China considers insurance against bank failures

China is expected to launch a deposit insurance system to compensate depositors should a lender collapse

Introducing such a system is crucial as China opens up its banking sector by allowing investment from private capital and the gradual liberalization of interest rates and exchange rates.

Without a deposit insurance system, the government assumes implicit responsibility for offering guarantees to the banks. This situation could weaken the regulatory mechanisms for commercial banks and open the door for them to engage in excessive speculation in pursuit of higher profits.

After the implementation of the new Basel Capital Accord, banks are no longer regarded as "too big to fail," particularly in the wake of the financial crisis. A deposit insurance system could improve the risk management of financial institutions. Banks would have to take responsibility for their own operations and financial results without relying on government to bail them out if they fail. Moreover, the system would help promote the liberalization of interest rates and exchange rates.

Still, there are potential problems. Depositors could be attracted by higher interest rates offered by banks despite higher risk, especially as the liberalization of interest rates progresses. Additionally, rising costs for banks may result in lower profits, which could force banks to take greater risks.

We believe the system could create tension for depositors who expect the government to bail them out in the event of a bank's failure. However, they will likely realize and gradually accept that the system is intended to protect them.

From the regulator's perspective, the highest concern is depositors' tendency toward adverse selection. Chinese depositors are very sensitive to interest rates but often do not have enough risk awareness. Regulators should, therefore, impose higher requirements on the risk ratings of banks to better protect depositors.

Long deliberated

China deliberated the deposit insurance concept as early as 1993 and proposed the establishment of such a system in 2007. That led to many questions: Which department should take the lead? Which party should fund the system? How should related legislation issues be managed? The process is, therefore, quite time-consuming and was even interrupted by the financial crisis in 2008.

A deposit insurance system was mentioned by People's Bank of China Governor Zhou Xiaochuan in a speech at the end of 2013. He clearly stated that the system should have review, error correction and risk handling functions, inferring that a deposit insurance agency to be established in the future would be a "non-corporate special agency" managed by the government, which is close to the US model.

Although specific regulations have not yet been announced, information available suggests that Chinese government leaders have reached a consensus on the basic framework for the deposit insurance system.

It will cover all deposit-taking financial institutions, it will adopt definite insurance compensation and risk-based differential rates, and it will establish a preliminary fund to perform necessary basic functions, such as information gathering and verification, error correction and risk-handling during the early stages.

Insurance compensation will be capped, but the vast majority of depositors will be covered, in line with international practice.

It is widely expected that at least 90 percent — or even as much as 99 percent — of a deposit needs to be insured, with 500,000 yuan (US$80,645) as the upper limit for compensation.

With two major obstacles to the system — balancing the benefits between the various departments and agencies of the State Council, and consensus on the system's design — essentially overcome, we believe the deposit insurance system could be launched this year.