China's mid-sized and smaller banks accounted for half of the trading value in the interbank market in each of the three quarters ended June, data from the China Foreign Exchange Trade System (CFETS) shows.

China's top four banks, including Agricultural Bank of China and Industrial and Commercial Bank of China, accounted for less than 20 percent even though they own 40 percent of China's $26 trillion (19.48 trillion pounds) in banking assets. Brokers and securities firms made up the rest.

While the larger commercial banks mainly use customer deposits - a stable and long-term funding source - to make loans, over the past year smaller Chinese lenders have been aggressively borrowing from local rivals to raise funds for investments and risky but lucrative shadow-bank loans.

Many of the banks classify the shadow-bank loans as investments to minimise the impact on their bank capital buffers.

"A lot of the credit is going into financial asset purchases. So the creditor is unfortunately being used to fund an investment," said Julian Evans-Pritchard, China economist at Capital Economics in Singapore.

If some of those bets turn bad and the small banks are faced with a liquidity crisis, the problem would reverberate across a banking system already concerned with the highest level of non-performing loans since the global financial crisis and a deterioration in asset quality.

"The smaller banks look more vulnerable at the moment. They have poured a lot of money into shadow banking sector where ... operating conditions have become tougher for a lot of firms," Evans-Pritchard said.

Although the smaller banks are not classified as systemic - able to bring down the entire banking system if they fail - some are quite large. For instance, China Minsheng Banking Corp, with a stock-market value of $49 billion and total assets of more than $793 billion, is bigger than Standard Chartered Plc.

Ninety-seven percent of the value of interbank trading was in overnight or seven-day funds in each of the last three quarters, CFETS data shows.

Citing figures from the People's Bank of China (PBOC), Moody's ratings agency said small and medium-sized banks had increased their reliance on interbank funding to 10.4 percent and 10.9 percent of their total funding respectively in the first two months of this year from 9 percent and 9.4 percent a year earlier.

Analysts said the concern is that a large portion of this debt is being used to increase investments, including shadow loans.

China Everbright Bank, for instance, boosted total investments in the first-half of 2016 by 39 percent from the end of 2015 to 1.3 trillion yuan ($194.70 billion) - roughly the same as Portugal's 2015 GDP. Its loan growth was 12.3 percent.

Its deposits from banks and financial institutions through interbank lending rose 33 percent, while customer deposits rose 9.2 percent, the filings showed.

China Everbright Bank did not publish a breakdown of the source of funding for its investments. It did not respond to a request for comment.

CENTRAL BANK DILEMMA

Traders said concern about the reliance on short-term funds prompted the central bank last month to push banks for the first time since February towards the use of the longer-dated and more expensive 14-day reverse repurchase agreements.

"The short-term cost of capital will be affected if the expectation of the future of this policy remains unchanged," a treasury department official at a mid-sized bank said, referring to the central bank's money-market operations.

A permanent rise in interbank interest rates would raise the banks' cost of funding and squeeze profit margins, which in turn would hurt their bottom line at a time when they are already under pressure from shrinking capital buffers and net interest margins.

Greater use of interbank lending makes banks more reliant on one another and more sensitive to counterparty risk, which in turn increases the threat of contagion if a bank fails, Moody's said in a report last month.

"We are going to be in a situation where Chinese banks just refuse outright to finance each other through this interbank lending market," said Patrick Chovanec, managing director and chief strategist at New York-based Silvercrest Asset Management.

"So, the pressure goes right back on to the PBOC."

While the central bank wants to guide banks away from an over reliance on very short-term borrowings, it is also wary of the potential for a credit crunch, so it has been injecting cash into money markets via seven-day reverse bond repurchase agreements in the last few days.

"The intention is not to cause a liquidity shock ... but they also want to start reigning in these (leverage) risks. What we are seeing now is the PBOC trying to smooth over the process," said Jonas Short, head of NSBO Policy Research in Beijing.

(Reporting by Sumeet Chatterjee; Additional reporting by Engen Tham: Editing by Lisa Jucca and Neil Fullick)

By Sumeet Chatterjee