A deposit insurance system should be established to cushion commercial banks against future risks, said an article in the Beijing-based newspaper China Business.

Discussion of the listing of State-owned commercial banks has been gaining momentum in recent months. Many regard listing as a key method for banks to sharpen their competitive edge and protect themselves from risks.

However, only a very limited number of banks can be allowed to go public. For the bulk of the banking sector, where information disclosure is still not sound enough, a deposit insurance system would be a more practical option to reduce risks, said the article.

A deposit insurance system settles bank debts once a bank goes bankrupt. Its purpose is to protect the interests of depositors and stabilize the financial system.

Financial institutions accepting deposit business usually pay insurance premiums to deposit insurers and if they encounter crises, the insurer provides funds to restore their liquidity or pay depositors for part of their losses.

It can help prevent a widespread financial crisis after the collapse of one or a few banks.

The system originated in the United States in the 1930s. By the 1960s, many other countries had realized the significance of such an arrangement and established their own deposit insurance companies.

In the wake of China's entry into the World Trade Organization, domestic financial institutions are about to face more challenges from their foreign rivals. Risks will increase accordingly for domestic commercial banks.

Meanwhile, as the liberalization of the financial sector accelerates, the operational risk of the industry grows.

The 1997 Asia financial crisis also highlighted the urgency of setting up a system to ward off financial crises and stabilize financial order, the article said.

The deposit insurance system could also play an effective supervision role in the financial system, and hence, to a large extent, prevent credit crises and the collapse of banks, the article pointed out.

Through its insurance business, the deposit insurer can regulate the business activities of financial institutions. In the process, the insurer examines financial firms' documents and based on that can either support them or put pressure on them to reform their operation.

Under such an arrangement, the insurer has the right to order badly mismanaged institutions to temporarily stop business for consolidation.

In extreme cases, the insurer can withhold insurance coverage.

Through those measures, the deposit insurance system can effectively supervise the financial system, forcing it to operate legally and in accordance with the rules of the banking administration.

The effective supervision of banking authorities certainly can lower the possibility of, or even ward off, the occurrence of financial crises. But such supervision cannot take the place of the deposit insurance system, the article said.

Financial supervision by banking authorities is an anticipatory crisis-prevention measure. In today's financial market, however, new financial products are emerging continually, making financial risks more unpredictable than ever. Financial panic may occur at any time and the supervisory measures from the banking authorities may be too late to deal with any crises.

The deposit insurance system, on the other hand, uses a combination of preventative measures instituted before the occurrence of crises and after-the-event remedial measures. It can counter any weakness of supervision of financial authorities, and thus it is an important line of defence.

In China, supervision of the financial sector is not very effective. The supervisors have much to learn from Western experience. The deposit insurance system is one of the major risk-spreading and risk-absorbing supervisory measures used in mature Western economies.

Therefore, the establishment of China's own deposit insurance system, based on Western experiences, is an urgent task of the country's financial regulators.

The establishment of such a system will reduce the pressure on the central bank in their dealing with crisis-threatened financial institutions, the article pointed out.

Currently, China's financial institutions depend heavily on the central bank for capital aid. Once a crisis occurs, the central bank shoulders the responsibility as the final provider of funds for both depositors and the concerned banks.

That means all the credit risks of the entire country are piled on the central bank, which is incapable of shouldering the burden, the article said.

In such a situation, if some financial institutions encounter a crisis, the central bank has no option but to put more money into circulation even at the risk of inflation and an oversupply of money.

(China Daily September 22, 2003)