Insurance system to improve banking

The introduction of the bank deposit insurance system in China will cause significant changes in the banking sector, increasing big banks' savings and putting small banks at a disadvantage. The move also signifies a fundamental change in the regulatory mentality.

Earlier, the government was obliged to keep all banks safe and solvent, but the new deposit insurance system will allow the market to have a bigger say in deciding the future of the banks.

On Sunday, the government issued draft rules on the crucial bank deposit insurance system, which will directly cover deposits of up to 500,000 yuan ($81,433) if banks go bankrupt. Such a scheme will protect 99.63 percent of Chinese depositors, the central bank said.

Primarily, the new arrangement is aimed at protecting the interests of the public as China's economic reforms, including those in the banking sector, deepen.

The expansion of the Chinese economy has given rise to some new risks, especially those brought about by exposure to the ballooning real estate sector and the pile-up of local government debts, both of which are related to the banking sector. If the risks become real, they will deal a heavy blow to the banks, leading to possible bankruptcy of some small lenders, which the insurance regime is intended to minimize.

This is not an unfounded alarm. From 1998 to 2003, more than 300 financial institutions and companies became insolvent and collapsed, producing large amounts of debts that were largely covered by the monetary authorities through issuing credits.

Although the bad loan ratio of China's banking sector remains low at about 1.1 percent, the central bank warned in April that the non-performing loan ratio of the 17 major banks could quadruple in the worst scenario of stress tests.

Apart from protecting depositors, the new system is set to bring about profound changes to the banking sector. Small banks, in particular, face an uphill battle in maintaining their capital sources as depositors tend to put their money in major banks that are "too big to fail".

According to the deposit insurance rules, the insurance institution can cover savings of up to 500,000 yuan. It means people who have more than 500,000 yuan in savings in small banks will have to consider moving their money elsewhere.

This will force small banks to further raise their deposit interest rates (smaller banks generally offer rates higher than the big ones to attract depositors) and improve their operational efficiency to earn more profits from lending. Otherwise, their profit level will drop and their operations will be unsustainable. The major banks, though, could benefit from money transfers from smaller financial institutions, leading to rising capital concentration in the banking system.

China's top five banks account for about half of the sector's assets and 60 percent of the total profits. In contrast, in the United States, the largest 25 banks account for about 40 percent of the overall banking assets.

Following the deposit insurance system, the asset concentration level in China may rise further, leading to the problem of "too big to fail" if regulators cannot properly regulate the sector in accordance with the upcoming new changes.

Nonetheless, the deposit insurance system is a major reform marking the shift to a more market-oriented regulatory model, which is crucial for a transitional economy such as China.

Until now, the State acts as the lender of the last resort and shoulders a de facto responsibility of bailing out any insolvent financial institution, creating the problem of moral hazard. Taking advantage of that hidden rule, depositors did not care much about which banks are safer while the banks were hardly worried about the sustainability of their operations. Also, some reckless financial institutions engaged in risky deals with a view to making more profits only to incur unaffordable losses and become insolvent.

The new insurance scheme will force such financial institutions to better abide by regulations and pay more attention to operational risks, thus improving the overall competitiveness of Chinese banks.

The author is a senior writer with China Daily. xinzhiming@chinadaily.com.cn