1990s to help them deal with mounting non-performing loans. Since then, AMCs have been roped in only occasionally to help distressed banks.

The banking and insurance regulator said on Friday that all qualified financial institutions can participate in M&As of smaller lenders, including AMCs.All commercial banks in good standing as well as qualified investors will be invited to participate in the restructuring of rural commercial banks, the regulator told Reuters in an emailed response on Thursday.

Debt levels are again on the rise in China as authorities roll out more stimulus to boost flagging economic activity and encourage banks to keep lending to struggling firms. Corporate bond defaults look set for another record year.

None of the four AMCs immediately offered comment when Reuters contacted them on Friday.

DIFFERENT ADVANTAGE

Technically speaking, big commercial banks and AMCs have their own advantages if they take control of a bank, a senior executive of a big AMC said.

AMCs are more familiar with laws and regulations, while big lenders are more familiar with the market and banking business, the executive said. “Local smaller banks have too much interference from the local government, which has led to credit lines (to local companies) being issued under pressure,” the executive said. “Takeovers from AMCs will contain the problems of those banks.”

China Construction Bank 601939.SS was appointed by the central bank in May to take control of Baoshang, a small lender based in Inner Mongolia.

The CBIRC said on Thursday that a small number of rural banks will continue to be exposed to credit risks due to “the impact of the macroeconomic cycle”.

MARKET REACTION

Banking shares fell slightly on Friday in Shanghai and Shenzhen, in line with the broader market. Small, regional lenders such as Jiangsu Changshu Rural Commercial Bank 601128.SS and Jiangsu Zhangjiagang Rural Commercial Bank 002839.SZ dropped the most.

Underscoring concern in China’s interbank bond market over the Jinzhou announcement, traders said that they saw offer yields of 5.5% for Bank of Jinzhou negotiable certificates of deposit (NCD) maturing in as little as 7 days, but no bids.

“Yields as high as this, and only offers, no bids, is not normal,” said one trader.

Investors’ worries have extended to other troubled northeastern banks, despite little trading activity in relatively illiquid interbank debt instruments.

The yield on a 1-year March 2025 NCD issued by AAA rated Harbin Bank Co 6138.HK jumped about 200 basis points between Wednesday and Thursday to an official close of 5.492%.

Many smaller Chinese banks rely heavily on shorter-term forms of financing and a sustained rise in such costs or problems obtaining funding would add to strains on the sector.

“The fact that imposing losses on even a tiny fraction of Baoshang’s creditors has triggered major interbank jitters highlights just how pervasive the assumption of (China) state support is and how difficult it will be to gradually withdraw this support without triggering a banking crisis.” Capital Economics said in a recent note.