* Debt campaign hits major source of funding for small banks
* Many banks will be forced to change business model
* Funding pressures could spark consolidation in sector
SHANGHAI, Jan 31 (Reuters) - Three years ago, China's Bank of Jilin transformed its business strategy and began to gorge on debt. With a presence in just two provinces in northeast China, its favoured borrowing was short-term loans from other banks.
Bank of Jilin is now beating a hasty retreat following a regulatory campaign to crack down on a business model, common among thousands of small banks in China, that relied on short-term loans to fund risky investments, or to ensure payouts to investors in its wealth management products.
Government officials have grown increasingly alarmed in recent years at rising debt levels, and analysts and investors said the clampdown on short-term interbank borrowing raises questions about the future of small banks like Bank of Jilin.
Lacking the national networks of larger rivals, these small banks face the prospect of slower growth and smaller balance sheets. Those that struggle may be forced into partnerships with other banks to survive.
"There's no choice but to shrink our interbank business," said a Bank of Jilin official, who declined to be identified because he is not authorised to discuss bank strategy. "We need to transform our business model."
Since the global financial crisis, China's debt has soared. In late 2016, the Bank for International Settlements warned China it could face a banking crisis in three years, and last year the International Monetary Fund said the country's credit expansion was "dangerous".
Chinese officials have taken action.
The government has issued 46 "major" regulations, statements and other documents aimed at reducing financial leverage since March 2016, Zhou Guannan, a senior analyst at Huachuang Securities in Beijing, noted in a report. No fewer than 14 of those have been issued since December.
The latest slew of rules from Beijing was aimed at tightening the screws on banks like Bank of Jilin, analysts said.
In 2015, the bank opened an office in Shanghai, China's financial hub, that it said was designed to expand interbank co-operation and explore "innovative" new business. A year later, the bank's total liabilities had grown 22 percent, almost double the pace of its deposit growth; its wealth management business had jumped 25 percent, compared with loan growth of 10 percent - and its bond trading volume had surged 140 percent.
Its issuance of negotiable certificates of deposit (NCDs) shot up to 108 billion yuan ($16.89 billion) in 2017 from 21.3 billion yuan in 2015.
It was not alone. Total issuance of NCDs in the interbank market rose to more than 20 trillion yuan in 2017, almost twice the size of the economy, just four years after they were introduced.
Initial regulations did not classify NCDs as interbank liabilities, which are capped under Chinese regulations at a third of total liabilities, so the market rapidly became a money fountain for smaller banks.
The latest regulations require banks to seek pre-approval from authorities for issuing NCDs and also limit how much of this debt they can issue.
At Baoshang Bank, another small lender, interbank borrowings, including NCD issuance, accounted for 48 percent of total liabilities at the end of the third quarter of 2017 - far exceeding a 33-percent cap stipulated by authorities in the latest regulations.
"Less leverage means less money for investment," said a manager at Baoshang Bank, whose job is to find high-yielding investment opportunities. "The policies are getting tougher than necessary."
Huachuang Securities estimated 19 banks, including Baoshang Bank and Bank of Jilin, had interbank borrowings that accounted for more than one-third of total liabilities as of the end of the third quarter of 2017.
Neither Baoshang Bank nor Bank of Jilin responded to requests seeking comment.
"The smaller (banks) will have a difficult time," said Gary Ng, an economist at Natixis in Hong Kong. "Even if they can manage to increase their loan book, the proportion is still much smaller than large ones."
One aim of the measures seems to be to push banks to shift their focus back to attracting deposits and lending to the real economy - rather than making speculative bets on securities - as the foundation of growth, analysts said.
But small lenders are at a disadvantage without the national networks of larger competitors, they said.
Industrial and Commercial Bank of China, China's biggest lender by assets, said in its 2016 annual report that it had 16,788 locations in China. As of March 2017, Baoshang Bank had 18 branches and 291 sub-branches.
Faced with dwindling options for funding, some banks are turning to new forms of debt issuance. A jump in convertible and subordinated debt issued by banks in 2017 is an early sign of what Ng expects to be a steady increase, particularly for banks that lack capital.
This could pour new supply into an already-struggling bond market.
"If banks increase their issuance, that may crowd out some of the space from other companies who need liquidity (in) the bond market," said Ng.
Some small banks may succumb to the pressure. While it is difficult to forecast whether regulators will allow banks to fail, market observers say consolidation cannot be ruled out.
"There will be a growing tolerance of the PBOC to allow these smaller (banks) to face financial challenges," said Arthur Lau, co-head of emerging markets fixed income and head of Asia ex-Japan fixed income at PineBridge Investments.
"Whether they will allow them to default, that (is) another issue that we can debate. I think they are likely to ask the strong banks to take over, especially to avoid any systematic crisis," he said.
(Reporting by Andrew Galbraith and Samuel Shen; Editing by Neil Fullick)