Banks must "strictly follow credit procedures and further step up risk controls on loans for property development", Liu Mingkang, the head of the China Banking Regulatory Commission, said.
Chinese banks have extended a huge amount of loans, which some researchers have estimated at 10 trillion yuan ($1.5 trillion), to local government finance vehicles since China started a massive economic stimulus package in late 2008.
Analysts fret that many of the projects they are funding will never be profitable, saddling banks with bad debts.
Since October, China's central bank has raised benchmark interest rates four times and tightened lenders' reserve requirements seven times including earlier this week as it seeks to rein in loan growth and keep a lid on inflation.
Liu said banks must change their past practice under which they focused on credit growth and expanding market share.
Lenders must also increase their scrutiny on loans to local government finance vehicles and "rectify" their existing loans to rein in risks, Liu said.
Liu cautioned banks against any attempt to lure deposits by offering benefits to savers or secretly raising deposit rates.
China bans its banks from raising deposit rates above the official benchmark for fear of fuelling risk.