Deposit insurance just one step on the path to reform

Regulators in China are set to announce a long-awaited deposit insurance system as early as the start of next year, which should pave the way for the full liberalization of interest rates.

Draft rules for the system have been released by the State Council, the Chinese cabinet, for public comment.

It is probable that the deposit insurance system may use practices commonly adopted in other nations, such as limited compensation for depositors and differential insurance premium rates for commercial banks.

It has been unveiled that the maximum compensation will be 500,000 yuan ($81,400) for each depositor in a failed bank and that a special agency will be created to manage the deposit insurance fund.

Several questions surround the change. It will unleash new competition in the banking sector, but what will it mean for the typical Chinese consumer? Since the idea was first raised in 1993, why has it taken so long to become a reality? And what does it mean for the full liberalization of interest rates?

First, new competition will indeed emerge, with banks able to lure customers with more attractive rates. Smaller banks will probably be at a considerable disadvantage and not just because of their relative lack of size and financial muscle.

Customers will likely place greater trust in China's larger banks, fearing that smaller ones are more vulnerable to the threat of failure.

There is a real danger, therefore, that the bigger banks will get bigger and a market shakeout will result fairly soon, leaving the consumer with fewer choices. Measures should be in place to avert a large-scale shakeout.

Second, the long delay in formulating the system is a cause of concern. In the early 1990s, the Chinese economy had tremendous momentum, significantly boosted by an exponential increase in foreign direct investment. At that time, deposit insurance was probably considered an unnecessary risk.

Third, looking ahead at the path toward full liberalization of interest rates, several conditions are crucial to a successful transition:

· Borrowers are in a financially sound position, with a positive net worth and strong cash flow.

· Banks of all sizes should also have a positive net worth. They should disclose lending track records that present clear evidence of decreasing nonperforming loans.

· There should be professional management in the banking sector. The credentials of senior personnel should be disclosed, as should the justification for key management decisions, to create a climate of trust.

· Regulatory and supervisory standards should remain consistently high. It is essential that public evidence of strict and swift enforcement is provided where codes of conduct have been breached.

For these conditions to be met, it is vital to move slowly, with careful and very public scrutiny of these conditions at all times.

Zhou Xiaochuan, the long-serving governor of the People's Bank of China, has set an ambitious period of two years for the full liberalization of interest rates.

The author, Mike Bastin, is a visiting professor at the University of International Business and Economics in Beijing and a senior lecturer in marketing at Southampton Solent University's School of Business.