Commensurate with the gloomy state of the A-share market, 10 out of the 16 listed banks have witnessed their share prices dropping below net asset values, including the big five in the banking sector—Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, China Construction Bank, and Bank of Communications.

For one thing, these big banks can rarely access financial support when in bad condition; for another, they have gradually lost favor with investors because of their focus on money encirclement rather than dividend distribution. In any case, the massive decline in the banking sector has, to some extent, mirrored public fears over a potential financial crisis in China.

Firstly, the impact of the cash crunch that occurred last June has not yet faded away. Since the end of 2013, China's monetary market has been plagued by a money shortage, which has intensified investors' anxiety regarding banks' inability to issue loans and their poor overall performance. Beyond that, there is a possibility that listed banks will bleed the stock market by launching huge refinancing projects. This is what investors fear.

In reality, most loopholes in the banking sector have their roots in the misallocation of credit and loans. Instead of bailing out the market by injecting liquidity, the central bank is supposed to attract more capital and liquidize existing capital.

Secondly, non-performing assets are overwhelmingly collapsing.

By the end of June 2013, local governments at all levels had owed 20.7 trillion yuan ($3.42 trillion) in direct debt, 2.9 trillion yuan ($479 billion) in debt for which local governments issued official guarantees, and 6.65 trillion yuan ($1.1 trillion) in debt for which local governments might shoulder some of the rescue burden.

Though local government debts are under control overall, concerns persist over repayment capacity. Most debts will expire in the following two years, indicating that a funding gap is on the cards after 2014. Even if local governments borrow new loans to repay old ones, the funding gap is inevitable after 2015.

In addition, industrial overcapacity will also contribute to bad loans. If "de-productivity" is promoted nationwide in 2014, numerous enterprises will have to undergo mergers and reorganizations, which is certain to increase the number of non-performing loans.

Thirdly, for China's banking sector, the era of explosive expansion has come to an end. On one hand, as interest rate liberalization keeps progressing, state-owned banks will stand to lose if they continue to live off the margins exploited from deposit and lending rates.

The China Banking Regulatory Commission has stepped up its oversight of shadow banking. More specifically, banks can no longer transform credit and loan into financial products, or invest them in the lucrative real estate market and government financing platforms. Banking performance is bound to take a blow.

Now, the alarm has been raised. If local government financing platforms default along with enterprises harassed by overcapacity, if real estate bubbles burst and shadow banking risks eventually break up, a financial crisis will probably surface. And then, investors will reappraise bank shares.

This is an edited excerpt of an article published in Economic Information Daily