China has tightened its grip on trust companies in another bid to head-off the danger posed by the massive debt held by the country's shadow banking sector.

The China Banking Regulatory Commission (CBRC), the country's banking sector regulator, has issued stricter rules governing trust companies, which are non-bank lenders that raise funds by selling high-yielding investments called Wealth Management Products or WMPs. Trust companies use the proceeds from WMPs to fund loans to risky borrowers such as local governments, property developers and sectors commercial banks won't lend to.

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The CBRC has compared WMPs to a Ponzi scheme. It is increasingly concerned that liquidity problems with WMPs have the potential to ignite a systemic risk that could seriously damage China's banking sector.

It want trust companies to match each WMP with a specific set of underlying assets instead of pooling cash and assets from different products together into common pools.

A JPMorgan report last year said the size of China's shadow banking sector doubled between 2010 and 2012 to US $6 trillion. Analysts believe that even with continuous government efforts to stanch unregulated lending, shadow banking might have already irreparably damaged the Chinese economy.

The new CBRC rules forbid trusts from operating "fund pools," which are pools of cash and credit assets from different WMPs that trust companies and their partner banks maintain. These fund pools enable trusts to fund cash payments on maturing products with revenues derived from new WMP sales. This move seeks to reduce liquidity risks associated with off-balance-sheet WMPs.

The new rules also order trust companies to develop clear mechanisms that enable its shareholders to provide emergency support to the trust firm during volatile periods of liquidity stress.

China's policymakers, however, have encouraged the rise of non-bank lending such as WMPs to diversify China financial system dominated by large state-owned banks that have successfully resisted government efforts to get them to lend to small businesses. Shadow banking has become an important funding source for weak borrowers such as small and medium sized businesses.