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.

Shares of Chinese banks dropped in Hong Kong. Industrial & Commercial Bank of China Ltd., the nation's largest, fell 1.7% as of 10:25 a.m. local time, while China Construction Bank Corp. declined 1.9%.

Deposit Coverage

The insured amount proposed will be enough to cover all the bank deposits of 99.6% 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% 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.

Assuming premium rates of 0.05% to 0.11% for different types of banks, the deposit insurance system may reduce China banks' 2015 earnings by 1.53% and their net interest margin by 26 basis points on average, Barclays Plc analyst May Yan estimated.

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.

“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.”

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% 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.

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