* Rules pave way for sale of new hybrid capital instruments
* Banks need funds to meet Basel III capital adequacy standards
* No equity conversion provisions allowed for publicly issued shares
* Strict disclosure requirements
SHANGHAI, April 18 China published detailed rules on commercial bank issuance of preferred shares on Friday, paving the way for lenders to begin fundraising designed to enable them to withstand an expected rise in bad loans.
Chinese banks are facing pressure to raise funds after the banking regulator began phasing in stricter capital adequacy requirements last year in line with global rules on bank capital known as Basel III.
Preferred shares are a form of hybrid security with characteristics of debt and equity. They enjoy seniority over common stockholders in the event of bankruptcy, but in other respects they have limited impact on common shareholders.
Such shares typically don't trade on the open market, carry no voting rights, and do not dilute net profits attributable to shareholders.
Stock market investors have been eagerly anticipating their introduction, hoping they will allow listed companies to raise necessary funds from stock markets with minimal dilution on equity valuations.
The need for capital among banks is especially acute. Regulators are implementing Basel III aggressively in order to fortify banks against losses on bad loans as the economy slows.
China's bad loan ratio hit a two-year high at the end of 2013. Data released this week showed the economy growing at its slowest pace in 18 months.
China's largest banks must meet a Tier-1 capital adequacy ratio of 7.9 percent by end-2014 and 9.5 percent by end-2018. Preferred shares will count as additional Tier-1 capital.
In order to protect the interests of ordinary investors, preferred shares issued to the public must not contain provisions that allow preferred shares to be converted to common equity, under the guidelines published on the China Securities Regulatory Commission's (CSRC) Twitter-like micro-blog.
In private placements, however, preferred shares must include such provisions, which force conversion of preferred shares when the bank's financial condition deteriorates, the guidelines said.
Commercial banks applying to sell preferred shares must already have a core capital adequacy ratio above the minimum standard, according to the guidelines published jointly by the banking and stock regulators.
China's State Council, the country's cabinet, gave the green light for issuance of preferred shares in China for the first time last November.
The CSRC followed through by issuing rules for the pilot programme in March, paving the way for the long-awaited scheme to be launched. While the CSRC's previous rules also applied to non-financial companies, the latest ones are specific to banks.
Friday's guidelines are issued to "help banks to expand their channels to supplement their capital," a CSRC spokesman said in a separate statement also published on the regulator's micro-blog.
Preferred shares will also help relieve the pressure on the Chinese stock market from large-scale rights issues by allowing banks to issue shares that will not be publicly traded, the spokesman said.
The guidelines also clarified procedures for banks to apply to issue preferred shares. Banks must first apply to the China Banking Regulatory Commission (CBRC), then the CSRC.
Banks will also be subject to strict information disclosure requirements. They will have to disclose any changes in the scale of their preferred share issuance plans, as well as changes to the fixed dividend.
In addition to preferred shares, regulators are also encouraging banks to raise regulatory capital through the sale of special subordinate bonds -- known as "Basel bonds" -- that contain provisions allowing them to be written off or converted to common equity if a bank is in financial distress.
(Reporting by Lu Jianxin and Gabriel Wildau; Editing by Jacqueline Wong)