Decoding the deposit insurance system

The deposit insurance system will play an important role in economic reforms, says the Decision on Major Issues Concerning Comprehensively Deepening Reforms, which was issued by the Third Plenary Session of the 18th Communist Party of China Central Committee on Nov 15.

Deposit insurance system is aimed at protecting depositors. Under the system, banks have to deposit a part of their funds in a deposit insurance institution so that depositors are guaranteed to get back at least part of their money in case of a bank collapse. The system is also designed to avoid a bankruptcy crisis involving financial institutions. In short, the core of such system is to apportion the losses because of bankruptcy rationally and reasonably by establishing a market-oriented risk compensation mechanism.

The deposit insurance system has been in practice since the 1930s, and today more than 100 countries have such a system in place. So there is enough global experience to help China study the system and avoid the mistakes committed by other countries.

Of course, no system is perfect. The deposit insurance system, for instance, could increase insured commercial banks' risk preference and aggravate their inherent vulnerability. It can cause depositors to loose their supervision and weaken market discipline. And of course, as data show, it cannot greatly reduce the chance of large-scale bank failures. Therefore, some other measures have to be taken to help the system play its role to full potential.

The proposal for a deposit insurance system in China first came up for discussion in 1993. Although fundamental changes have taken place in interest and exchange rates, the commercial bank regime and other financial systems in the past 20 years, no breakthrough was made on the issue in China.

That the system has proven its worth is beyond doubt. The United States established the Federal Deposit Insurance Corporation during the Great Depression, while Japan set up a deposit insurance system during stable economic times, and the system has played the key role in protecting depositors' interests during economic crises in the two countries.

In China, a good system would be one that combines the deposit insurance system with macro-prudential regulation, closely related to deleveraging strategy in areas of macroeconomics. This would also be in line with Premier Li Keqiang's emphasis on "deleveraging", "cutting over-capacity" and "decreasing debt risks" since the beginning of this year.

The increasing leverage ratio is inseparable from the increase in commercial banks' portfolio, especially through excessive credit creation via non-traditional channels.