* Public criticism of bank profits puts execs on back foot
* Commercial banks defend interest rate regime
* Chinese banks don't depend on regulated rates - ICBC
* Freeing rates may disintegrate into a free-for-all - BOC
* Smaller banks hardest hit by any change
By Kelvin Soh and Koh Gui Qing
BEIJING, March 15 (Reuters) - Public anger about soaring profits at Chinese banks has strengthened calls to address the country's interest rate regime, forcing bank executives to defend the regulated deposit and lending terms that have helped them reap mega profits.
Some delegates attending China's rubber stamp annual parliamentary meetings in Beijing over the past two weeks openly criticised rising bank profits, taking a public stand that is rare for the country's normally docile legislature.
Critics include Wu Xiaoling, a former deputy head of the People's Bank of China, which has long promised to speed up rate reforms, who called the banks' profits "unreasonable" in today's economic climate.
Many blame Beijing's interest rate policy, which puts a ceiling on the interest rates banks can pay to attract deposits and sets a floor on lending rates, ensuring a healthy interest rate spread that is currently hovering around 270 basis points.
The government has for years talked about freeing up rates to let banks compete without restraint, but has so far failed to act, in part due to fears that the banks -- bailed out for about 4 trillion yuan ($630 billion) in the early 2000s -- may succumb to the pressure of free competition.
The rising tide of criticism, however, has put top Chinese bankers on the defensive. Net profits at China's four biggest banks leapt between 28 percent and 45 percent in the first-half of 2011 to a total 336 billion yuan ($53 billion).
Yang Kaisheng, the president of the world's biggest and most profitable bank, ICBC, said banks did not enjoy any discernible advantage because of the country's regulated rate regime.
"Chinese banks' net interest margins are actually low when compared to other markets where rates are liberalised," Yang said on the sidelines of the parliamentary meeting. "To suggest that Chinese banks depend on a wide interest margin to drive earnings growth doesn't conform with reality."
Generally, bank executives worry that free competition would drive up deposit rates and crimp banks' profits by forcing them to pay more to woo savers.
Bank of China Chairman Xiao Gang told reporters that any hasty lifting of deposit rates could spur overly aggressive competition for deposits, which would in turn push up funding costs in the country.
"China has been working on interest rate liberalization for the past 20-30 years, and it won't just decide one day that it'll suddenly become a free-for-all," Xiao said.
Chinese bankers point to the United States to bolster their argument, where U.S. Federal Reserve numbers show that U.S. lenders have a wider net interest margin than their Chinese peers, coming it about 315 basis points as of the end of 2011.
However, analysts note that U.S. banks typically securitise many of their top-quality loans, taking them off balance sheet by selling them to investors in the secondary market.
This leaves higher-yielding unsecured loans such as credit cards or credit facilities on their balance sheets, which artificially boosts their net interest margin figures.
At the same time, the high level of funds that Chinese commercial banks must place in low yielding reserves with the central bank -- currently at 20.5 percent -- leads to an artificial narrowing of their net interest margins, said Patrick Pong, an analyst at Mirae Asset Management in Hong Kong.
Any liberalisation would be especially severe for smaller banks that cannot compete against the extensive branch networks of China's giant state banks and rely on paying higher deposit rates to draw customers.
Most small- and mid-sized banks in China already have loan-to-deposit ratios (LDR) that are close to the regulatory limit of 75 percent, while large state-owned banks such as ICBC have reported numbers of about 65 percent.
"The worst hit will likely be the smaller banks," said Mirae's Pong.
"Most of these banks have already hit the limits to their lending, so the only way to grow loans is to acquire more deposits, which may lead to cut-throat price competition on deposits."
Well aware of the threat, executives at smaller banks were busy doing the rounds at China's parliament, talking about the dangers of changing the regime too quickly.
"Interest rate liberalisation needs to be a slow and gradual process," cautioned Ma Weihua, chairman at mid-sized China Merchants Bank, whose LDR is just below 75 percent.
Other mid-sized banks all report similar numbers, with lenders such as Shenzhen Development Bank and Shanghai Pudong Development Bank all reporting LDRs of about 70 percent.
But for those who blame high net interest margins at Chinese banks for the past years of high earnings, a liberalised regime might yield some surprises.
Banks in countries that moved from a regulated to free interest rate regime have mostly been able to transfer the higher cost of funding to borrowers, said Mike Werner, an analyst at Sanford Bernstein in Hong Kong.
Japan, which freed up deposit rates in its banks around 1979, saw net interest margin remain largely stable for most of the 1980s until the country's own asset bubble popped late that decade.
"What happens is that demand from the state-owned companies will decline," Werner said. "Small- and medium-sized enterprises will step in, but their higher risk profile means higher borrowing rates, which may drive up profits."
Banks could even take advantage of a change in interest rates in a system which still faced other shortcomings to increase their profits, said Jim Antos, an analyst at Mizuho Securities in Hong Kong.
"The only way banks don't make more money is if you change something else. You have to have risk-based pricing and you have to have a logical credit rating system and a logical credit provision costing."