The nasty cash squeeze that has bitten the mainland's banking system in recent weeks could be just a preview of greater instability to come if Beijing pushes ahead with liberalising interest rates and capital controls. A spike in the interest rates that banks charge for lending to one another sent stocks falling last month and raised the spectre of bank runs as reports circulated about automated teller machines with no cash and electronic payments that failed to clear. But further progress towards deregulation of interest and exchange rates will only increase the challenge for mainland banks in managing risk, analysts say. Yukon Huang, a former World Bank country director for China and a senior associate at the Carnegie Endowment for International Peace, said: "The recent instability reflects some of the risks with interest rate liberalisation that proceeds too rapidly, or more precisely relying excessively on interest rates to achieve objectives." The State Council has said it wants to push interest rate liberalisation, and the central bank made a move towards that goal in June last year when it granted commercial banks limited flexibility to vary deposit rates. One reason that freeing up interest rates could lead to instability is that such a move would unleash fierce competition between banks for customer deposits. Markus Rodlauer, a deputy director of the Asia and Pacific Department at the International Monetary Fund, said at a panel discussion in Shanghai on Saturday: "One has to be very careful and think about what do we do with banks if they become overly aggressive? What do we do with banks that compete themselves into losses?" Last month's crunch, which saw interbank lending rates on the mainland soar to record levels on June 20, was engineered by the central bank, which declined to inject liquidity into the market in a blunt signal to lenders to rein in risky credit growth. The resulting turmoil, which rippled across financial markets, sending emerging market equities and currencies reeling, was reminiscent of the onset of the global financial crisis in 2008, when money markets froze as banks stopped lending to each other amid fears that many were overextended. The rise of so-called wealth management products, which banks on the mainland market to customers as a higher-yielding alternative to traditional bank deposits, has already increased banks' liquidity risk. Wealth product funds are less "sticky" than old-fashioned deposits because investors frequently shift between banks in search of the highest returns. Banks also face liquidity risks due to the mismatch between the short maturity of wealth management products and the longer-term underlying assets. Cash rates spiked last month in part because banks were borrowing in the wholesale market to finance payouts on maturing wealth products. Yet the struggles already facing some banks in managing these risks is only a taste of the much more brutal competition that lies ahead. Outstanding wealth management products reached 8.2 trillion yuan (HK$10.3 trillion) at the end of March, the mainland's chief banking regulator said on Saturday. While such products barely existed five years ago, the current total still represents only 8 per cent of all mainland bank deposits. Lifting the cap on deposit interest rates could open up the mainland's entire 99 trillion yuan stock of bank deposits to similar competition. Huang Jinlao, a vice-president of Hua Xia Bank, a mid-sized lender, wrote in a commentary on the website of Caixin , a respected financial magazine, in April: "Liberalising interest rates now will inevitably cause deposit interest rates to soar. "Banking institutions may take on excess risk under the pressure of narrowing interest spreads. This could trigger a financial crisis." Some market watchers take a more sanguine view. Jimmy Leung, the lead partner for banking and capital markets at PricewaterhouseCoopers China, says banks are not only competing with each other, but also with the mainland's vast informal lending sector. "If we liberalise interest rates more aggressively, the banking sector would actually attract more money from the shadow banking system, or from individuals, to go into the formal banking system, because interest rates would rise, attracting more deposits," he said. Interest-rate liberalisation could threaten individual banks, but as long as strict capital controls remain in place, most funds will remain locked inside the country, making a system-wide crisis unlikely.