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* Haircut for some Baosheng creditors has spooked interbank market
* Bejing-based mutual fund house defaulted on some products
* Small lenders unable to raise as much via NCDs as previously
SHANGHAI, June 21 (Reuters) - Nearly three weeks after Chinese regulators took over troubled Baoshang Bank, a mid-sized mutual fund house in Beijing suddenly became unable to borrow cash in the interbank market and was forced to default on some products.
Around the same time, Great Wall West China Bank, a regional lender in Sichuan province, set out to sell negotiable certificates of deposit (NCDs) - usually a routine fundraising tool for small lenders - but was only able to raise a tenth of its targeted amount.
Both examples highlight increasing distrust in China's interbank market as smaller banks, asset managers and brokerages find their creditworthiness questioned in the wake of the takeover of Inner Mongolia-based Baoshang.
Fund managers and traders say they are worried about the prospect of further defaults in interbank borrowing as well as more troubled banks coming to light.
"As the old saying goes, when you see one cockroach, you will discover a swarm of them," said Liu Haiying, founder of Shanghai-based Haiying Investment and author of the book "China's Huge Debts."
"Worryingly, Baoshang Bank is likely that first cockroach."
Particularly shocking for the market has been the government's decision to only guarantee the principal for interbank deposits with Baoshang worth 50 million yuan ($7.3 million) or less, shattering a widely held belief in full government guarantees for such assets.
Short-term interbank lending rates have spiked to as high as 15% this month from more normal levels of around 3.5%.
"The liquidity stress we're witnessing now is rooted in concerns over insolvency, which is very difficult to cope with," said Liu, adding that while authorities were right to try to clean up problems, they risked creating chaos in the financial system.
Many small lenders rely on short-term borrowings for long-term investments and surging financing costs could hit their returns or force them to liquidate assets. That in turn could further strain liquidity conditions in a market that is also a key fundraising channel for smaller fund houses and brokerages.
The Beijing-based fund house, New China Fund Management, told clients on June 12 it needed to sell assets after defaulting on several products, according to a letter it sent that was reviewed by Reuters.
Asked about the letter's contents, the fund house said in an emailed statement it was "obliged to take active measures to flag and reduce risks." It has not publicly disclosed the size of the default or whether it has made repayments.
Controlled by Hengtai Securities Co Ltd, New China Fund ranked 62nd in terms of assets among 124 Chinese mutual fund houses as of March 31, according to fund consultancy Z-Ben Advisors.
Great Wall West China Bank, which has an investment grade credit rating of AA, had sought to raise 500 million yuan ($73 million), according to an interbank market statement. It offered a 3.9% yield on one-year deposits, above the 3.25% offered by issuers of NCDs with top-notch AAA+ ratings.
An official at Great Wall West China's capital markets department said the lender had had contingency measures in place and was not suffering from a liquidity shortage.
It is not the only lender to be disappointed.
Estimates by CITIC Securities showed issuers of NCDs with a second-tier investment rating of AA+ or lower raised on average only 15% of their fund-raising targets this month, compared with over 70% before the Baoshang Bank takeover in May.
Wang Ming, a product supervisor at Hua Chuang Securities' trading department, said investors are thoroughly re-assessing counterparty risks and demanding higher-quality collateral.
"Interbank lending used to be a no-brainer. But now, it has become very difficult to borrow money if you pledge securities rated AA+ or below."
The China Banking Association declined to comment.
Regulators have said the Baoshang takeover was necessary to stave off risks to the financial system and have tried to limit the fallout, urging larger lenders not to starve smaller players of cash. The central bank has also pumped money into the market.
Over the past week, the central bank and securities regulator have held meetings with brokerages and mutual fund houses, urging them to support each other rather than blindly blacklisting counterparties.
In one such gathering, regulators put it bluntly: "If mutual distrust keeps spreading, it will eventually evolve into systemic financial risks," according to minutes of the meeting seen by Reuters.
The China Securities Regulatory Commission did not respond to a Reuters request for comment.
For many China experts, the Baoshang takeover is the first shot in a new campaign by Beijing to reduce excessive leverage in the banking system and curb reckless interbank lending. It follows a slew of 'deleveraging' policies between 2016 and 2018 that targeted the shadow banking sector and off-balance-sheet investments.
They also see Beijing's move as a precursor to consolidation in an industry with more than 4,000 players and where smaller lenders account for a quarter of the sector's assets.
Many of those smaller banks have been expanding aggressively, using cash raised via NCDs. Proceeds are channeled into riskier but higher-yielding investments, such as corporate bonds, or even local government pet projects. ($1 = 6.8494 Chinese yuan) (Reporting by Samuel Shen and John Ruwitch in Shanghai; Editing by Vidya Ranganathan and Edwina Gibbs)