China's lenders were given notice yesterday to strengthen their internal controls and improve risk management by the nation's banking regulator.

And, in the wake of a recent spate of financial scandals, the China Banking Regulatory Commission pledged further scrutiny of bank fraud.

The commission alerted lenders yesterday to the potential risks in derivatives trading, urging them to strictly abide by the rules governing this.

The notice was published just one day after the banking regulator demanded the nation's lenders do more to watch out for potential operational risks.

This is an indication that the regulator is working hard to improve domestic banks' risk controls before foreign competitors flood into the market.

"Risk control is vital for Chinese banks at the moment," said Yi Xianrong, a senior economist at the Chinese Academy of Social Sciences.

In line with China's commitments to the World Trade Organization, foreign banks will be allowed unrestricted access to the nation's market by the end of next year.

Chinese banks are now working hard to improve their corporate governance in the face of this impending competition.

In a statement issued yesterday, the regulatory commission asked banks to improve their management of derivatives dealings and establish a sound risk-reporting mechanism.

It said that banks already granted licences to trade derivatives should start self-inspection and submit their inspection reports to the banking regulator.

Any bank trading in derivatives without a licence will be punished, with the officials involved facing legal proceedings.

The rule is a very important one for Chinese banks, which lack concrete measures to punish wrongdoers, according to Yi.

The commission also urged local regulatory bureaux to closely scrutinize local financial institutions in order to guard against irregularities and malpractice.

It also issued a 13-point circular to banks on how to improve their control of operational risks.

Instructions in the circular referred to establishing rules and regulations on risk controls, strengthening internal checks and the management of local branches, and the shifting of major officials at local financial institutions.

"Some banks' weak ability to handle operational risks failed to keep in line with the development of the banking sector," the commission said.

"Their inadequate rules, ineffective inspection and poor internal controls have already led to severe problems, causing huge losses to the banking industry."

Fraud totalling 115 million yuan (US$13.9 million) was recently uncovered by the commission at branches of the Agricultural Bank of China in Baotou, a city in the Inner Mongolia Autonomous Region in northern China.

A man who worked as a typist at the Bank of China has also been arrested and charged for fraudulently obtaining US$6 million from the State bank, now earmarked for a multi-billion-dollar public share offering.

China Construction Bank Chairman Zhang Enzhao also quit this month for "personal reasons" amid corruption allegations.

The commission said China's banks need to attach greater importance to the industry's credit risks, market risks and operational risks, as required by Basel II, the new global accord on bank capital standards.

China's banking regulators, though acknowledging the vast difficulties for local banks in complying with the new capital requirements, are eager to promote Basel II.

The commission is actively encouraging the nation's big banks to intensify their efforts to take a internal-ratings-based approach in accordance with Basel II requirements and improve their risk management.

Last Wednesday, the commission said it would carry out on-the-spot checks at 10 commercial banks to ensure they were properly classifying how risky their loans are.

The commission also demanded better computer systems to automatically detect wrongdoing and risks.