Tens of millions of people have flocked to Internet companies' wealth management products since last year, attracted by interest rates on deposits higher than those the banks offered to customers, which remain subject to a cap of 3.3 percent for one-year savings.

Individual savers have not been the traditional target market for China's commercial banks.

"If they (online financial firms) are allowed to do whatever they want for too long, the chances that something could go wrong will become bigger and the impact on the stability of financial markets will be bigger," Yang said on the sidelines of China's annual parliament meeting.

Yang went on to say that the China Banking Regulatory Commission, China Securities Regulatory Commission and the People's Bank of China are currently working on rules to regulate the nascent industry, but he was not aware of their timetable.

Chinese e-commerce giant Alibaba Group Holding Ltd (IPO-ALIB.N) kickstarted China's online finance industry with the high-yield Yu'e Bao money market fund, which has attracted 400 billion yuan in assets under management in less than eight months, more than the customer deposits held by the five smallest listed Chinese banks.

Rival Internet heavyweights Baidu Inc (BIDU.O) and Tencent Holdings Ltd (0700.HK) quickly followed suit, drawing the ire of China's banks, who are lobbying regulators to introduce curbs on the growth of online funds offered by non-banks. Yu'e Bao was dubbed a "vampire" by state broadcaster CCTV, which accused it of sucking the life out of China's banks.

Money market funds offered by Alibaba, Baidu and Tencent contributed to a fall of one trillion yuan in traditional bank deposits in January.

Non-finance specialist Internet companies offer these products online by partnering with fund companies. Alibaba has applied to invest in a 51 percent stake in Tianhong Asset Management Co Ltd, which is currently going through a regulatory approval process.

Three state-owned banks have halted interbank deposit transactions with Tianhong, citing too-high costs, the official Xinhua news agency reported on Thursday, citing an anonymous bank source.

A spokeswoman for Tianhong told Xinhua the fund makes enquiries to over 170 banks in China each day, and remains unaffected.

Yang rebuffed accusations however that Alibaba's Yu'e Bao is damaging Chinese banks' liquidity.

"Money from Yu'e Bao flows back to the banks, it has been mostly invested in negotiated deposits offered by the banks," Yang said.

"So the conclusion Yu'e Bao has hurt the liquidity of banks is not scientific."

Chinese Premier Li Keqiang threw the government's support behind online finance in his opening address to China's parliament on Wednesday but said the industry needs to be closely watched.

"We will promote the healthy development of Internet banking, improve the mechanism for coordinating financial oversight, keep a close watch on the cross-border flow of capital, and ensure that no systemic or regional financial risks occur," Li said.

Baidu Chief Executive Robin Li agreed that online finance needs greater regulation as Internet companies are not finance experts, adding that without oversight there would be risk, state news agency Xinhua reported on Monday.

In response to the success of the Internet funds, Industrial and Commercial Bank of China, Bank of China (601988.SS), Bank of Communications (601328.SS) and Ping An Bank (000001.SZ) have all launched new products in recent weeks that match the attractive features of Yu'e Bao.

ICBC has also fought back by limiting its depositors monthly transfers to Alipay to 50,000 yuan per month. Last month 12 Chinese banks imposed transfer limits on Tencent's Licaitong wealth management

(Reporting by Fang Yan and Paul Carsten, Editing by Angus MacSwan)

Stocks treated in this article : Baidu Inc (ADR), Tencent Holdings Ltd