News Analysis: China's deposit insurance brings floating interest rates closer

China's introduction of bank deposit insurance is ultimately expected to lead to deregulation of interest rates, signaling policy makers' commitment to financial reforms.

The central government announced on Tuesday that the scheme will begin on May 1, reimbursing savers if their banks suffer insolvency or bankruptcy. The scheme has been debated for nearly 20 years.

The reimbursement cap of 500,000 yuan (81,500 U.S. dollars) covers around 99.6 percent of accounts in China's banking system. Close to 12 times annual per capita GDP, the cap is more generous than the prevailing international standard of two to five times.

"Deposit insurance will pave the way for a market-based exit mechanism for banks and greater interest rate liberalization," said Qu Hongbin, chief China economist at HSBC.

The move is expected to put paid to the widespread belief among investors that the government will invariably bail out banks and protect deposits. Deposit insurance can lower the possibility of a run on a bank and contain financial contagion.

Fan Jianping, chief economist at the State Information Center, said the scheme will hold financial institutions responsible for their own losses and profits, making both banks and depositors more aware of the risks they face and more cautious about them.

The United States created the Federal Deposit Insurance Corporation (FDIC) in 1933 in response to thousands of bank failures in the 1920s and early 1930s. The FDIC is now the recognized leader in addressing risk in the U.S. financial system and protecting consumers.

"The success of similar schemes in the U.S. and other countries has shown that deposit insurance can help maintain financial stability," said Cao Fengqi, a finance professor with Peking University.

With deposit insurance in place, regulators may have greater confidence to liberalize deposit rates, which are under tight government control to shield banks from competition and safeguard profits.

Financial regulators, including central bank governor Zhou Xiaochuan, have hinted about major steps toward freeing up deposit rates in 2015. Loan rates were liberalized in July 2013.

The deposit insurance comes as the comfortable days of Chinese banks seem to be drawing to a close. New financial platforms with higher return promises, including Internet-based financing and wealth management products from Alibaba and Tencent, have prompted Chinese savers to withdraw their money from banks and invest directly, causing a decline in deposits.

Affected by this "financial disintermediation" and the economic slowdown, Chinese banks are reporting rising bad debts and squeezed profit margins. If deposit rates are liberalized, banks can fight back with rate hikes to win over savers.

Small and private banks, burgeoning in China thanks to government support, will particularly benefit from the scheme, which can attract deposits with higher rates.

Despite all the benefits, Lian Ping, chief economist of the Bank of Communications, said the scheme could also be a test for small banks. "The scheme is expected to level the playing field for smaller and private banks in the long term," she said.

"They need to strike a balance between high deposit rate incentives and their own investment management to secure a proper profit margin," said Lian. Endi