The earnings prospects of Chinese commercial banks are clouded by their excessive reliance on interest income and sub-standard internal controls, top domestic and overseas bankers said on Saturday.

Local banks have seen notable improvement in profitability and asset quality in the past few years, partly due to China's 10 percent a year economic growth and a fat interest margin granted by the government, they told a banking forum here.

But their earnings are largely driven by corporate loan growth, making them more vulnerable to economic downturn, rather than by retail banking that generates fee income and is a core revenue source of many overseas banks, they said.

Deputy central bank governor Wu Xiaoling said state banks, such as the Industrial and Commercial Bank of China (ICBC) and China Construction Bank, were facing head-on competition from other local banks and foreign players.

State banks are meeting a fierce fight in the domestic retail banking market. They are beginning to lose market share, she said.

The competition is set to intensify as foreign banks were just allowed to conduct full-fledged local currency business in China under World Trade Organisation rules, bankers said.

Most Chinese banks derive 9-10 percent of their revenues from fees for products and services, compared with over 50 percent for some international banks such as JP Morgan, Wu said.

The biggest challenge faced by China's banking industry is whether they can sustain their earnings growth, said Zhu Min, group executive vice president and chief financial officer for Bank of China, a major state-run bank.

Bank of China, ICBC and China Construction Bank posted 18-38 percent year on year growth in their 2006 after-tax profits attributable to shareholders, according to Wu, on the back of surging loan growth.

They are among the world's largest commercial lenders in terms of market capitalisation, thanks to rises in their stock prices, although they still lag far behind their peers in terms of return on assets and return on equity, bankers say.

But if China's economy slowed down sharply, its banks would be hit hard, bankers said.

Stephen Roach, chairman of Morgan Stanley in Asia, said China needed to cut its reliance on the banking system for economic growth, and one solution is to greatly expand its capital market.

Roach said China's economic growth is unbalanced, unstable, uncoordinated and unsustainable because it comes mainly from exports and fixed asset investment rather than consumption.

Bankers also say state banks still have huge room to improve their governance. They identified problems such as inadequate risk controls, bureaucracy and weak boards of directors.

Chinese banks have been hit by a series of scandals such as embezzlement and fraud in recent years, although most have reported higher capital adequacy and lower non-performing ratio.

The Bank of China said on Monday a review of its financial accounts at the end of 2005 by the country's auditing watchdog uncovered a series of irregularities.

The biggest challenge faced by Chinese banks remains corporate governance, Wang Jun, senior financial specialist for World Bank, said, adding that he found some banks were cutting the number of risk control staff just to cut costs.