China's banking regulator has urged domestic banks to improve internal controls to prevent bank loans from flowing into the peer-to-peer lending market, in which individual and corporate borrowers may get money to invest in industries the government is trying to cool.

P2P lending is a form of financial transaction which occurs directly between peers - individuals or companies - bypassing financial institutions. The P2P lending activities are conducted over the Internet, which increases the risks, according to the China Banking Regulatory Commission.

Banks should set up "firewalls" to stop risky P2P private lending to companies and individuals as the loans may flow into industries the government is trying to cool, such as property and energy, according to the central bank's Financial News, citing a notice from the CBRC.

As P2P agencies do not check a borrower's creditworthiness, it increases opportunities for fraud, money laundering and other criminal activities, the CBRC said.

"Due to the lack of strong supervision, P2P agencies are likely to evolve into illegal financial institutions that take deposits and make loans," the CBRC warned.

The People's Bank of China has raised interest rates three times so far this year to tame inflation. There have also been six reserve requirement ratio hikes that force commercial banks to set aside money with the central bank.