China's State Council announced that it had approved a plan that outlines the country's financial industry development during the 12th Five-Year Plan (2011-15) period, which serves as a guide for future legislation and policy.

Although the plan reiterates the need to deepen capital market development and financial reform, it now includes calls for establishing a deposit insurance system and bankruptcy mechanism as part of a framework to facilitate the orderly wind downs of failing financial institutions.

For small Chinese banks, these new elements are credit negative because they weaken the government's incentive to provide support to them.

Small banks are deposit-taking credit institutions that have limited geographic exposure and networks in China. They include city commercial banks, rural credit cooperatives, rural commercial banks, and rural cooperative banks.

At the end of 2011, China had 2,811 small banks, accounting for 20 percent of all banking system assets. By comparison, China's five large commercial banks and 12 joint-stock commercial banks together hold 64 percent of total bank assets.

The five-year plan suggests that China is moving closer to implementing a formal bank resolution regime. But while these measures would protect the depositors covered by the insurance system and contribute to the public confidence in, and the stability of, the banking system, the measures would be credit negative for bondholders and uninsured depositors in the several ways.

The rules will weaken the government's incentive to provide support, especially to small banks. Insurance protection for retail depositors and a clear exit framework will reduce the social costs of bank failures and the potential for contagion. As a result, there will be less need for the government to provide blanket protection and guarantees to support non-viable banks.

Such government support would remain more likely for those banks whose failure would cause systemic risk.

The new measures facilitate faster implementation of market reforms. With a formal bank resolution regime in place, we expect the Chinese government will be emboldened to pursue faster market reforms, such as interest rate liberalization and disintermediation.

Such measures would raise competitive pressure on small banks relative to large banks because small banks generally lack deposit and loan pricing power, thereby putting them at risk of net interest margin compression.

Higher premiums

The new arrangement could result in small banks paying higher deposit premiums for perceived deposit risks.

Although a deposit insurance system would bolster confidence among depositors covered by the insurance, the effect of deposit insurance and a formal bank resolution regime could be the reduced expectation of a blanket or unconditional bailout at times of stress.

The perception of greater risk could lead to increasing risk discrimination among depositors toward smaller banks.

Although the 11th Five-Year Plan also mentioned implementing a deposit insurance system and establishing an exit process for financial institutions, the 12th Five-Year Plan contains more operational detail that makes these efforts more likely to come to fruition in this planning period.

Specifically, the plan highlights the need to accelerate the legislation for a deposit insurance system and to implement it at the proper time. It also mentions establishing a bankruptcy mechanism, which was not specified in the previous plan.

Those plans echo the People's Bank of China's July China Financial Stability Report, which suggested that China is approaching the appropriate moment to introduce deposit insurance, and in an August speech, Zhou Xiaochuan, the Chinese central bank governor, mentioned the need to accelerate the establishment of deposit insurance. Therefore, we expect the deposit insurance system to be in place within the next year or two.