China's banking sector faces growing risks from small banks' aggressive issuance of wealth management products to attract and retain depositors, Fitch Ratings said.

As competition for deposits has intensified, Chinese banks — particularly small non-state-owned entities — have been rapidly expanding their WMP offerings, Fitch said in a report released on July 27.

At the end of the first half, WMPs stood at an estimated 10.4 trillion yuan ($1.7 trillion), or 11.5 percent of total deposits, largely unchanged from three months ago, it said.

"However, unlike in the past, recent issuance has been driven by non-state banks, while state banks have been reining in activity," the ratings agency said.

"There was a dramatic shift in issuance patterns in the second quarter, with state banks' posting a 1 trillion yuan contraction and small banks posting a nearly equivalent rise," said Charlene Chu, head of Chinese banks' ratings at Fitch.

Small banks' weaker funding and liquidity relative to state-owned peers could make them more susceptible to WMP repayment issues, Fitch said.

"The fact that smaller, less resilient banks are now driving activity means that overall WMP risks are rising," said Chu.

According to Fitch, liquidity risk is the paramount concern for WMPs, but product credit risk also remains an issue.

"Regulators have cracked down on the amount of loans moving into products, but a myriad of credit-related assets disguised as non-credit still appear," Chu said.