Long-awaited deposit insurance harbinger for further reforms

BEIJING -- China is undergoing one of the boldest financial reforms so far this year following the central bank's publishing of draft rules on a deposit insurance system.

The People's Bank of China (PBoC), the central bank, published the rules on Sunday and has since started soliciting public opinion after 21 years of deliberation.

Under the draft rules, accounts with deposits of up to 500,000 yuan ($81,500) will be insured per depositor if a bank suffers insolvency or bankruptcy.

Financial institutions will be required to pay insurance premiums into a fund and an agency will be set up to manage the money.

The move highlights the leadership's resolve in further rebalancing the financial system with market-oriented measures.

Deposit insurance was mulled as early as December 1993, when the State Council, or China's cabinet, said a deposit insurance fund would be founded in order to protect public interests in a decision to reform the financial system.

Since then, the DIS has been repeatedly brought under the spotlight, including in 2005, 2008 and 2010. Nevertheless, it remained on hold.

It gained renewed attention last year when, in a key document on deepening reforms, the Communist Party of China mentioned moves to establish a deposit insurance system and improve the market-based exit mechanism for financial institutions .

The delay was partly due to opposition from banks that would have to pay for the scheme, instead of enjoying the implicit government guarantee already in place free of charge.

In particular, bigger banks, with strong state backing and established roots in the community, would have to set aside capital for the DIS despite the chance of a bank run being very unlikely.

The plan did not address in detail what premiums banks would have to pay, but made clear a risk-based system with standard rates plus additional risk rates that took into consideration individual banks.

A Bank of Communications research paper published on Monday said the international average was around 0.015 to 0.02 percent, while Wei Yao, China Economist of Paris-based Societe Generale, put the international average rate at 0.05 percent.

Setting specific rates and managing the DIS fund will be a new agency's task, according to the plan, which also empowered the agency to step in before bank runs, bearing similarity to the United States Federal Deposit Insurance Corporation's role in forestalling bank failures.

With such broad authority, and given China's two standing bank overseers - the PBoC and China Banking Regulatory Commission - experts urge a clear coordination mechanism.

Harbinger for further reform

The scheme, commonplace around the globe as a way to boost confidence and prevent bank runs, also serves as a great leap of faith in China which seeks to introduce more disciplined risk-taking to the banking industry long dominated by giant state players.

The scheme will significantly improve the competitiveness of medium and small-sized banks as the insurance will assure depositors of the safety of their savings, according to the central bank.

As a string of private banks look to join the game, deposit insurance will also put up the necessary foundation for potential insolvency risks.

Chinese banks' favor of state-owned enterprises and disdain for private entrepreneurs have long been accused as one core problem of the economy's imbalance.

The DIS is also seen as a monumental step of policy rate liberalization. Without deposit protection, smaller banks would most likely need to pay significantly higher rates to retain depositors under a fully liberalized rate environment - owing to the greater stability the larger banks could offer depositors, said Fitch ratings. As such, a deposit insurance plan would be essential to creating a more level playing field between larger and smaller institutions.

"Once the DIS is put into place, deposit rate liberalization, the transition for the central bank towards a new policy rate as well as the relaxation of the loan-to-deposit ratio will all need to speed up," according to Yao of Societe Generale.

Moreover, the DIS could impact China's vast shadow banking system, where wealth management products have usually been protected under the previous universal government guarantee.

Taken together, the insurance would be an important development for further financial reforms to reduce moral hazard and inappropriate risk-taking by banks - by extension contributing to a more rational pricing of capital in the economy, said Fitch.

This would ultimately translate into greater economic rebalancing as well as a potentially lower propensity for the state to support non-systemically important banks, Fitch added.