* Interbank deposits currently not subject to rate cap
* Banks want online products treated as retail deposits
* Huge outflow of bank deposits as savers move online
* PBOC would have to approve regulatory change
By Heng Xie and Gabriel Wildau
BEIJING/SHANGHAI, Feb 27 (Reuters) - The China Banking Association is lobbying regulators to cap the yields on online money market funds, two bankers told Reuters on Thursday, in the boldest effort yet by banks to answer the threat from online financial products.
If adopted by the central bank, the proposal would subject yields on online money market products to the same administrative cap that governs traditional term deposits, effectively eliminating the key competitive advantage that online products enjoy.
Bankers formulated the proposal at a meeting of the CBA on Tuesday, the sources said.
"This can be seen as the direction that the commercial banks want to move," said a senior executive at a major state-owned bank in Beijing.
"But the banking association just wants to serve as a spokesman (for the industry). (The regulation) it's hoping for can't necessarily be achieved," he said.
Since launching last June, Alibaba Group Holding Ltd's deposit-like money market fund, Yu'e Bao, has attracted 400 billion yuan ($65.3 billion) in assets under management, more than the customer deposits held by the five smallest listed Chinese banks.
Similar online products from Baidu Inc and Tencent Holdings Ltd also contributed to a fall of one trillion yuan in traditional bank deposits in January.
The interest rates on Chinese bank deposits are now subject to a cap of 10 percent above the benchmark set by the People's Bank of China (PBOC). The current benchmark is 3 percent for one-year deposits.
By comparison, the annualised yield on Yu'e Bao is 6.09 percent. Moreover, unlike bank savings deposits, investors in Yu'e Bao and similar products can withdraw cash at any time with no penalty.
Yu'e Bao and other products currently invest most of their funds in interbank deposits, which are not subject to the cap governing retail deposits.
This structure allows Alibaba to pass higher interbank yields on to customers, but it hurts bank profits by reducing their supply of low-cost deposits while increasing reliance on relatively expensive funding from the interbank market.
Despite banks' desire for regulation that would reduce the competitiveness of online products, regulators haven't yet made a final decision on how they will proceed.
"The question of whether to treat bank deposits from Yu'e Bao and similar products as interbank deposits or to begin treating them as normal (retail) deposits -- the PBOC has the final word on this," said a source close to regulators.
"Other regulatory agencies and the industry association can't do this on their own," he said.
Bankers say that the China Banking Regulatory Commission, which is separate from the PBOC, is more sympathetic to banks' concerns about online products than the PBOC.
While major regulatory changes would require PBOC approval, bankers could take some action on their own. The banking association also wants to force money market funds to pay a penalty if they withdraw interbank deposits prior to maturity.
Currently, money market funds often have informal "drawer agreements" with banks allowing the fund to withdraw cash early with no penalty if the fund needs additional cash to meet unexpected redemption demand from investors.
In case of early withdrawal, the banking association wants to ensure that banks pay out only the interest rate on demand deposits, which is lower than the rate on term deposits. That change could force money market products to offer lower yields, reducing their competitiveness.
"Paying the demand-deposit rate on early withdrawals, or assessing a penalty -- on this point the industry could act on the basis of self-discipline," said a senior executive at a mid-sized bank.