The moves, coming separately from the People's Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC), form part a campaign to clean up China's financial system as it opens up domestic capital markets to diversify funding options for cash-strapped firms in the world's No 2 economy.

Two sources close to the CBRC said China's big four managers of bad loans - so-called asset management companies (AMCs) - will be banned from lending directly to investment trust companies under the pretext of acquiring bad debt.

Meanwhile, continuing a clampdown on the corporate bill that began in 2011, the PBOC will, from next year, stop bankers acceptances and similar products from being used to camouflage off-balance-sheet lending to firms, sources with direct knowledge of the situation said.

Trade in commercial bills began to cause concerns in Beijing when the economy showed signs of overheating on a flood of cheap credit in 2010 and issuance of such notes exploded.

Neither the CBRC nor the PBOC provided comment on their plans when contacted by Reuters.

The initiatives could provide reassurance that Beijing is serious about rooting out hidden risks that investors fear lurk in a financial system dominated by state-controlled banks and government-backed business.

For years, China has shuffled bad debt that was run up by big state firms between state banks, other state companies and the government in labyrinthine deals that hid the cost of bad banking, and shielded un-viable state enterprises from bankruptcies.

These losses lurk in the system unaccounted for, tarring banks' and China's fiscal health, and frustrating potential investors who say Beijing quashed the bad debt market by refusing to sell dud loans openly to protect state firms from creditors.

The new rules take aim at two key areas - real estate and lending to China's biggest, mainly state-backed, firms.

"Right now, asset management companies are focusing their main acquisitions among property trusts," one of the sources with knowledge of the CBRC plan said.

"The new rules are obviously targeting areas in the property trust sector vulnerable to problems," added the source, who is not authorized to talk to the media.

Property trusts absorb nearly 13 percent of China's total trust investment and have been pressured in the past year as falling home sales strain developers' ability to repay loans.

Some developers have sold land or half-finished projects held as collateral with trusts to repay debts, with the four AMCs emerging as buyers, Chinese media have reported.

That raises the risk of collateral being pledged twice, or that developer simply uses land to raise fresh loans to fund another unviable project.

Chinese trusts are essentially private capital funds that get money from rich individuals and wealth management arms of Chinese banks on the hunt for lucrative investments.

They had 5.5 trillion yuan ($864 billion) of assets as of the end of June, and had 5.3 trillion yuan of cash to invest, data from the China Trustee Association showed.

PROPERTY TRUST BOOM

Property trusts have boomed in the past two years after Beijing banned real estate developers from borrowing from banks, or raising money in public capital markets in an attempt to dampen record rises in house prices.

Meanwhile the target of the new PBOC rules is the trade in vaguely endorsed, repeatedly discounted corporate bills, which change hands in an intermediate market of "bridge institutions" that regulators fear impair transparency in the financial system.

These bills are notes from a firm instructing a bank to pay a specific sum to a third party payee on a particular date. But if the payee needs the money earlier, it can cash the bill early for a discount - either at the same bank or a different one.

The discounted bill is recorded on the bank's balance sheet, but Chinese banks that wish to decrease the amount of loans that appear on their balance sheets may use repurchase agreements with domestic brokerages, trust firms, wealth management products or rural credit cooperatives to temporarily erase the asset from their balance sheets in order to avoid breaching loan-to-deposit ratios or other lending restrictions.

According to PBOC data, undiscounted corporate bankers acceptance notes increased by 608.9 billion yuan ($95.65 billion)in the first half of 2012, on track to match or exceed the 1.02 trillion yuan increase China posted in 2011.

CLOSING LOOPHOLES

The latest proposed regulations would address highly technical aspects of the corporate bill trade, related to how such instruments are endorsed and resold, but the result would close another loophole for banks attempting to use commercial bills to hide lending, a trader at an Asian bank said.

At the same time, it also appears the rules will make it even more difficult for mutual funds and brokerages to participate in the corporate bill market, sources said.

"The central bank is preparing to hold a training session in Guangxi by the end of the month, and if the revision of the document requesting suggestions goes smoothly, the rules should be implemented next year," a source close to the situation told Reuters.

The last time Beijing cleaned up its banks and rescued them from bankruptcy, it took three broad waves starting in 1998 and ending in 2005, required huge capital injections and bad loan transfers to specially created asset management companies.

The four loan managers are China Cinda Asset Management Corp., Orient Asset Management, Great Wall Asset Management and Huarong Asset Management. They were set up in 1999 to remove about 1.4 trillion yuan of bad debt from China's top four banks.

The Bank for International Settlements estimates 20-24 percent of 2004 GDP was pumped into the banking system, in one of the biggest bank rescues in history.

China's Premier Wen Jiabao says he wants to break the lending monopoly that state-controlled banks enjoy, bringing private capital into carefully policed markets away from unregulated, underground lending that the PBOC estimates was worth 2.4 trillion yuan as at the end of March 2010.

(Reporting by Zhao Hongmei, Aileen Wang and Koh Gui Qing in Beijing and Hongwei Li and Pete Sweeney in Shanghai; Writing by Nick Edwards; Editing by Simon Cameron-Moore)

• A Permanent Economic Emergency