(Updates close, adds trader and CISA comments)
SHANGHAI, April 28 (Reuters) - China iron ore futures fell nearly five percent on Monday after the country's banking regulator urged local authorities and banks to step up an investigation into iron ore financing deals in a bid to minimize default risks.
The probe, confirmed to Reuters by sources with direct knowledge of the matter, raised fears that a major cut-back in trade financing facilities to China's steel sector would lead to a rout in the steelmaking raw material.
A commission spokesman declined to comment.
According to a document issued on April 18, the China Banking Regulatory Commission (CBRC) has told local regulators to start investigating iron ore financing and to submit detailed reports by April 30.
"Local offices must step up measures to manage risks arising from commodities trade financing and to assess the risks presented by iron ore financing," the CBRC said in a document, adding that regulators should also check if firms were using fake trades to secure financing.
Trade sources said Chinese banks started to tighten loan requirements for steel mills and trading firms seeking credit for iron ore imports.
"The thing we've been hearing from traders is the margin on the letters of credit has gone up quite sharply over the last week - it used to be 10-20 percent and now is 40-50 percent, and that seems seems to be forcing a bit of liquidation," said Graeme Train, an analyst at Macquarie Commodities Research in Shanghai.
The benchmark iron ore contract for September delivery on the Dalian Commodity Exchange tumbled to 757 yuan ($120) a tonne, its lowest since March 27, and closed down 4.5 percent at 760 yuan, the biggest daily fall since the contract was launched in October 2013.
Chinese banks have cut loans to the capital-intensive steel industry, including iron ore traders, due to concerns over their inability to repay loans, particularly as growth in demand for metals has slowed in line with the economy this year.
Investors in China have turned to commodities as a way to obtain credit. Some analysts have attributed part of the continued strong growth in China's iron ore imports to financing, rather than underlying demand.
Iron ore inventories sitting at main Chinese ports have hit record levels of above 100 million tonnes since mid-February, data from industry website Umetal showed, putting banks on high alert that any big collapse in prices might cause wide default risks.
The big drop in futures trading has also driven down spot prices for the raw material and steel rebar futures.
A cargo for Australian iron ore fines with 62-percent grade was sold at $107 a tonne on Monday, down $3 from last Thursday, traders said.
Spot iron ore for immediate delivery to China <.IO62-CNI=SI> dropped 2 percent to $111 a tonne on Friday, its lowest since March 24, according to data provider the Steel Index.
The most-active rebar futures contract on the Shanghai Futures Exchange also fell 1.74 percent to 3,222 yuan a tonne by close.
Surging steel output has added to downside pressure on the market, given demand growth is set to slow in line with the broader economy.
China's average daily crude steel output extended gains in the second ten days of April from the previous 10-day period, surging 6 percent to 2.28 million tonnes, data from the China Iron & Steel Association (CISA) showed on Friday.
CISA expects quarterly margins for China's steel sector to improve over the three months to June, but a tough credit market and rising environmental costs will restrict gains.
Shanghai rebar futures and iron ore indexes at 0702 GMT
Contract Last Change Pct Change
SHFE REBAR OCT4 3222 -57.00 -1.74 DALIAN IRON ORE DCE DCIO SEP4 760 -36.00 -4.52 THE STEEL INDEX 62 PCT INDEX 111 -2.20 -1.94 METAL BULLETIN INDEX 111.54 -2.04 -1.80 IO 62%Fe APR14 SWAP 115.13 -0.04 -0.03 IO 62%Fe MAY14 SWAP 111.13 -1.37 -1.22
Dalian iron ore and Shanghai rebar in yuan/tonne Index and swaps in dollars/tonne, show close for the previous trading day
($1 = 6.2536 Chinese Yuan)
(Additional reporting by David Stanway, Xie Heng, Zhao Hongmei and Li Ran in BEIJING; Editing by Richard Pullin)