(Reuters) -China oversaw its largest-ever wave of rural bank mergers last year, a Reuters review of official data showed, but analysts say Beijing's efforts to tackle risks in the small banking sector could end up creating more problems down the road.

Many of the roughly 4,000 small Chinese banks are backed by indebted provincial governments and largely funded via short-term money market and interbank borrowings, potentially jeopardising financial stability in the event a few of them fail.

The move comes at a time when many of these smaller banks have been hit hard by slowing loan growth and a spike in bad loans amid a property sector crisis and a prolonged downturn in the world's no. 2 economy.

At least 290 rural Chinese banks and rural cooperatives were merged into larger regional lenders in 2024, according to Reuters calculation of regulatory and company filings over the past 12 months.

The scale of the mergers, which have not been reported previously, underscore the depth of the problem in a crucial corner of China's financial sector.

It's also the most sweeping consolidation since China's small rural commercial banks were transformed in early 2000 from socialist-style, rural cooperatives to serve farmers and small enterprises overlooked by major state banks.

China's rural or small banking sector has about 3,700 firms with a combined 57 trillion yuan ($7.8 trillion) in assets as of the end of June last year, roughly twice the size of Australia's banking sector and one-third the size of the United States.

"After years of clean-up the banking system is in relatively good health despite the weakening economic backdrop," said Jason Bedford, a former Asia analyst with Bridgewater and UBS, known for his in-depth research on the Chinese banking sector.

However, often these mergers simply create "larger troubled banks" by combining insolvent institutions, said Bedford.

China's banking regulator, the National Financial Regulatory Authority, did not respond to Reuters request for comment.

SOARING BAD LOANS

Over the past decade, many small banks started aggressively lending to property developers and local government financing vehicles.

That practice made them vulnerable to the post-COVID economic downturn, the property market upheaval, and the weakening financials of the indebted local governments.

Rural commercial banks' bad loan ratio hit 3.04% in the third quarter of last year, nearly double the overall banking sector's 1.56%, show the latest official data. Analysts say the financial health of many small lenders is in a much worse state.

In one of the most elaborate merger exercises last year, the government in northeast China's Liaoning province in September 2023 set up Liaoning Rural Commercial Bank with 20.8 billion yuan in registered capital.

Liaoning Rural Commercial Bank then absorbed 36 local small rural lenders in June last year. Many of the absorbed lenders were struggling with soaring bad loans, the Reuters review of filings showed.

Liaoning Dengta Rural Commercial Bank, one of the 36 institutions, reported a 21.54% bad loan ratio at the end of 2021, compared with a sector average of 1.73% at that time, the bank's latest available disclosures showed.

Liaoning Rural Commercial Bank's balance sheet has not been made public yet. The lender did not respond to a request for comment.

In a more recent consolidation move, Lanzhou Bank, based in northwestern Gansu province, received regulatory approval to acquire two rural banks, the country's banking sector regulator said in statement in December.

As part of those acquisitions, financial details of which were not made public, the two banks' assets will be transferred to Lanzhou Bank, which had 453 billion yuan in assets and 1.73% bad loan ratio as of end-2023, its annual report showed.

China's mainland banking index is up roughly 10% this year, having gained nearly 40% last year buoyed by hopes of recapitalisation of big lenders.

'CASH MACHINES'

The small banks merger drive is part of reforms launched by Chinese authorities in 2022 to overhaul the rural banking sector and clean up struggling smaller lenders, after a series of scandals that in some cases saw depositors losing money and holding rare public protests.

Ten other small banks in the Liaoning province are set to be merged into Liaoshen Bank, established in June 2021 to absorb 12 smaller regional lenders, according to official disclosures seen by Reuters.

Highlighting the risk of the merger drive creating bigger troubled banks, Liaoshen Bank inherited large amount of soured assets from the acquisition of two smaller banks, resulting in its bad loan ratio hitting 4.67% in 2022 and 4.53% in 2023.

That's substantially higher than the 1.75% average among city commercial banks.

"The two original banks had insufficient quality assets, large high-interest liabilities... unbalanced business structure, and weak operational management," Liaoshen Bank said in its 2022 annual report, adding it's still not a 'normal bank.'

Liaoshen Bank did not respond to a request for comment.

Some rural institutions had become shareholders' "cash machines" and had strayed from their mission of supporting the agricultural sector and small businesses, the central bank said in a report released in December 2023.

"The problem is that there are so many small regional banks that the banking regulator clearly doesn't have the capacity to monitor them all," said Christopher Beddor, deputy China research director at Gavekal Dragonomics.

These consolidations will create fewer, larger institutions that regulators can supervise more effectively, he said, but the strategy would not resolve issues like bad assets and "plenty of problems" will remain.