China must "tackle" shadow banking, particularly the short term investment vehicles known as wealth management products, Xiao Gang, the chairman of the board of Bank of China (601988.SS), one of the top four state-owned banks, wrote in an op-ed in the English-language China Daily on Friday.

"Unsurprisingly, although Chinese banks' non-performing loans are at a low level of 0.9 percent, the potential risks are worse than the official data suggest," Xiao wrote, adding that a problem could come as indebted borrowers face cash flow problems or enter default, straining the banking system.

"The music may stop when investors lose confidence and reduce their buying or withdraw from WMPs," he said, referring to wealth management products.

He warned of a mismatch between short-term products and the longer underlying projects they fund, adding that in some cases the products are not tied to any specific project and that in others new products may be issued to pay off maturing products and avoid a liquidity squeeze.

"To some extent, this is fundamentally a Ponzi scheme."

Xiao's op-ed is in line with similar warnings issued by outsiders, particularly the Fitch Ratings agency whose China banking analyst Charlene Chu has long warned of a maturity mis-match and the threat to the Chinese banking system of products with various terms and interest rates.

But it is rare for a senior Chinese official to acknowledge the extent of the problem.

"It is uncommon to find wealth management products that fail to clearly specify the underlying securitized assets," an official from the China Banking Regulatory Commission, which oversees financial products, told Reuters in August in response to a query on the underlying assets.

NEW FUNDING TOOL

Wealth management projects, which are technically off-book, have grown to account for about a fifth of all new financing in China. They fund projects, such as property development or infrastructure, that have trouble tapping normal loan channels.

Their growth has been spurred by credit curbs meant to rein in speculative property investment and by investors' desire for higher yields than traditional bank deposits, which often offer negative real interest rates. More than 20,000 of such products are in circulation, up from just a few hundred five years ago.

Although the products are technically more risky than deposits, most investors believe they are backed by the banks' implicit guarantee and they are marketed aggressively in bank branches nationwide. Xiao acknowledged this perception posed a risk for banks' bottom line.

"The rollover of a large share of WMPs could weigh heavily on formal banks' reputations, because many investors firmly believe that banks won't close down and they can always get their money back," Xiao said.

In June, People's Bank of China vice governor Liu Shiyu said many banks are not transparent enough about the risks wealth management products carry.

"China's shadow banking system is complex, with a close yet opaque relationship to the regular banking system and the real economy," Xiao concluded by saying.

"It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless."

(Reporting By China Economics Team, Editing by Lucy Hornby and Jacqueline Wong)

• A Permanent Economic Emergency