China is intensifying its cat-and-mouse pursuit of the 4 trillion yuan ($635 billion) investment trust industry, with credit risks on the rise as economic growth slows.

The watchdog of the country's 60-strong trust investment firms, the China Banking Regulatory Commission (CBRC), has made clear its disdain for the risks that off-balance sheet lending pose to the financial system, banning trust programs focused on bank-accepted commercial paper.

But Beijing's bans are a way of life for financiers constantly looking for the loopholes in China's tightly-controlled credit markets.

Trust firms really know how to live with harsh regulation -- when one thing is banned, they can quickly find a new thing and make it big before regulators notice it, Li Yang, the chief analyst for Use Trust, a trust-focused consultancy in Chinese city of Nanchang, told Reuters.

Trust firms raise private capital fund vehicles, typically from high net worth individuals, working hand-in-hand with banks to find investors and distribute products.

Their emergence has been particularly appealing to China's big state-backed lenders who can use trust products to put deposits to work off-balance sheet, bending rather than breaking the rules on strict lending limits laid down by Beijing.

The seemingly-permanent shortage of official bank loans for the small firms that generate around 80 percent of the jobs in China, as well as negative real interest rates on bank deposits, has generated soaring demand for trust products.

Annual yields of 9 percent versus bank deposit rates of 3.5 percent and inflation that averaged 5.4 percent in 2011 have tempted a wide range of investors, even those who struggle to meet minimum investment rules of millions of yuan, designed to keep the general public out of the often risky enterprises.

Sales are possibly the easiest part of managing a trust investment firm. You just print out the brochure and clients will knock at the door, Li said.

The real tough job is to find right investment project that offers good returns.

FEAR OF FRENZY

Regulators fear a return to the experience of the late 1980s, when at the industry's peak China had more than 1,000 trust firms and a host of investment-fed asset bubbles, moral hazards and systemic risks that ultimately led to, at the time, the biggest bankruptcy in Chinese history.

The People's Bank of China, and later CBRC, clamped down aggressively. New rules from the CBRC since, such as no deposit-taking and no direct investment in property, have calmed the most unruly sector in China's financial world.

Still, trusts have boomed under the new rules.

Investment trust assets were worth 4.1 trillion yuan as the end of September 2011, up from 350 billion yuan at the end of 2006, according to figures from the China Trustee Association.

Analysts believe as much as 2 trillion yuan of credit has been extended by trusts, fuelling a shadow banking system that lends outside the scope of CBRC bank credit rules.

Regulators can't tolerate banks which run under their radar, said a trust industry official in Shanghai who declined to be identified.

Patience has been stretched to the breaking point, as January's ban on trust programs focused on bank-accepted commercial paper demonstrated.

Default risks in bank accepted commercial paper are almost zero, but regulators just can't tolerate the bank practices of taking credit off their balance sheet, Li with Use Trust said.

On the other hand, the CBRC will be acutely sensitive to the risk of cutting off regulated alternatives to bank credit as the economy slows and small firms struggle for cash.

Trust companies have a lot of smart business plans and are always one step ahead of spotting the next money making market. I don't think the CBRC is very willing to tell them what they can or can't do, but feels it has to because of the current economic environment, Hao Wang, a partner at Beijing law firm Rayyin & Partners.

ESCHEWING SCANDAL

The last thing China's top leadership will want in the run-up to a political handover later in 2012 is another Wenzhou-style scandal, where a flurry of local entrepreneurs fled into hiding last year to escape the loan sharks they'd been forced to borrow from in the face of falling credit from big banks.

Premier Wen Jiabao was ultimately forced to step in and pledge to improve credit conditions for small and medium-sized enterprises (SMEs).

The regulators know how important the shadow banking sector is in providing much needed non-bank capital funding for China's entrepreneurial SME market, said David Olsson, head of law firm Malleson's banking and finance practice in Beijing.

But there are big risks to manage, particularly in the property sector which has been a lucrative area for trusts as bank credit for property ventures has evaporated.

China International Capital Corp reckons Chinese property firms need to pay back 250 billion yuan in 2012 of an estimated 310 billion yuan owed to trust investors -- a daunting task for developers who had turned to the trusts because they were already struggling for cash.

Risks are imminent, CICC warns.

It's a delicate balance, Olsson said, and one likely to lead to more innovation.

On one hand you're seeing these measures against trust companies which seem quite strict, but on the other hand you're starting to see much more commentary about the need to have a more considered plan for the development of the financial markets, he said.

The trust companies are all looking a lot more actively at new ways to generate business. There are a lot of foreign financial institutions now working with the trust companies and there are quite a lot of discussions going on about how to bring in more international know-how to help them undertake different forms of businesses that they hadn't previously thought about.

($1 = 6.3120 Chinese yuan)

(Additional reporting by Rachel Armstrong in Singapore; Editing by Kim Coghill)