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China's brick-and-mortar banks are launching a counter-attack against the assault on their business from Alibaba and other Internet heavyweights, in a bid to staunch the outflow of bank deposits into high-yielding online investment products.

In less than eight months, Alibaba Group Holding Ltd's money market fund, Yu'e Bao, has attracted 400 billion yuan ($66.0 billion) in assets under management, more than the customer deposits held by the five smallest listed Chinese banks.

Similar online products from Baidu Inc and Tencent Holdings Ltd also contributed to a fall of one trillion yuan in traditional bank deposits in January.

"Yu'e Bao and similar products are posing a very strong competitive challenge to banks," said Zennon Kapron, head of Kapronasia, a finance and technology consultancy based in Hong Kong. "Although the amount of money that (online products) have attracted is still small as a portion of banks' overall deposit base, it's very significant in terms of the speed at which they've grown."

Now traditional lenders, initially caught flat-footed, are striking back.

Industrial and Commercial Bank of China , Bank of China , Bank of Communications and Ping An Bank have all launched new products in recent weeks that match the attractive features of Yu'e Bao.

Banks are also lobbying regulators to introduce curbs on the growth of on-line funds offered by non-banks.

Ultimately, however, competition for deposits will drive up banks' funding costs and crimp profit margins this year.

As China gradually moves to liberalize deposit interest rates, banks will be forced to compete among themselves to attract customers, which means offering higher yields.

The development of new deposit-like money market products designed to compete with online rivals will further accelerate the trend toward higher funding costs.

"It's going to negatively affect bank margins. Costs will go up," said May Yan, Asia ex-Japan banks analyst at Barclays Capital in Hong Kong.

CASH ON DEMAND

Chinese savers in recent years have flocked to so-called wealth management products (WMPs) that banks market as a higher-yielding alternative to traditional savings deposits, which remain subject to a cap of 3.3 percent for one-year savings.

Alibaba super-charged the switch away from traditional deposits last June when it launched Yu'e Bao in partnership with Tianhong Asset Management Co Ltd, in which it owns a 51 percent stake. The product is currently yielding 6.2 percent.

Beyond the attractive yield, several innovations allowed Yu'e Bao and other online money-market funds to draw funds away from bank deposits and offline WMPs. Unlike most bank WMPs, the Yu'e Bao fund allows investors to redeem shares for cash at any time, rather than locking up their funds for months at a time. Yu'e Bao also requires no minimum threshold to buy in.

The product's seamless integration with Alibaba's widely used third-party payments platform, Alipay, also makes buying into the product simple and convenient.

Now banks are getting in on the act with their own cash-on-demand money market products.

ICBC, the world's largest bank by assets, launched a money-market WMP called "Tiantian Yi, which translates as "Everyday Benefit." So far only account holders based in the eastern province of Zhejiang are allowed to purchase, but the pilot is likely to ramp up quickly.

ICBC hopes to gain an edge over Alibaba by allowing customers to transfer up to 30 million yuan into its product, known as "Everyday Increase."

ICBC has also fought back by limiting its depositors monthly transfers to Alipay to 50,000 yuan per month.

Bocom, China's fifth largest lender, has launched "Quick Benefit Channel," while Ping An Bank has a product called "Ping An Profit."

Bank of Beijing Co Ltd , a mid-sized lender, on Wednesday announced a partnership with smartphone maker Xiaomi Tech on mobile payments and sales of WMPs and insurance products.

Banks are also tweaking WMPs to make them more competitive.

"We're trying to increase the convenience of our WMPs, like letting people buy them during non-working hours. We're also asking the bank regulator to let us lower the 50,000 yuan minimum investment for some products," said a wealth product manager at a mid-sized bank in Shanghai.

CALLS FOR REGULATION

UBS estimates that if 10 percent of total bank deposits flow into online products, it could reduce banks' net interest margin by 0.1 percentage points, while lost fee income would amount to 4 percent of estimated 2014 net profit.

The China Securities Regulatory Commission said last week that it is working with other agencies to develop rules for Internet finance. Industry observers say that banks are lobbying for curbs on the proliferation of online products from third-party payment services.

"Regulators are trying to walk a fine line. They don't want to kill innovation that benefits consumers, but they also don't want deposit-taking activity that's completely unregulated," said Yan.

Analysts say that even if banks are able to draw funds into their own money-market products the trend of rising funding costs will continue, as the banks' products would have to match the yields offered by online rivals.

Indeed, funds invested in Yu'e Bao and similar products eventually end up with banks anyway. Tianhong uses Yu'e Bao funds to invest mainly in interbank deposits and repurchase agreements. So whether banks borrow from Tianhong or raise funds from their own products, the cost is still higher than on ordinary deposits.

"The money stays in the system, but (online products) turn cheap deposits into expensive ones," said May Yan, Asia ex-Japan banks analyst at Barclays Capital in Hong Kong. ($1 = 6.0641 Chinese yuan)