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Chinese banks are scrambling to get on top of bad debts they have downplayed for years, cutting off riskier borrowers, further tightening lending terms and, in one case, deploying teams of investigators to assess the risk of loan defaults.
China's banks keep reporting bad loan levels well below what most analysts consider realistic, but their recent actions suggest the slowing economy may be squeezing borrowers and lenders harder than thought only a few months ago.
China's fifth-largest lender, Bank of Communications, assembled research teams last month to look over the assets of troubled borrowers in Zhejiang province, according to bank sources and an internal document. The province is a hotbed of China's credit stress.
BoCom denied that special teams had been set up or that there was any surge in potential bad loans in an email to Reuters. The bank said it had always placed great importance in its risk control efforts.
Bankers from other major listed lenders said they were further cutting lending to riskier borrowers, in particular smaller private companies.
"We're lending almost exclusively to state-owned enterprises in our department at the moment, because it's just seen as the least risky," said a senior loan officer at the Bank of China. The banker, who would not be named because he is not authorized to speak to the media, added that the bank had also raised the bar for state-owned firms, in particular by demanding more collateral.
Read MoreChina's debt soars to 250% of GDP
Bank of China could not be reached for comment on changes to its lending practices.
Lawyers for banks say increasing numbers of transactions fall through because of lenders' last-minute risk worries.
A senior lawyer, who works for Industrial and Commercial Bank of China among others, said only a third of the financing deals she had been asked to work on were actually completed this year.
This compares to 70 percent in the last two years, she said.
The lawyer declined to be named because she is not authorized to speak to the media.
An ICBC spokesman said the bank had not changed its approach to risk and the value of its non-performing loans was low.
In March, Reuters reported that Chinese banks had become unsettled by some highly publicized defaults and were toughening terms for highly indebted borrowers or those plagued by overcapacity.
Now it appears that banks are moving one step further, effectively cutting off many private firms from financing.
Regulators may welcome signs that banks have become more diligent in assessing risk, but it is bad news for policymakers and China's near-term economic prospects.
Beijing has been counting on consumption and a services sector dominated by private firms to take up the slack as it aims to cut industrial overcapacity and China's over-reliance on large state-financed investment projects.
While manufacturing and exports have been improving in recent months, a surprisingly weak service sector survey this week cast doubt on market assumptions that the world's second-largest economy would stabilize this year around Beijing's 7.5 percent growth target.
The average bad-loan ratio for Chinese commercial banks reached a three-year high of 1.08 percent at the end of June, above the regulator's 1 percent red line, but still below most analysts' estimates which range as high as 5 percent.
Bankers and analysts expect bad debts to rise further as the slowing economy makes it harder to repay loans taken out during the Beijing-orchestrated lending binge to soften the impact of the global financial crisis and there are signs this rise could be faster than banks may have anticipated only a few months ago.
Chinese firms remain under intense credit pressure, with strong demand for short-term debt, including high-yielding shadow banking instruments like bankers acceptance notes.
Assessing the damage
Read MoreChina GDP – what's in store?
Sources told Reuters BoCom's management had grown increasingly concerned about a potential surge in bad loans in some regions in mid-July. In response, it set up teams to assess the situation in Zhejiang, Shandong, Fujian, Hubei and Guangdong provinces, according to two people with direct knowledge of the matter and an internal document reviewed by Reuters.
Each team was assigned different tasks, such as checking borrowers' assets, data collection and drafting tailor-made recovery plans for troubled borrowers, the document showed.
Increased attention to bad debts and loan recovery should ensure banks maximize the value of their loan books. They have been selling off bad debts cheaply but major lenders now want to recover as many of them as possible.
"I think it is a good thing," said Chen Xingyu, a banking analyst from Phillip Securities in Hong Kong. "It'll help clarify the situation, so they can take appropriate action."