China's nervous savers press home need for deposit insurance

* Draft of law dealing with bank failures now expected within three months

* Resolution and deposit protection framework likely to follow US model

* Jiangsu bank run shows state support no longer seen as absolute

By Lianting Tu

SINGAPORE, March 28 (IFR) - This week's run on a small rural lender in Jiangsu province has underlined the urgent need for Chinese authorities to unveil a framework that will protect retail depositors and wind down insolvent banks.

On Monday, depositors queued up to withdraw their money from Jiangsu Sheyang Rural Commercial Bank in Yancheng after rumors that the bank had turned down a request to withdraw Rmb200,000 (US$32,680). The panic soon spread to other branches in the area, which by Wednesday were exhibiting stacks of cash to try and calm depositors.

"It is logical that the Chinese government wants to insure bank deposits now with the noise of recent bank runs and corporate defaults," said Mike Murphy, managing director and restructuring specialist at Alix Partners.

Onshore market players now expect that the government will finish drafting legislation on a deposit insurance scheme within the next three months, and that the scheme will be accompanied by rules on bankruptcy of financial institutions.

Yiwen Lu, a Shanghai-based banking analyst at Shenyin Wanguo Securities, said she expected the two laws to be unveiled later this year. In fact, the bank bankruptcy law has already been drafted, according to Simon Gleave, regional head of financial services at KPMG.

Chinese depositors have long assumed that the government would step in to prevent a bank from failing. But the nervous savers in Jiangsu show that those assumptions are being challenged after an unprecedented bond default and a build-up of risks in the financial system. A recent government approval for the establishment of smaller privately-owned banks also increases the need for depositor protection.

As a result, market participants expect the government to speed up the rollout of the legal infrastructure to ensure stability and pave the way for further reforms.

"China's financial sector risks have moved into our forecast horizon as the authorities appear to be laying the groundwork for addressing widespread moral hazard problems in the credit market," said Standard & Poor's economist Paul Gruenwald in a recent report on China's financial risks.

Murphy noted that deposit insurance would have to be put in place before interest rate deregulation.

"Deposit insurance is the next stage for banking in China in order to increase visibility," Murphy said.

US MODEL

So far, China does not have a law that deals with bank failures nor does it offer an explicit guarantee on deposits.

The current bank regulation states the People's Bank of China could step in to oversee banks that are in danger of being insolvent, but there are no details about liquidation procedures. Also there are no measures that allow the regulator to step in before a bank faces liquidity issues.

"It is important for the regulator to intervene before banks actually run into liquidity troubles. It is a way to curb losses and therefore limit the hit on the deposit insurance fund," Lu of Shenyin Wanguo Securities noted.

Such an approach would mirror what happens in the United States. There, the Federal Deposit Insurance Corporation, established in 1933 to regulate deposit insurance, also has the authority to wind down failed banks.

The agency can close a bank as soon as its capital adequacy ratio drops below 2%. This is in addition to the traditional book value or liquidity definition of insolvency.

Once the FDIC declares receivership, it takes over and winds down the bank in order to prevent further losses. Specific liquidation procedures include calculating the value of the bank's assets and inviting bids for them.

The regulator may either sell the bank as a whole or sell it in pieces. In the meantime, the FDIC makes sure depositors' activities are uninterrupted in an "orderly liquidation." For depositors, the portion that is not covered by deposit insurance tends to be paid out proportionally after the liquidation.

The US bank bankruptcy and deposit insurance arrangements may provide an appropriate model for China to consider, partially because China also has a number of very big banks as well as medium and smaller banks at a provincial level, Gleave of KPMG pointed out.

"The US model is a good one for China to benchmark itself to. China will also need an outside independent regulatory body, like the FDIC in the US, to provide security to retail depositors," Murphy echoed.

"The US model is intended to protect depositors and wind down failed banks in a quick and efficient manner," Murphy said.

A CHINESE FDIC

China has been working on its bank deposit insurance rules since 1998. Current drafts call for the Chinese government to establish an entity called the Financial Stability Commission under the People's Bank of China to oversee deposit insurance, according to people familiar with the plans.

The scheme would cover up to Rmb500,000 (US$80,500) of retail deposits, but this would not include investments in wealth management products, according to a recent research report from Shenyin Wanguo Securities. The FDIC insures the first US$250,000 in deposits.

In the beginning, big banks in China are expected to put in more money toward the deposit insurance fund. On average, banks are expected to pay an insurance fee of 8bp to 30bp of their deposits, according to Shenyin Wanguo's report. The insurance scheme could guarantee a 40%-50% payout of the deposit covered by the insurance, the report said.

Meanwhile, China is also likely to adopt the approach least costly to the deposit insurance fund when winding down failed banks.

While many market participants believe the upcoming rules will instil some discipline into the Chinese banking system, some analysts are less optimistic.

"What the Chinese government cares about is social stability. Hence, it is likely to still look at bank bankruptcy on a case-by-case basis even after the release of the new rules," said Ritesh Maheshwari, lead analytical manager of financial services ratings at Standard & Poor's.

(Reporting By Lianting Tu; editing by Christopher Langner and Steve Garton)