Between January 2015 and June 2016, small and mid-size banks drew nearly half of their new funds from wholesale funds, said Moody's using data from the People's Bank of China. At end-June 2016, wholesale funds accounted for 34 percent of mid- and small-sized Chinese banks' total source of funds, up from 29 percent at end-January 2015.
"This increasing use of wholesale funds constitutes a systemic risk as it raises interconnectedness in the system and makes transmission of unexpected shocks more pronounced," said Christine Kuo, a senior vice president at Moody's in a report released Tuesday.
"With an increasingly larger number of banks now more actively engaged in the interbank financial product business, the banks are becoming more sensitive to the risk of potential counterparty failure, which could magnify any collective reaction to negative news and trigger a sharp tightening in system liquidity," added Kuo.
Negative news could include investment losses or hiccups in the settlement of wealth management or shadow banking products.
Moody's report came amid the results season and on the heels of a the PBOC's reintroduction of the 14-day reverse repo for the first time in six months last week to inject liquidity into the system.
According to Moody's, 13 percent of mid-size and small banks' source of funds come from interbank liabilities and repurchase agreements, four times that at the big four banks--Agricultural Bank of China, Bank of China, China Construction Bank, and Industrial and Commercial Bank of China.
Eleven percent of the funds at mid-size and small banks are deployed in interbank lending and reverse repo, double that at the Big Four.
But the interconnectedness of the banking system means that big banks may be vulnerable to negative shocks too, as they are net fund suppliers in China's interbank market.
"With more banks now more actively engaged in the interbank financial product business, they have become more sensitive to the risk of potential counterparty failure. This feature – plus the lack of public disclosure for the majority of financial institutions in China – could magnify any collective reaction to negative news and trigger a sharp tightening in system liquidity," the rating agency added.