China is preparing to conduct its first-ever stress test on the brokerage industry this year to ward off potential risks arising from a possible deterioration in the economic or market environment, three sources with direct knowledge of the plans told Reuters.

China's securities watchdog has already urged select brokerages including China International Capital Corp (CICC) to conduct a pilot test, and the programme is expected to be launched industry-wide in the second half, said the sources, who declined to be identified because the information is not public.

The planned stress tests by the China Securities Regulatory Commission (CSRC) come at a time when Beijing is walking a tightrope in taming inflation without hitting the brakes on growth too hard, but some analysts said the move had little to do with current economic difficulties or market sluggishness.

Instead, it was part of broader efforts to improve risk management in the financial sector, following similar moves by the banking regulator in the past few years, they said.

A CSRC spokesman was not immediately available for comment.

The importance of stress tests is rising as Chinese brokerages are conducting more and more innovative businesses such as index futures, said Liang Jing, analyst at Guotai Junan Securities Co, adding that he was not aware of the scheme.

Still, China's brokerage industry won't face systemic risks, and even in the event of a prolonged bear market, brokerages' losses won't have far-reaching social impact.

During China's 2001-2005 bear market, for example, an industry-wide loss among brokerages did not trigger a series of bankruptcies or social turmoil, partly because they have limited ability to leverage or access the country's under-developed derivatives markets, analysts said.

WORST-CASE SCENARIO

Under the planned stress tests, brokerages will be asked to gauge, among other things, the impact of a steep fall in the stock market, or a sudden shortage of liquidity in the financial system.

They will also be asked to test business, operational and credit risks under extreme circumstances.

Brokerages for which the stress tests uncover serious risks will be urged to restructure certain business lines, adjust their development plans, or replenish their capital base, one of the sources said.

However, the CSRC has yet to decide on the scenarios to be used in the stress tests when they go nationwide, two of the sources said.

That has meant the brokerages in the pilot programme have been able to select their own worst-case scenarios, they added.

The pilot tests, in which participating brokerages created models for the industry as a whole, concluded that 60 percent of brokerages would make losses under the worst-case scenario -- defined as the CSI300 Index <.CSI300> of Shanghai and Shenzhen-listed shares falling below 2,500 points, about one fifth lower than the current level, one source said.

However, they emphasized the selection of that scenario did not reflect regulators' expectations of where the market would head.

FRAGMENTED SECTOR

There are more than 100 brokerages in China's fragmented securities market, and many firms in smaller cities are weak in their financial strength.

Revenues at China's 13 listed brokerages, including Citic Securities <600030.SS> and Haitong Securities <600837.SS>, fell 6.5 percent in the first half from a year earlier amid cut-throat competition for trading commissions -- their main source of income -- according to the official China Securities Journal.

Stress tests have become common among regulators around the world since the global financial crisis, as governments struggle to prevent a repeat of the turmoil.

In 2009, U.S. regulators conducted stress tests on 19 banks, including Morgan Stanley and Goldman Sachs , gauging the impact of a higher unemployment rate and sharp falls in real estate prices. Europe conducted a health check on its banks last year.

China's banking regulator has also urged banks to conduct regular tests on their mortgage lending businesses.

(Additional reporting by David Lin; Editing by Jason Subler and Jacqueline Wong)

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