SHANGHAI/HANGZHOU, July 31 -- Within six months, three banks set up by Chinese private entrepreneurs will open for business, raising questions as to how can they fit in a sector dominated by state-owned lenders.

China's banking regulator gave the go-ahead last week for several companies to set up the banks incorporated and run by domestic, private firms in three cities in east China, where economic output accounts for more than 60 percent of the country's total.

The pilot, which seeks to add five private lenders, is being implemented at a time when China is pushing for interest rate liberalization and more efficient allocation of credit.

Profit in the Chinese banking sector has slid from 30 percent three years ago to 10 percent last year, with a further profit decline expected in the years ahead. Banks are also facing rising volumes of bad loans as growth in the country moderated from double digit to around 7.7 percent last year.

Yet this prospect does nothing to dishearten private entrepreneurs from making inroads into the banking industry. Interest and applications for joining the pilot program have already come from a diverse range of companies, from conglomerates such as the Shanghai-based Fosun Group to Internet behemoths Alibaba and Tencent.

However, bankers have urged caution, warning that failure of a bank would wreak havoc.

In terms of the pilot, authorities have taken a measured approach to prevent a reckless private bank opening binge.

There are also concerns about firms that apply to open a private bank and use it to secure cheap credit for themselves instead of lending to other companies based on creditworthiness.

Chen Xiaojun, Chairman of Taizhou Bank in east China's Zhejiang Province, said that instead of approving new establishments, authorities should consider changing ownership structures of existing rural and urban commercial banks by replacing their government stakeholders with private ones.

Taizhou Bank underwent such a reshuffle in the early 2000s, with the local government now holding only a 5-percent stake in the bank.

Lian Ping, chief economist with Bank of Communications, China's fifth largest lender by assets, said the success of these up-and-coming lenders lies in their ability to meet demands in areas long ignored by large state banks.

The country's first private-run bank -- China Minsheng Bank -- was founded in 1996 in Beijing and has since made its reputation through lending to small and medium enterprises (SMEs). The new contenders approved last week are also expected to broaden SMEs access to banking credit.

SMEs contribute more than 60 percent of gross domestic product (GDP) and provide more than 80 percent of urban employment but they are underserved in the banking system.

State-owned lenders are more willing to lend to large firms and state-owned enterprises (SOEs), or entities with an implicit guarantee of a government bailout should they default.

Many small companies thus resort to underground lenders for financing at a cost several times higher than what is charged on loans extended in formal banking systems. Some cash-starved firms go bust after they hit a liquidity crunch.

To survive, private-run banks have a lot challenges to overcome. New lenders are not rivals to established, state-backed lenders in the scramble for bank deposits, though wealth management products marketed by Internet firms have been slowly chipping away at state-owned banks' deposit base, Lian said.

Given the difference between large banks and these newcomers, the banking regulator should draft tailored policies to regulate private banks, according to Taizhou Bank's chairman Chen.

In China, banks' lending activities are restricted by rules such as asking them to park more than 20 percent of their deposit at the country's central bank and to lend no more than 75 percent of their deposit.

Authorities are also working to put in place a system to insure deposits against bank failures. Chinese Premier Li Keqiang said during the country's annual parliamentary session in March that the country would roll out the scheme this year.

This arrangement is deemed as a crucial step in the reform to liberalize interest rates in the banking sector. The central bank removed the floor of renminbi loan rates last July and asked nine leading domestic banks four months later to report daily the rate they charge their best clients to reflect market rates for loans.

The central bank still sets deposit rates and allow banks to offer returns to depositors at 1.1 times the benchmark rate. Analysts say the cap will be removed only after banks are covered by deposit insurance.