Interest rate deregulation and disintermediation, or money flowing out of bank deposits to other investment channels, will be the top challenges for the Chinese banking sector over the next one and a half years, Moody's Investors Service said Thursday.

China's banking sector has a stable outlook over the next 12 to 18 months, but asset quality will remain under pressure and profitability will decline as interest rate liberalization erodes net interest margins, Moody's said in a report.

Chinese bank's semi-annual results this year have signaled a visible deterioration in asset quality, Moody's warned.

Delinquent loans were on the rise in the first six months, "many of which will migrate to non-performing loans," Hu Bin, vice president and senior analyst at Moody's Financial Institutions Group, said at a media roundtable Thursday.

Interest rate deregulation and liberalization, which allows a wider range of fluctuation in benchmark interest rates, will lead to a narrower net interest margin (NIM) for Chinese banks as they rely on interest revenues, Hu said.

Disintermediation, or a flow of money out of banking deposits and toward other investment channels such as wealth management products, will also limit banks' ability to get more funds for lending.

The total value of wealth management products in China reached 3.3 trillion yuan ($524 billion) or 4 percent of total outstanding loans by June 2011, but the figure climbed rapidly to 8 trillion yuan by the third quarter of this year, accounting for 8.7 percent of outstanding loans, said Huang Can, general manager and rating director at China Chengxin International Credit Rating Co.

As part of an effort to make interest rates more market-driven and to encourage lending to businesses to support the economy, the central bank in June allowed commercial banks to cap their rates at 10 percent higher than the benchmark deposit rate and set a floor 30 percent lower than the benchmark lending rate in July.

The greater flexibility will depress Chinese commercial banks' net interest margin by 4 to 6 basis points in 2012 and reduce their net profits by about 28.5 billion yuan or 3 percent of the sector's net profit for 2011, according to Moody's.

The negative impact on NIM could be as much as 10 to 13 basis points and could reduce net profit by 79.6 billion yuan for 2013, the credit rating agency estimated.

The drive to maintain profitability in view of the likely compression in NIM could push the banks to increase lending to higher-risk borrowers, according to the Moody's report.

But as the slowdown in the economy is bottoming out and the export situation is improving, "asset quality issues are not as severe as (previously) expected," Hu said.