The State Council recently published draft regulations for establishing a deposit insurance system that will cover more than 99 percent of all depositors in the country, signifying a landmark reform to the banking system.

According to the draft regulations, all deposit-taking financial institutions including commercial banks and rural credit cooperatives are obliged to join the program. Foreign banks’ branches in China and Chinese banks’ branches overseas will be exempt.

Banks will have to pay a certain proportion of deposits they accept to an insurance fund. Ratio figures, which have not yet been determined, will vary among banks based on their management and risk conditions. The system will offer full compensation to anyone with up to 500,000 yuan ($81,271) in their savings. Compensation for any loss beyond that will depend on how the bank’s assets are liquidated.

The draft regulations absorb previous practical experience of different countries and largely conform to China’s real situation. As a fundamental financial reform, it will profoundly influence China’s banking industry.

First, the deposit insurance system will make financial risks explicit, improving conditions for liberalizing interest rates. It will have important implications for enhancing the stability of the banking system and improving economic entities’ understanding of financial risks. Without such checks and balances, most banks would focus on profits and ignore risks, inevitably resulting in serious systematic risks in the future.

Second, the system will be conducive to establishing and perfecting the market-oriented exit mechanism. Restricting risks provides necessary pre-conditions for dealing with bank failure. The system is a significant component of the market-oriented exit mechanism, enhancing the efficiency of the banking system and reducing barriers to entry for banks. Private banks are expected to enjoy greater development under a deposit insurance system.

Third, it will also favor the banking operation. In the short term, the deposit insurance system will increase banks’ operating costs. The draft regulations do not specify how much banks will need to pay into the insurance fund, but the ratio is expected to be very low and will have a limited impact on bank profits. Meanwhile, setting differential insurance premium rates will encourage banks to adjust their deposit structures and relative business. After the public fully understands and accepts the deposit insurance system, small- and mid-sized banks will have the same advantages as big banks and be more competitive.

Fourth, the system will have minimal direct impact on depositors. The system will cover both individuals and enterprises.

According to central bank estimates, the maximum compensation of 500,000 yuan will cover more than 99 percent of all depositors. Interest rate liberalization will be completed under the deposit insurance system, bringing benefits for all depositors.

As a fundamental reform to the banking industry, there is still much work to be done before the system is officially implemented. Close attention needs to be paid to the process and relative preparations must be made to ensure the system’s steady promotion and efficient operation.

The author is a research fellow at the Institute of Finance and Banking at the Chinese Academy of Social Sciences.

Translated by Chen Meina

Revised by Tom Fearon