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* Run on rural co-op as depositors rush to withdraw cash
* Funds meant for farm loans shifted to real estate
* Co-ops lightly regulated to encourage innovation
* Farmers' co-ops became platform for grey-market lending
By Gabriel Wildau
YANCHENG, China, March 6 (Reuters) - Depositors wanting to withdraw money from a rural bank in eastern China's prosperous Jiangsu province ahead of the Lunar New Year holiday found the doors locked, their money gone and employees offering a simple explanation.
"We've lent out all the money. There's none left," an employee told Reuters, repeating the explanation given to depositors weeks earlier.
In the run-up to the holiday in late January, word had spread that at least three rural cooperatives were running short on funds. In what the local government described as a "panic", depositors rushed to withdraw cash. Local officials say several co-op bosses fled after committing fraud.
Though the incident is modest, it highlights the risk that financial liberalisation intended to channel more credit to farmers and others who struggle to access loans from big state banks could open regulatory loopholes that enable a surge in risky lending.
"The core problem is, after using this (co-op) structure to raise funds, effective regulation is lacking," said Chen Ping, director of the Farmers' Credit Co-operative Union, an association of researchers studying rural co-ops.
"Actually a large amount of funding has been shifted into large-scale projects like real estate."
Depositors would normally be protected by China's banking regulator, which requires lenders to keep a certain amount of cash on reserve to meet depositor demand.
But as participants in a pilot programme, the depositors quickly woke up to an unpleasant reality: so-called "Farmers' Mutual Help Funding Cooperatives" aren't technically banks. Not only did they not have sufficient reserves on hand, they weren't legally required to.
Officials in Yancheng city told state media that the situation would be resolved before the holiday, but Reuters found on a recent trip that two of at least three co-ops that closed their doors before the holiday remain locked.
On the city's semi-rural outskirts, the offices of the Yancheng Environmental Protection Industrial Park co-op appear to have been abandoned in haste. The lobby, visible behind padlocked glass doors, was strewn with trash.
In an emailed statement, the propaganda department of Tinghu district in Yancheng told Reuters that 18.3 million yuan ($3 million) had been returned to depositors of three troubled co-ops before the Lunar New Year. That compares with 80 million yuan that state media previously reported had gone missing.
"The related departments of Tinghu district and the co-ops are working together to take effective measures and actively raising funds to ensure the timely payment of funds to depositors," the department said in an unsigned statement.
Farmers' co-ops began appearing in Jiangsu province around 2006, after the Communist Party issued guidelines encouraging the establishment of innovative rural financial institutions as part of a broader "New Socialist Countryside" campaign.
But, like many such policy statements, the document was vague, setting out broad goals for rural development while leaving specific agencies to fill in the details.
The government was content to allow co-ops to operate with minimal supervision because, at least in principal, they are membership institutions, not banks. Only members who have paid into the co-ops could get loans, and members assumed the risks from lending to one another.
Rather than the China Banking Regulatory Commission (CBRC), local agriculture affairs offices, with little experience of financial regulation, were tasked with supervising farmers' co-ops.
"These institutions didn't impinge upon the interests of the general public, so they could be lightly regulated," said He Guangwen, professor at the College of Economics and Management at China Agricultural University.
The idea was to allow farmers who knew one another to co-operate on financing as well as work together on production. And because each loan would be small, the co-op's overall portfolio would be diversified, preventing isolated defaults from bringing down the whole co-op.
By the middle of last year, 137 such co-ops had been established in Yancheng, with total membership reaching 170,000, deposits of 2.3 billion yuan, and total loans outstanding of 1.9 billion yuan, according to figures cited by official media.
But in practice, many co-ops shifted into riskier forms of lending. Jiangsu, along with neighbouring Fujian province, is known for its vibrant grey-market lending networks, serving small factory owners and real estate developers who often cannot obtain bank loans.
Informal lending generally occurs through family and friends, but the rise of farmers' co-ops created a platform for informal lenders to scale up their operations by collecting funds in a bank-like setting.
"The revelations of problems in Yancheng is mainly because the institutions aren't standardised and regulation isn't in place," said He. "In China, lots of institutions exist calling themselves (farmers co-ops), but few are actually based on agricultural co-operation and sharing funds between members. Most have undergone mission creep."
Despite the problems, the government is pushing further expansion of co-ops.
In January, China's cabinet issued new guidelines on rural reform that called for expanding the co-op system based on "maintaining the membership system, the principle of closure, and restricting deposit-taking and loans to members".
At the same time, the government is pushing other financial reforms designed to expand credit to under-served groups. The internet-based peer-to-peer (P2P) lending, micro-lending institutions, and privately-owned banks are among the initiatives the government is supporting.
Yet there are already signs that the problems afflicting co-ops in Yancheng may also affect other forms of non-bank lending. Local media have reported that dozens of P2P lending firms, which operate fee-based platforms to connect lenders with borrowers, have gone bankrupt in recent months.
"The truth is that a lot of burgeoning P2P platforms in China have no basic risk diversification, not to mention risk management," Liang Xiaozhong, CBRC deputy director, wrote on the Financial Times website last week. ($1 = 6.1462 Chinese Yuan) (Additional reporting by Shanghai newsroom; Editing by Ian Geoghegan and Alex Richardson)