An explicit  Deposit Insurance System (DIS) has been under extensive consideration by the government for more than 20 years. The factors that have delayed it appear to have subsided, and it looks  like China is ready to start a DIS. But the real question is—Does DIS helps in the event of a systemic  banking crisis?

Deposit Insurance System

A  Deposit Insurance System (DIS)  is  a  practice  widely  adopted  by  countries  around  the  world,  and appears  consistent  with  the  Chinese  authorities’  goal  to  build  a  better-functioning financial  market  with  fair  competition  for  both  large  and  small  institutions  as  reforms increase competition.

Deposit Insurance System has grown Chart

Major features expected for a Deposit Insurance System in China

  • A government-administered “risk  minimizer” actively involved in supervisory monitoring and failure  resolution of troubled banks.
  • Compulsory  membership  for  deposit-taking  institutions  of  all  sizes.
  • A coverage  limit  of  cRMB 200,000-500,000,  which  would  protect  more  than  99 percent  of deposits.
  • A target size for deposit insurance funds at 0.5 percent of covered deposits, ex-ante, funded by fees charged on banks, likely to initially be based on a simple fee by size of bank and eventually benchmarked to banks’ risk profile, as assessed by bank regulators.

Regulators’ goals in introducing Deposit Insurance in China

Deposit insurance has been widely adopted around the globe

Since the 1960s, more and more countries worldwide have adopted an explicit Deposit Insurance System (DIS) with the total reaching 111 as of 2011. This demonstrates that a DIS is widely accepted by financial regulators  globally  as  a  key  element  in  building  a  modern  financial  safety  net.  As financial development and reform in China reaches a crucial stage of liberalization, a Deposit Insurance System (DIS) comes  naturally  into  the  regulator’s  sight  as  a  major  building  block  to  creating  a  more market-oriented financial environment.

Enhance  market  discipline

An explicit DIS provides a clearly defined exit strategy for troubled financial institutions. Compared with an implicit DIS, the depositors share the responsibility with regulators to monitor bank risks if they have large deposits exceeding the  insurance  limit.  If  banks  take  excessive  risks,  a  depositor  could  withdraw  their deposits if they perceive the bank is taking high risks and their deposits are unsafe.

Improve confidence for smaller institutions

As market competition intensifies, savers may  be  reluctant  to  deposit  in  small  financial  institutions  that  may  be  less  safe  than large banks. The existence of an explicit DIS helps improve savers’ confidence in small banks  by  ensuring  the  safety  of  their  deposits,  even  in  the  case  of  bank  failures, therefore enhancing the credibility of small banks. This improves the funding position for small banks in a competitive market environment.

Protect public interests

Social stability is a core concern for the Chinese government. A well-executed Deposit Insurance System (DIS) protects depositors, especially  the  mass-market  depositors.  As China’s financial market becomes more market-driven, failures of financial institutions are possible by historical experience. This makes protecting the wealth of the public a top priority if the regulators want to push reforms.

Deposit Insurance Moderate impact likely on net profits and ROE’s of banks

Implementation Of DIS Chart

Barclays said that, “We estimate the immediate negative impact of a Deposit Insurance System (DIS) on our net profit estimates for 2014 for the China banks in our coverage universe at -0.86 percent to -1.91 percent and the impact on ROE’s at -19bps to -36bps. We estimate it would take the fund 13 years to reach our assumption for target size of 0.5 percent of insured deposits. Although the market may interpret a DIS as the beginning of accelerated financial reform, creating a negative impact on bank shares, we estimate that any negative impacts on banks’ financials would be manageable and we believe the benefits of a DIS in the China banking system would outweigh the negatives in the long run.”

Deposit Insurance helps in a normal banking environment, not in the event of a systemic banking crisis

The DIS first came into existence in the US as a response to thousands of bank failures that took  place  during  the  Great  Depression  –  depositors  lost  US $1.4 billion  in  total  during  the period.  However,  an  explicit  DIS  may  not  be  able  to  curb  a  systemic  banking  crisis  as occurred recently in the US and Europe during the global financial crisis:

Governments still need to intervene with an implicit guarantee in a financial crisis

During widespread financial crises, governments may still need to offer a broader explicit guarantee as not doing so would further precipitate the situation. This is evidenced by the  recent  global  financial  crisis  in  which  many  countries  launched  extraordinary measures, including raising coverage limits, providing emergency liquidity to banks and offering full blanket guarantees for deposits.

Flight to quality

Deposits could fleet to big names in a crisis: When panic sentiment prevails  in  a  market,  historical  experience  suggests  that  bank  runs  usually  occur  on problem banks and extend to smaller/weaker banks. Depositors may move their money to larger/safer banks, further weakening the liquidity at the troubled financial institutions.

High concentration of deposits in China

The ability of an insurance scheme to share risks only applies when there are a large number of insured parties and they are highly independent. However, Chinese banks are dominated by the big 4 state-owned banks – ICBC, CCB, ABC and BOC – which together share almost half of the banking system. As of  April  2013,  RMB  deposits  at  the  four state-owned  commercial  banks  stood  at RMB47tn while the total deposit balance at all financial institutions was RMB97.8tn.

Deposits In China Chart

Barclays believe that a Deposit Insurance System (DIS) in China would not likely lower systemic risk, but rather create a fair competition environment supporting medium- and small-size financial institutions in an increasingly  competitive  market.  A  proper  and  comprehensive  exit  mechanism  for  banking failure could also reduce moral hazard and enhance market discipline.