The move is part of broader efforts, including raising bank reserve requirements, to check explosive lending growth that has set off concerns about asset price bubbles and the potential creation of a fresh crop of bad loans.
Financial markets have been rattled by fears that a tightening of monetary conditions in the world's third-largest economy would stump its demand and so hamper a revival in global growth.
In the latest push, the China Banking Regulatory Commission (CBRC) ordered banks to inspect their existing loans to commercial units used by local governments to raise funds, and to stop lending to those projects that are backed only by expected fiscal revenues, the state-run Shanghai Securities News newspaper said, citing unidentified sources.
That follows a decision by the top economic planning agency to tighten control over bond issuance by such investment vehicles, as worries mount over a buildup of local government debt.
About 40 percent of China's 9.6 trillion yuan ($1.4 trillion) in new loans last year, or 3.8 trillion yuan, went to local governments, state media reported in January.
"The new restriction will have a huge impact," said Shi Lei, an analyst at Bank of China in Beijing.
Shi estimated the move had the potential to trim lending to local governments by a third this year, or by more than 1 trillion yuan. That would leave about 2 trillion to 3 trillion yuan in credit to allow them to complete projects already under way.
"So banks may divert their cash into loans to other types of companies and borrowers, or into bond investments, as they allocate funds to meet their lending targets," he said.
Investors took the news in stride. Shares of Chinese lenders listed in Shanghai were mostly up on Wednesday. They fell slightly in early trade after Bank of Communications said late on Tuesday that it planned to raise as much as 42 billion yuan via a rights issue.
The Shanghai Composite Index ended up 1.3 percent, while bond yields edged down across the curve.
The relatively calm response in the stock market contrasted with the sharp falls that followed reports on regulators' efforts to tighten credit last month and early this month, suggesting investors have gotten used to Beijing's determination to keep credit growth in check.
Chinese provinces and municipalities are not allowed to issue bonds directly, apart from through a limited pilot program launched last year. But they have set up more than 3,000 commercial units and borrowed heavily through them.
Banks lent a record 9.6 trillion yuan ($1.4 trillion) in 2009 as they rushed to support the government's economic recovery program. This year Beijing has set a loan target of 7.5 trillion yuan.
The CBRC has already ordered banks to check that their loans are not being used to speculate in the property or stock markets, while the central bank has twice raised banks' required reserves and ordered some lenders to put up additional punitive reserves.
The latest step could reduce some of the cash flowing into the stock market, as some of that credit is thought to have been used for speculative purposes, analysts said.
"The stock market is really feeling a crunch of funds after a slew of official liquidity clampdown steps effectively cut money supply, particularly funds improperly flowing into the market," said Chen Huiqin, stock analyst at Huatai Securities in Nanjing.
"Once the government starts such a campaign, it won't stop until it reaches its goals." The bond market could benefit though as banks look for other places to park their money, analysts and traders said.
"The news of the lending restriction triggered fiery trade today," said a bond trader at a mid-sized domestic lender in eastern China.
The Shanghai Securities News also reported that the CBRC had ordered trust companies to ensure that they were not supplying credit to developers to build up reserves of land.
With property prices soaring in many major cities, the government has sought to rein in speculation and limit practices such as land hoarding that drive up prices.
