"As a result, corporate debt has reached 165% of GDP, and household debt, while still low, has risen by 15 percentage points of GDP over the past five years and is increasingly linked to asset-price speculation".
According to the IMF's health check of China's financial system, four-fifths of the country's banks are at risk.
The report follows a series of alerts over the debt pile which has ballooned in China alongside its rapid economic expansion. The IMF and World Bank launched the FSAP in 1999 to gauge the stability and soundness of the financial sector, the regulatory framework of member economies and financial sector's potential contribution to growth. The Bank for International Settlements (BIS) - also known as the central bank of central banks - for example, warned that the Chinese banking sector could be facing an imminent blowout, raising worries about its effect on the world economy.
The IMF said: "Given the centrality of banks to the financial system, the FSAP team recommended a gradual and targeted increase in bank capital".
The stress tests covered banks holding 171tn yuan ($26tn; £19bn) in total assets, and 27 out of the 33 tested needed to raise more funds, despite already complying with Basel III regulations on bank capitalisation. China's "big four" banks had adequate capital, but "large, medium and city-commercial banks appear vulnerable", it said.
"Implicit guarantees to SOEs [state-owned enterprises] need to be removed carefully and gradually", she said. Local government leaders were aiming to maintain high employment "even if that means cash-bleeding enterprises continue to operate".
The IMF said the growth in credit held by companies and households had outpaced that of the wider economy and the ratio of credit to GDP was now "very high by worldwide standards and consistent with a high probability of financial distress".
In addition, the International Monetary Fund noted the reluctance of financial institutions to allow retail investors to take losses and the expectation that the government stands behind state-owned companies and local government financing vehicles.
Increasing capital would enhance the resilience and credibility of the financial system, as well as reassure markets.
The People's Bank of China (PBOC) said the reports have fully acknowledged China's achievements in recent economic and financial reforms, but there are "a few descriptions and views in the reports that we don't agree with".
But it said it did not go along with all of the findings and that the stress tests "do not fully reflect the whole picture".