Deposit insurance should be implemented at right time
By Chen Yao (China Business Weekly)
Updated: 2004-03-15 17:14

It's been seven years since China's central bankers began talking about introducing deposit insurance, a scheme widely adopted in Western countries, into the nation's banking regulatory framework.

Now is the time for them to take serious actions.

"We are waiting for the final approval from the State Council," Xie Ping, director of the Financial Stability Bureau of the People's Bank of China (PBOC ) told reporters early this month. "The scheme is likely to be implemented within the year."

Xie's remarks were echoed last week by Li Yang, a member of the PBOC's Monetary Policy Committee, who confirmed that establishing deposit insurance systems will be on the central bank's agenda but no timetables have been issued yet.

A local resident receive service at the Industrial and Commercial Bank of China's local branch in Nanjing, capital of Jiangsu Province. The country's top policy-makers are planning to establish a compulsory deposit insurance system within a year, which will expect to significantly improve regulations in the banking industry. [newsphoto]

"Much research has been done, and many pros and cons have been weighed. Now everyone is expecting a final resolution, which will significantly change the country's banking regulatory landscape," he said.

Over the past seven years, China's banking regulators have seen an increasing number of bank closures across the country.

The Hainan Development Bank, whose trust and investment subsidiaries invested heavily in the volatile local real estate market, closed in 1998, leaving 14.2-billion-yuan (US$1.72 billion) in unpaid debts.

In the same year, Guangdong International Trust and Investment Corp, one of southern China's largest banking firms, announced a US$9 billion bankruptcy claim, causing a panic among foreign creditors.

Last year, Xunda Co-operative, based in Zhejiang Province, was forced into a liquidation process when the firm was unable to repay depositors.

These recent bank failures have sparked concerns among regulators that the ongoing reforms in rural co-operatives will probably cause more losses for depositors.

Xu Dianqing, a leading financial researcher with the Great Wall Financial Research Institute, estimated that a large portion of 30,000 existing rural co-operatives will go bankrupt during the reform.

China's policy-makers, since the establishment of an independent banking regulatory body -- the China Banking Regulatory Commission (CBRC ) -- last year, have become increasingly aware that a well-managed deposit insurance system is the last missing link in the country's financial safety net.

"The stability of China's banking system will ultimately rely on the regulatory triangle: the central bank, the CBRC and a deposit insurance corporation," said Wei Jianing, deputy director of the Research Department of Macro-Economy under the Development Research Centre of the State Council.

Too big to fail

"Now the biggest obstacle for regulators in implementing a deposit insurance scheme comes from the country's large banks, especially the Big Four," Wei said.

The Big Four, or China's four largest State-owned banks, dominate the country's banking industry with an overwhelming 85 per cent of the market share.

Although private banks have sprouted over the last 20 years and have been gradually scoring credit from depositors, the Big Four still hold 65 per cent of deposits from residents.

Chinese depositors, with one of the world's highest propensities for saving funds, take it for granted that State-owned banks are the safest places for their savings, said Lin Zhiyuan, a senior financial expert with the National Development and Reform Commission's research institute.

Economists said the belief of "too big to fail" among depositors or banks themselves has become a worldwide phenomena, and can pose a serious threat to a country's long-term financial stability.

Judging from international experience, large banks are among those unwilling to join in a deposit insurance scheme, because they believe the government will bail them out once they are somewhere near bankruptcy.

Even in the United States, the government has been repeatedly forced into situations in which large banks have to be savaged to prevent further financial crises.

The United States pioneered the establishment of a deposit insurance corporation -- the Federal Deposit Insurance Corporation (FDIC) -- during the 1929-33 "Great Depression," when many of the country's banking firms went bust.

"A compulsory, rather than optional, deposit insurance system is preferred by most countries, and currently favoured by Chinese policy-makers," Lin said.

The Chinese Government is offering de facto insurance on deposits in the Big Four, covering all potential losses for depositors, individuals and enterprises alike.

This has been unfair for small banking firms, which are struggling to take in deposits, and may remove incentives for the Big Four to further improve risk control and corporate governance, she added.

Timing is key

An explicit deposit insurance scheme is good, but the timing to implement it is the key, economists said.

"While a deposit insurance system is aimed at enhancing stability in the banking sector, establishing it at the wrong time may cause instability," Lin said.

Depositors, during or immediately before a financial crisis, would see the government's efforts to insure their deposits as a signal for bank runs, according to Lin.

A country's banking sector should be "crisis-remote" when a deposit insurance scheme is established, according to Lin.

"That is why now is the best time to do it," she said.

The Big Four have long suffered from non-performing loans (NPLs), which is a result of decades of policy-directed lending to loss-making State-owned enterprises.

Economists said that NPLs are largely economic costs from China's market-oriented reforms, and a once-and-for-all solution is needed before the issue weighs on China's economic growth.

"In the late 1990s, the impression for outsiders is that China's banking industry is creaky and a financial crisis is imminent," Lin said.

However, the country's ailing banking firms have recently seen light at the other end of the tunnel as the government is pushing the Big Four for initial public offerings both home and abroad.

An injection of US$450 million by the PBOC into two of the Big Four has also helped them significantly increase their capital adequacy ratios.

If China manages to maintain its high economic growth in the coming years, the Big Four's NPL ratio will come down and capital adequacy ratio go up to be eventually in line with international standards, economists said.

"A drastic reform is going on within the country's banking firms. A nationwide banking crisis is highly unlikely now," Lin said.

China's proposed deposit insurance scheme will most likely incorporate the establishment of a deposit insurance corporation similar to the FDIC in the United States, economists said.

The insurance fund will likely come from the government and premiums charged from banking firms, they said.

However, a deposit insurance scheme may reduce incentives for depositors and other creditors to monitor the financial health of these institutions, according to a report recently released by the European Central Bank.

"Markets can limit the risks taken by banks, but only if some market participants unambiguously have their money at stake," the report said.

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