By Enda Curran 

HONG KONG--After years of boosting lending into mainland China, the city's banks are reporting rising levels of souring debt, prompting worries among some analysts that Hong Kong's smaller banks may need to raise additional capital.

With interest rates expected to rise next year in tandem with moves by the U.S. Federal Reserve, and China's sluggish economy squeezing borrowers' earnings, bad-loan levels at Hong Kong's banks could rise. In a sign of stress last week, two Chinese steel companies--state-owned Sinosteel Corp. and steel transporter Anhui Wanjiang Logistics (Group) Co.--said they were having trouble paying back lenders.

"Over the next few years we are going to start to see more challenging conditions for banks in Hong Kong," said Stephen Long, head of financial institutions in the Asia-Pacific region for Moody's Investors Service. The ratings firm has had Hong Kong's banking system on a negative outlook for more than a year.

Hong Kong's banks have been lending heavily to mainland Chinese clients, seeking growth beyond this city of seven million. Last year, one-fifth of Hong Kong's banking-system assets came from loans to mainland China, up from 16% in 2012. Chinese customers have taken advantage of lower interest rates in Hong Kong, which follow those in the U.S., and the yuan's rising value against the U.S. dollar, to which Hong Kong's currency is pegged.

Overall loans by Hong Kong banks grew 15.5% year over year through July, and have risen 21% a year since 2010, well ahead of the city's economic growth, which was 2.9% last year, according to official statistics.

While the growth in lending is feeding through to higher bad debt at Hong Kong's banks, overall nonperforming loans remain low, at just 0.45% of total loans, and not at dangerous levels, according to the city's de facto central bank, the Hong Kong Monetary Authority.

Of loans made to China, nonperforming loans at five banks in Hong Kong that report such data amounted to 0.69%, on average, at the end of June, compared with a 0.31% total nonperforming-loan ratio. The banks are Bank of China Hong Kong (Holdings) Ltd., the local unit of Bank of East Asia Ltd., Dah Sing Banking Group Ltd., Hang Seng Bank Ltd., and Wing Hang Bank Ltd.

"Cross-border loans extended by Hong Kong banks are deteriorating," said Jim Antos, a Hong Kong-based banking analyst at Mizuho Securities Asia Ltd.

The banks either declined to comment or didn't respond to a request for comment.

Bank of China Hong Kong had overall bad loans of 0.29% of its total lending, but the ratio of bad loans in China was more than three times as high at 0.90%.

The bad-loan ratio at Bank of East Asia, one of the city's largest family-run banks, rose 0.09 percentage point to 0.44%, spurred by mainland Chinese bad loans which rose 0.15 percentage point to 0.59%. About 46% of Bank of East Asia's loans are to China.

Hang Seng Bank, whose parent is the British bank HSBC, is less exposed to China, with just 10% of its lending to the country. Its total for bad loans fell to 0.18%, according to a Macquarie analysis.

The bigger lenders in Hong Kong don't break out their Chinese loan books but, in common with their smaller counterparts, have been raising their exposure to China in recent years.

HSBC Holdings PLC saw its nonperforming-loan ratio for its Asia-wide operations nudge higher to 0.49% in the first half, compared with 0.48% in the previous six months. HSBC declined to comment.

The nonperforming-loan ratio at the Hong Kong unit of Standard Chartered Bank rose to 49% from 0.43%. A spokeswoman for the bank said the bank's loan portfolio is stable and that the increase in bad loans was mostly attributable to suspected loan fraud at Qingdao port, where authorities are investigating the alleged use of the same collateral several times to secure loans from different banks.

The city's banks, especially the smaller lenders, are vulnerable to the fortunes of China's hard-hit manufacturers and companies linked to the weakening real-estate sector, analysts said.

These companies continue to tap lenders in Hong Kong. For instance, Agile Property Holdings Ltd., a real-estate developer based in Guangdong province, announced a share rights issue last week to pay down debt, the third Chinese developer to do so in recent weeks.

In total, Hong Kong-based banks have exposure to China's nonbanking sector of just under $500 billion, or 55% of all loans in the system, according to the HKMA.

"Hong Kong banks may end up going to the market to raise capital," Macquarie analyst Ismael Pili said of the smaller lenders, and not including HSBC or Standard Chartered. "They are not as well capitalized as people perceive them to be."

Mr. Pili rates these Hong Kong banks as his least-preferred picks in the region.

The rise in bad loans to China is a wake-up call for a city where banks have become an ever-bigger proportion of the city's economy. The ratio of loans to the size of Hong Kong's economy reached a record 203% at the end of the June, compared with 138% in 2007.

Write to Enda Curran at enda.curran@wsj.com

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