Insuring a Path to Chinese Reform; Deposit Insurance Would Be an Important First Step in China’s Big Financial Reforms

Insuring a Path to Chinese Reform

Deposit Insurance Would Be an Important First Step in China’s Big Financial Reforms

AARON BACK

Nov. 5, 2013 7:28 a.m. ET

China’s reformers are banking on deposit insurance. As Communist Party leaders meet this weekend for the secretive “third plenum,” there are high hopes the parley will lead to big bang changes to the financial system. Deposit insurance for savers would be an important first step. Investors should expect movement on this soon. The U.S. Federal Deposit Insurance Corp. recently extended a memorandum of understanding with China’s central bank, a signal that momentum is building.Liberalization of China’s financial sector is necessary to cut the economy’s reliance on investment and to discipline banks so the country’s deep pool of savings flows to companies that deserve it, rather than to white elephant projects. There is no specific timetable, but policy makers say they will eventually let markets set interest rates, rather than the state, and permit free flows of capital across China’s borders. These are big steps that would bring China’s economy into the global financial fold, and expose it to its whims.

Deposit-insurance is a prerequisite for deeper reforms, providing a foundation to withstand the inevitable volatility that will come when banks are forced to compete for customers with market interest rates, or when savers suddenly have the ability to send money abroad easily.

Deposit insurance gives assurances to savers to leave money put and it can stem bank runs jumping bank to bank. It would signal that authorities are prepared to let some banks fail, encouraging bankers to say no to borrowers who aren’t likely to pay them back, while directing money to private companies that are now starved for credit.

In the U.S., deposit insurance was put in place after the bank collapses of the Great Depression. In the wake of the euro-zone crisis, Europe is looking to create a continentwide system, although it may face greater challenges than China over how European governments would backstop the program. It’s encouraging that China might pre-empt a future crisis by putting a deposit plan in place beforehand.

In China, faith in deposits rests on the banks’ implicit guarantee from the state, which hasn’t let a major financial firm fail since Guangdong International Trust & Investment Corp. in 1998. This perceived backstop favors the big four state-owned banks with direct links to Beijing at the expense of smaller, privately owned lenders.

By encouraging savers to spread deposits around, an insurance program would diversify the financial sector and shore up funding for midsize banks, such as China Merchants Bank 600036.SH -0.46% and China Minsheng Banking. 1988.HK -1.00% These banks get less of their funding from deposits and rely more on the volatile interbank market instead.

Deposit insurance will be at the top of the list when China’s leadership huddles to plot policy priorities. It’s the key to building a banking system that is both market-oriented and resilient.