Why Chinese banks resorted to using substandard collateral

Lack of regulatory enforcement is one reason.

According to Natixis, there are a number of reasons why Chinese banks have stepped up the use of sub-standard collateral for their interbank transactions. One is greed, combined with the lack of regulatory enforcement. For example, investment receivables offer a higher yield but are certainly not AAA rated as standard collateral is meant to be.

Here's more from Natixis:

The other reason is that the two major pool of standard (AAA rated) collateral are treasury bonds and financial bonds issued by policy banks. Neither of the two has expanded issuance quickly enough to catch up with the growth of China’s interbank market. As a consequence, the search for other sources of collateraland uncollateralized financing was hard to avoid.

In addition, China Securities Depository and Clearing Corporation (CSDC) has imposed a minimum rating of the acceptable collateral from 7th April in the exchange-traded part of the money market. Although the regulator has tried to smoothed out the transition to tougher collateral rules (by exempting roll-over related transactions), it has a clear signaling effect for the interbank market as a whole.