BEIJING, Jan. 26 -- Credit ratings agency Moody's has highlighted the increased uncertainty and risk Chinese banks are facing amid volatility in interest rates, exchange rates, stock prices and fund flows.

Their financial performance over the next two years will be driven primarily by the evolution of their asset quality, which is in turn a reflection of their appetite for risk, Moody's said in a report on Tuesday.

It forecast that banks focusing on growing loans to small and mid-size borrowers will see a faster rise in credit costs as such customers are more vulnerable to sector downturns and financial market volatility.

"We also anticipate further increases in loan delinquencies, more defaults on corporate debt and some losses in wealth-management products, as more borrowers struggle to meet payments against the backdrop of high financial leverage and a downturn in their respective sectors," said Moody's Senior Vice President Christine Kuo.

While the government will implement measures to mitigate financial market volatility and corporate defaults, their effectiveness will vary due to the complicated nature of China's markets, Kuo added.

On the effects of yuan devaluation on Chinese banks, Moody's said that the direct impact will be modest because the banks show only small net open positions on foreign-currency exposures.

However, the indirect impact of a weakening yuan will be more significant for banks, as it will lead to more company defaults, according to the report.

As for the recent stock market volatility in China, Moody's said Chinese commercial banks have little direct exposure to equity price movements, because of their low direct holdings of listed stocks.

While Moody's believes the central bank will inject liquidity into the market when necessary, it expects more frequent episodes of tight funding conditions due to capital flows and banks' growing portfolio of illiquid investments.