The latent risk embedded in the massive loans borrowed by local government-backed investment entities might dampen the profitability of China's banking sector by 7.9 percent between 2010 and 2012, a government think tank report said.

The 2010 Blue Book for China Finance, the annual report on China's financial development compiled by the Chinese Academy of Social Sciences (CASS), forecast that Chinese banks would need to set aside 283.1 billion yuan ($41.6 billion) as bad loan provisions over the next two years, which may reduce Chinese lenders' net profit.

The forecast was based on the projection that the bad loan ratio for lending to local financing vehicles will climb to 3.36 percent, with 13.46 percent of loans being in the special attention category by 2013.

"Loans extended to local financing vehicles, which is implicitly backed by the unstable fiscal revenue of local governments, accounted for about 10 percent of the total lending extended by listed Chinese lenders at the end of 2009," the report said.

After China unveiled a giant 4 trillion yuan stimulus package amid the financial crisis in November 2008, a big chunk of the record 9.6 trillion yuan in bank lending was directed to thousands of local financing vehicles, set up by local governments to fund public works nationwide.

With mounting worries over rising local government debts, policymakers are now concerned that such infrastructure loans could be a possible Achilles heel for Chinese banks, causing a new round of government bailouts for the banking sector.

China Development Bank, the nation's State-run lender for public works, bears the highest exposure to such loans, accounting for 69 percent of its total loan portfolio, the report said.

The China Banking Regulatory Commission estimated that outstanding loans to 8,221 funding vehicles set up by local governments jumped to 7.38 trillion yuan by the end of 2009, up 70 percent from a year earlier.

"The government is facing a dilemma in dealing with local government debts. If the government suspends giving follow-up funds to local projects, it may lead to an earlier-than-expected 'hard landing' for the economy," said Liu Yuhui, fellow researcher at the Institute of Finance and Banking of the CASS and co-author of the report.

"But if the government lets this situation carry on, risks will continue to accumulate and may lead to greater problems in the future," he said.

The report suggested that it is necessary for the country to fully assess the debt repayment ability of local government projects, and allow local governments to issue bonds directly to raise funds for local infrastructure projects.