CHINA RETHINKS SAFETY NET FOR ITS BANKING SYSTEM

The Bank of China’s Beijing headquarters. A deposit
insurance system goes into effect on Friday.

HONG KONG; April 30, 2015 — When the United States started insuring customer deposits, the government wanted to instill faith in the country’s financial system, which had been broken by a string of bank runs and failures during the Great Depression.

China wants to do the opposite.

With the introduction of deposit insurance on Friday, Beijing is looking to shake the public’s faith, namely the long-held belief that the government will bail out troubled banks. In short, China is trying to introduce risk into the system.

As China moves to restructure its state-run economy, such banking reform is considered critical. To help bolster consumer demand and wean itself off growth fueled by cheap credit, China needs banks to take a more market-driven approach. That means making smarter loans to companies and individuals — and accepting the consequences when they don’t work out.

“The reality in China was that the deposits of the proletariat have always been de facto backed up by the central government,” said Jim Antos, a banking analyst in Hong Kong at Mizuho Securities Asia. Formal deposit insurance is “the first step in a process where maybe we can have some way to deal with the resolution of financial problems in banks in China, something like a bank failure.”

A Nation of Savers

China has a lot to insure when it introduces bank deposit insurance on Friday.

$20

trillion

CHINA

15

Total bank

deposits

10

UNITED

STATES

5

Adusted for inflation

0

’00

’05

’10

’15

Source: Bloomberg

By The New York Times

Since China started opening its economy in the late 1970s, Beijing has played the role of financial arbitrator and ultimate guarantor. It has used banks to promote industries and companies deemed important to the state, propping them up in times of trouble.

When Hainan Development Bank collapsed in 1998, China’s central bank made sure no depositors incurred losses, by transferring their accounts at full value to the much larger Industrial and Commercial Bank of China. During a bank run last year at a rural lender in the eastern province of Jiangsu, the central bank delivered cash by the truckload and local politicians went on television to reassure people their savings were safe.

Now, the government is signaling a willingness to pull away, at least selectively. On April 21, for example, China’s huge domestic bond market experienced its first default by a state-owned company, and analysts expect more to follow.

The banking sector sits at the center of the overhaul effort. For years, China’s banks have paid ordinary savers generally low rates on their deposits and lent those funds to state-run companies, which have been known for making wasteful investments. Allowing market forces to play a bigger role in this process is intended to push banks to more accurately price risk when lending.

Deposit insurance is just the first step — and a relatively easy one. The government also plans to remove the caps on interest rates that banks pay on those deposits, which officials have signaled could happen as soon as this year.

Combined, these two measures will force Chinese banks to reorient their thinking and take into account market dynamics. Without the implicit backing of the government, banks will have to pay more attention to the creditworthiness of borrowers, rather than simply favoring loans to state-owned enterprises.

They will also have to compete for customer deposits by paying higher interest rates to savers. China’s leaders hope that consumers, with extra money in their accounts, will increase their spending; Beijing sees consumer demand as a main driver of the country’s future economic growth.

The challenges are significant, for banks and the economy. China has been considering more liberal interest rates since the mid-1980s, and the introduction of deposit insurance since at least 1993. Policy makers have hesitated in part because similar financial reforms have set off crises in other markets.

Officials at China’s central bank have closely studied the situation in the United States in the 1980s, when government deregulation of interest rates contributed to what became known as the savings and loan crisis. Banks and other lending institutions became locked in competitive increases in deposit rates, which drove them to make increasingly risky, high-interest loans. By the mid-1990s, nearly 3,000 United States financial institutions had failed.

Chinese regulators are hoping to avoid a repeat of the American experience. To help keep banks in check, China’s deposit insurance plan will require the banks to pay a two-part premium: a fixed minimum rate, plus an adjustable rate based on the riskiness of their lending practices.

“Banks are on notice if they raise rates and then engage in what the regulators regard as riskier lending, they will have to pay higher insurance premiums,” said Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics who has studied China’s financial system for decades. “This it is hoped will deter such risky behavior and thus head off a competitive race to raise rates when the cap on deposit rates is lifted.”

For the banks, the insurance premiums represent an additional expense that could crimp their profit margins. China’s central bank governor, Zhou Xiaochuan, said the base premium would be set at only 0.01 percent to 0.02 percent of deposits at the onset, a level he described as “much lower than the initial rates in the majority of countries when they introduced deposit insurance,” according to transcripts of interviews published this week in the Chinese press.

So far, regulators have declined to say at what level they will set the adjustable, risk-based premiums. “It’s like with car insurance,” Mr. Zhou said in the interviews. “Drivers who get in accidents pay higher premiums, those that don’t pay lower ones. This helps create a positive incentive to reduce risk.”

Ordinary Chinese, too, will have to digest the new risk in the banking system. Under the insurance plan, only the first 500,000 renminbi, or roughly $80,000, in any given account will be insured.

Officials say this will effectively cover 99.6 percent of all depositors. But analysts point out that the amount of deposits covered will be much lower — some estimate that only around 50 percent of deposits by value will be insured, because some very wealthy individuals park large sums in their accounts.

Changing public perceptions about the risk of bank deposits could have implications for another huge part of the system: shadow financing, or off-balance-sheet fund-raising.

In recent years, trust companies and other loosely regulated institutions in China have issued billions of dollars in loans, relying on funds raised by selling short-term, high-interest wealth management products. It is a murky market where levels of risk, including of default, are difficult to quantify. But ordinary investors regard the risk of such products as comparable to savings deposits, since they are often marketed by banks.

Analysts say that could change with the introduction of deposit insurance, potentially pulling money out of riskier investment products and putting it back into the official banking system. That could be a good thing in the long term, even if it leads to more defaults in the near term.

“Households will likely keep some resources in higher-return, higher-risk instruments, but they will properly recognize the risks involved,” said David Dollar, a senior fellow at the Brookings Institution and a former China-based official at the United States Treasury Department and the World Bank.

“The government can then allow some defaults and bankruptcies, which they have done recently,” Mr. Dollar added. “This is a normal part of a market economy and should not be alarming.”

The New York Times