Deposit insurance a 'solution for failing banks'

The deposit insurance system that is set to start on May 1 will offer a market-based solution for banks that fail in an increasingly complex business environment, said economists and bankers.

Several shockwaves of change hit the traditional banks last year: accelerated interest rate liberalization, a boom in Internet finance and the long-anticipated entry of private-sector banks.

With these pressures have come risks for banks that cannot be ignored, said Zhou Jingtong, a senior analyst with Bank of China Ltd's International Finance Institute.

"As interest rate liberalization intensifies competition among banks and erodes their profits, the financial institutions that have relatively weak risk management can easily run into operational difficulties. The banking sector urgently needs a market-based exit mechanism, which means it's an opportune time to launch the deposit insurance system," Zhou said.

Qu Hongbin, co-head of Asian economic research at HSBC Holdings Plc, said the system will provide "basic, explicit government insurance for deposits". It is widely used in both developed and developing markets to lower the possibility of "bank runs" and limit systemic risks.

The cap for the deposit insurance system will be 500,000 yuan ($81,000) per depositor.

"At close to 12 times annual per capita GDP, this is more generous than prevailing international standards (of two to five times). The move is expected to level the playing field for smaller, private-sector banks in the long run by removing the perceived 'implicit guarantee' for State-owned banks," Qu said in a report on Wednesday.

Lou Lili, general manager of the strategy and innovation department at Shandong-based Evergrowing Bank Co Ltd, said: "The launch of the system will lay a more solid foundation for interest rate liberalization and help maintain the stability of the financial system."

Banks will pay a fee for the insurance that will be divided into two parts, a flat fee and risk-based fee, which will vary according to the institutions. The impact on each bank will be different, and that cannot be determined until detailed regulations are released, Lou said.

"We have learned from the experiences in the United States that the insurance fees should not be too high, so that they will not have a big impact on banks' liquidity and profit. To some extent, the deposit insurance system will reduce the necessity to maintain high reserve requirement ratios, which act as 'implicit insurance' for deposits," she said.

As to the exact fees, Qu said: "Various estimates have surfaced, such as around 10 to 12 billion yuan, or 1 percent of the banking sector's profits. We believe the size will be manageable as a start, to prevent over-burdening the system. Given the weakening economy, it is possible that further rate cuts or additional liquidity will be delivered around the system's start date to smooth the transition process."

The deposit insurance system will have a limited impact on banks in general, but some small and medium-sized banks may come under pressure.

Guo Tianyong, director of the Research Center of the Chinese Banking Industry at the Central University of Finance and Economics, said that small banks may experience deposit outflows because they have lower credibility than large banks.

With the further liberalization of interest rates, small banks will have to attract deposits with higher rates, which will increase their operating costs. Their insurance fees will also be higher than those of large banks. As a result, small banks are likely to offer financial products that feature higher promised returns but also higher risks.

Guo said: "Although the system may have a negative impact on small banks, we still need to make progress by launching it and replacing the 'implicit government guarantee' with an explicit market-based insurance system.

"During the transition period, small and medium-sized banks should improve their competitive position with differentiated business strategies."