China () - Chinese banks had lent 8.5tn yuan ($1.3tn; £820bn) to the local governments in 2010 in an attempt to boost growth.
However, the agency said the debt burden could be 3.5tn yuan larger than auditors had estimated.
It warned that bad debt could reach between 8% and 10% of the total loans.
"When cross-examining the findings by the 27 June National Audit Office (NAO) report, in conjunction with reports from Chinese banking regulators, we find that the Chinese audit agency could be understating banks' exposures to local governments by as much as 3.5tn [yuan]," said Yi Zhang of Moody's.
Ms Zhang explained that since these loans were not covered by the NAO, they were not considered as real claims on local governments by the audit agency.
"This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency," she added.
Moody's warned that given the scale of the problem, the credit outlook for China's banking sector could turn to negative.