"They (IMF executive board directors) welcomed the significant steps taken by the People's Bank of China and regulatory agencies to strengthen financial sector supervision against a background of rapid financial sector growth and deepening", said the IMF in a statement after concluding the discussion of financial system stability assessment with China.
China's big four banks had adequate capital but "large, medium, and city-commercial banks appear vulnerable", the International Monetary Fund said.
The IMF said China's growth has been supported by a financial system that is increasingly complex and lacks rigour.
A stress test on China's banks found four-fifths were vulnerable. The fund has warned of large risks and imbalances.
The IMF said the growth in credit held by companies and households had outpaced that of the wider economy and the ratio of credit to GDP was now "very high by global standards and consistent with a high probability of financial distress".
It found that Chinese banks, while meeting worldwide "Basel" targets, should gradually increase their levels of capital to provide buffers against potential losses that can be expected as credit is tightened and the assumed guarantees for investors are removed.
Chinese bank assets have increased to 300 percent of gross domestic product (GDP), and its equity and bond markets are now the second and third largest in the world, respectively.
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China's central bank said it disagreed with "a few descriptions and views" in the report. China has seen robust growth over recent years, driven by debt-financed investment and exports.
But it said it did not go along with all of the findings and that the stress tests "do not fully reflect the whole picture".
That came weeks after the Bank for International Settlements - dubbed the bank of central banks - said the banking sector could be facing an imminent blowout, raising worries about its effect on the world economy.
In some cases local banks face pressure to lend to politically important companies, as local governments aim to maintain high employment even if that means cash-bleeding enterprises continue to operate. Beijing should put less emphasis on growth, beef up regulation, and improve banks' finances, the International Monetary Fund said.
"Implicit guarantees to SOEs [state-owned enterprises] need to be removed carefully and gradually", Sahay said.
China's economy beat expectations by growing 6.9 percent in the first three quarters of the year, though several worldwide credit agencies have sounded the alarm about rising debt.
"It would be wise to have a high-level committee to monitor the risks across all sectors".