China will start an insurance system for bank deposits, a move toward scrapping remaining controls on interest rates and allowing lenders to fail in a more market-driven economy.

The government will insure deposits of as much as 500,000 yuan ($81,367) per saver at each bank covered, the People’s Bank of China said in a draft rule on its website yesterday. It didn’t give a start date or detail what premiums banks may pay, saying only that they may differ depending on lenders’ management and risk conditions. The PBOC is seeking feedback through Dec. 30.

Deposit insurance removes an implicit government guarantee behind China’s state-controlled banks and clears the way for the nation to deregulate savings rates, increasing competition for funds. That may exacerbate a liquidity shortage at smaller banks and boost their chance of failure as savings shift to the biggest lenders.

Deposit insurance is not only standard in all developed banking markets but in addition it is one of the least contentious of banking reforms — this looks like an ‘easy win’ for financial sector reform,” Jim Antos, a Hong Kong-based analyst at Mizuho Securities Asia Ltd., said before the announcement. “China needs deposit insurance now because the mainland economy is less robust and there is, implicitly, a greater risk of small banks having a liquidity crisis.”

Riskiest Part

China’s savers had piled up 112 trillion yuan of local-currency deposits as of Oct. 31., while bad loans have climbed to a six-year high, pointing to stresses within the financial system. The dominance of state-controlled lenders has left savers believing in an implicit government guarantee. China is the only major economy in Asia without a formal deposit insurance system.

Such systems can help to prevent bank runs. At the same time, by acknowledging the possibility of bank failures, the plan may encourage depositors with balances exceeding 500,000 yuan at small lenders to shift to larger ones seen as more stable.

The system can “promote the establishment of market-based risk prevention and resolution mechanisms,” the central bank said in the statement.

Coverage

The insured amount proposed will be enough to cover all the bank deposits of 99.6 percent of savers, the central bank said in a separate statement. BNP Paribas SA has estimated that a system of the type planned may cover 46 percent of deposit balances, based on past PBOC data. Authorities may adjust the 500,000 yuan ceiling, which includes both principal and interest, in line with economic and financial conditions, the statement said.

The rule would apply to all deposit-taking financial institutions and covers both local and foreign-currency deposits, according to the draft. A deposit insurance fund management agency, to be decided by the State Council, will set the premium rates. The ratios will be “much lower than” the starting level or current level in most countries with a deposit insurance system, and the financial impact on lenders is “very small,” the PBOC said in a separate statement.

Money in the plan could only be held by the central bank or invested in government bonds, PBOC notes, high-rated debentures or other channels approved by the State Council.

Slower Growth

Foreign lenders’ branches in China and Chinese banks overseas units aren’t covered, the statement said. Interbank deposits by other financial institutions and deposits by senior bank management in their own bank aren’t insured.

The central bank on Nov. 22 moved further toward freeing interest rates by raising the deposit-rate cap to 1.2 times the benchmark from 1.1 times. Revamping deposit rates is the “riskiest” part of liberalization, the PBOC said in July 2013, when it allowed banks to freely price loans.

China’s economy is poised for the weakest expansion since 1990 and Communist Party leaders have discussed reducing the 2015 growth target from this year’s 7.5 percent goal, a person familiar with the matter said in November.

Deposit insurance is “a clearly defined exit strategy for troubled banks,” Judy Zhang, a Hong Kong-based analyst at BNP Paribas, said in a Nov. 28 note. “It protects the public interest and shows the government is accelerating financial reform to gradually break its implicit guarantee of the financial system. However, it may lead to a deposit shift from small banks to large and medium-sized banks in the short term.”

Smaller banks face the risk of withdrawals by corporate depositors to counterparts with strong capital bases and extensive distribution networks, Zhang said. Besides liquidity risk, smaller lenders may have to bear higher funding costs to keep customers, putting pressure on their earnings, she said.

The deposit insurance system will “significantly” enhance smaller banks’ credibility and competitiveness and create a fair environment for them to compete, according to the PBOC statement.

 

Source : Bloomberg