Hu Xiaolian, vice-governor of the central bank, said last month that what troubles the authorities most is that promoting rate liberalization will endanger small lenders at the township level and put them on the edge of bankruptcy, which will take tolls on depositors if a deposit insurance system has not yet been established.

"Rising competition would make them raise deposit rates and increase costs. To guarantee enough profit, these lenders will probably charge more for loans - and risks will surge," she said.

By the end of June, 17 regional banks had increased the rates paid on deposits with maturities of more than 2 years to 1.1 times the benchmark rates. Large State-owned lenders applied higher-than-benchmark rates only to 1-year deposits.

After this round of rate hikes, net interest income in the banking industry will evaporate at least 140 billion yuan during the year, said Guo Tianyong, banking research director at the Central University of Finance and Economics.

The government should establish a deposit insurance system to protect depositors' interests and improve the proportion of direct financing to total financing to make the whole market less dependent on regulated interest rates, he said.

At present, lending takes up more than 75 percent of financing in China.

Lu Zhengwei, chief economist at the Industrial Bank Co, said the establishment of a deposit insurance system is not a necessary precondition for a further freeing of rates.

"Such a system means government backup would not exist for most lenders. Fearing a loss of their deposits when rates are freely set, depositors would move their money to State-owned banks because the authorities always underwrite them."

He said a priority should be put on banks to run universal businesses, which is crucial for avoiding the bankruptcy of financial institutions after competition gets fiercer.

Deregulation of the financial market must be put ahead of interest rates and currency liberalization, said Yin Jianfeng, deputy director of the Institute of Finance and Banking at the Chinese Academy of Social Sciences.

"Without sufficient and market-based development of domestic financial institutions, it would be dangerous to free rates first," Yin said.

He said that if banks were unable to develop their business freely when interest rates are liberalized, they will have to spur lending to real estate to guarantee their profits, which will worsen asset bubbles across the country.

But Yang Zaiping, executive vice-president of the banking association, said financial deregulation should not go forward with a "big bang" approach, which would worsen the vicious competition among banks.

"The authorities should give financial institutions sufficient buffer time to adjust their balance and income structure, and to gradually establish a pricing and risk management mechanism," Yang said.

The association said the government should allow Shanghai Interbank Offered Rate, or Shibor, to play a dominant role in determining market interest rates and to make the pricing system more reasonable and orderly.

"But one problem is that most Shibor rates are for one year and cannot reflect middle and long-term rates," it said.

"If Beijing really wants to liberalize rates without causing problems, some supporting policies are needed, such as securitizing bank assets and broadening the definition of capital to alleviate the capital tension of lenders," Li Daokui said.