China's city commercial banks, nicknamed 'bonsai banks' for the government prohibition on setting up branches outside their native cities, are kicking up a fuss. They want to grow.

Bank of Shanghai is one of the most high-profile city commercial banks since HSBC, International Finance Corporation and Commercial Bank of Shanghai – confusingly based in Hong Kong – each acquired stakes over the past two years.

Its profile has risen even higher since it was reported that it had tried to break out of its metropolitan straitjacket and set up a branch in the port city of Ningbo in Zhejiang province, one of the top-three wealthiest provinces in China. The branch failed to open at Chinese New Year, leading the local press to speculate the People's Bank of China (the central bank) is undecided on allowing the expansion.

City commercial banks are a distinct category on China's banking landscape, sandwiched between the massive, state-owned national commercial banks on the one hand, such as Agricultural Bank of China or ICBC, and the 10 nationwide share-holding banks on the other, such as Minsheng Bank, Huaxia Bank, China Merchants Banks, Pudong Development Bank and Shenzhen Development Bank. The big state banks have size and connections; the share-holding banks are nationwide, pioneering and flexible, and include foreign investors.

But CCBs are not permitted to grow out of the metropolitan boundaries, a situation they consider threatening. CCB executives are anxious to preempt foreign competition in 2007 and spread their wings into richer provinces such as Fujian, Zhejiang and Jiangsu. According to press reports, the banks keenest, besides Bank of Shanghai, include Tianjin City Commercial Bank, Beijing City Commercial Bank and Nanjing City Commercial Bank. They will, not doubt, be following the efforts of Bank of Shanghai to expand into Ningbo very closely.

Rumour has it expansion is taken so seriously by the Bank of Shanghai that the chairman told the team of hand-picked executives sent to open the branch in Ningbo that they were not to return to Shanghai until they had succeeded.

But CCBs suffer not just from regional mandates, but from a lack of respect from their bigger peers. The shareholding banks have been slow to grant reciprocal services to the CCBs. In 2002, for example, many CCBs started writing and honoring bankers' drafts, both for their customers and for those of other CCBs, but the shareholding banks refused to cooperate.

"The shareholding banks don't want the CCBs to become stronger and get national scope, since they are already direct competitors in the big cities," points out Wei Yen, senior credit analyst at Moody's Investors Service. "At the moment, the CCBs can't offer banking services to their customers when they go out of town, and that is a big negative."

The 111 CCBs have the same restrictions but otherwise differ in quality. Many are very small and burdened with lots of dud loans while others are as large as the shareholding banks.

CCBs were originally amalgamated from the credit societies that emerged during the early reform period of the 1980s. At that time, it was clear that the formal banking system was unable to cope with the new financing requirements of newly liberated Chinese companies. Credit societies were to help fund the myriad emerging small- to medium-sized enterprises. By 1995, there were already some 5000 credit societies in existence, but many of them were infiltrated by high-level local cadres who staffed them with family members.

The abuse of the credit societies was leading to systemic risk, and in 1998 the government set out the conditions under which the credit societies could become city commercial banks: if the number of CCBs in that area numbered over eight, if total assets came to at least Rmb800 million and if non-performing loans didn't exceed 15%. In practice, and due to necessity, the stipulation regarding NPLs was not strictly followed. Ultimately, some 2000 credit societies were absorbed into the 111 CCBs.

Bank of Shanghai rose from the merger of 100 credit societies and became one of the biggest and most profitable CCBs, with total assets last year of Rmb162 billion ($19.5 billion) and profits of Rmb880 million ($106 million). Even among the shareholding banks, only Minsheng and CMB exceed total assets of Rmb200 billion.

The CCBs' main problem is lack of economies of scale, as a southern banking official complained: "The cost of developing any new service such as a bank card can only be spread around a very limited number of branches, due to the geographical restrictions."

In response, the CCBs have been setting up alliances with one another to maximize the number of service outlets they can offer their customers. Shenzhen, Nanjing, Guiyang, Dalian, Wuhan and Hangzhou CCBs set up an alliance in 2001, as did 14 banks in the northeast of the country, offering bill discounting foreign exchange, personal finance, bank cards and corporate finance services. Last year, a further 17 banks got together with total assets of Rmb50 billion to set up a network across Shandong and adjoining provinces.

Last year Bank of Shanghai even led the establishment of a nationwide CCB clearing centre.

On the other hand, since none of the cooperation ventures involve genuine mergers and acquisitions through shares transfers, there are limits to the effectiveness of such ventures.

At the policymaking level, there is concern that the CCBs will give up their mission to finance the small enterprise sector if they go national.

But at the local level also, bank executives might find it difficult to convince their local governments to let them expand. Local government and affiliated companies often have stakes of 30% and more.

"The CCBs were invested at the startup phase by the city government and local companies, which treated them like a cash machine. That's a clear conflict of interest that needs to resolved," says Moody's Wei Yen.

If the CCBs eventually do get the go-ahead to compete across the country, it will introduce a whole new level of competition into the domestic banking sector. Alternatively, suggests Wei Yen, it could lead to a raft of mergers and acquisitions by the shareholding banks of the CCBs.

In either case, they will be making an impact.