The establishment of a deposit insurance system is being planned that aims to protect depositors when financial institutions go bankrupt.

The People's Bank of China is working closely with the China Banking Regulatory Commission, the Ministry of Finance and other related government agencies on the design of the system.

"The State Council has agreed in principle, but more work needs to take place," said an official familiar with the plan. "It's going to be a long process."

The system, which would require banks to buy insurance for the deposits they take and compensate depositors if the banks go bankrupt, aims to raise public confidence in the banking system, reduce government spending on covering losses from bankruptcies of financial institutions, and contain moral hazards that may arise if the government fully covers losses, the official said.

As reforms deepen, financial authorities are increasing efforts to build mechanisms to safeguard stability.

The authorities announced the establishment of an insurance protection fund earlier this month, which aims to compensate policyholders in case of insurer bankruptcy.

The idea of establishing a deposit insurance system, which is commonplace in developed countries, was proposed in China during the 1997 Asian financial crisis, when a string of small financial institutions closed.

The need became more urgent last year, when a few loss-making securities brokerages were shut down and the failure of an influential private company pushed some of its subsidiaries, including financial firms, to bankruptcy.

"The sooner the system can be established the better," said Qiu Zhaoxiang, dean of the Institute of Finance at the University of International Business and Economics in Beijing.

Financial security networks typically include a combination of central bank lending, prudent supervision and a depositor compensation system.

China has typically compensated the creditors of failed financial institutions with central bank lending, often guaranteed by local governments' fiscal incomes, and the cost can be very high.

The system is likely to provide only partial compensation to creditors by setting a ceiling to prevent moral hazards, and will treat individual and institutional creditors on an equal basis, the official said.

In previous cases, individual creditors have generally been fully compensated by the government.

The deposit insurance system, which would charge higher-risk banks higher premium rates, will also provide strong incentives for financial institutions to operate prudently, the official said.

China is reforming its banking sector at an increasingly fast pace as it gradually opens up to foreign competition.

(China Daily January 13, 2005)