The People's Bank of China, the central bank of the country, has started to solicit public opinions on the establishment of the system, a prelude to formal installation of this long-awaited deposit safeguard mechanism.

The central bank will cap insurance coverage at 500,000 ($81,000) for each depositor's saving at each bank. Such coverage will give full protection to 99.6 percent of the depositors in China.

China is not the first economy to have such a system to protect depositors. The United States established such a system during the Great Depression, while more than 100 other economies such as Canada, Germany and Hong Kong all followed the practice.

The system, which was born at the vortex of a financial crisis, aims to reduce information imbalance between banks and depositors, protect the latter and boost market confidence.

But China's decision to introduce such a system has more purposes. It is supposed to inject more risk and competition into the market to pave way for more financial reforms.

To understand this, it is needed to first review China's deposit protection practice.

Although China doesn't have a deposit insurance system, the government actually bailed out almost all insolvent financial institutes in the past decades. From 1998 to 2003, more than 300 financial institutes went bankruptcy. Their debts of 170 billion yuan, owed to individual depositors and investors, was repaid by governments. The practice leaves an impression to retail depositors that all their savings are 100 percent safe with the government believed to provide the final guarantee.

So, unlike developed economies, which go from no guarantee to limited guarantee or full guarantee, China actually goes from full guarantee to limited guarantee.

The government guarantee in China, an unwritten rule, is a legacy of the era of planned economy, when nearly all banks and other financial institutes were invested and controlled by the government.

Now that the government is working toward establishing the deposit insurance system, it means that the authority will let a market system to replace the government-insures-all model, a typical attempt to reduce government intervention with the market.

By asking the market to insure its banks, the government is injecting a little risk into the banking system.

The insurance system can be seen as a prelude for the establishment of private banks. As a prerequisite, private banks must be responsible for their decisions and operations. They shouldn't expect the government to bail them out in case of financial meltdown.

With this rule erected, China is paving the way for the establishment of private banks.

Similarly, the introduction of the deposit insurance system also conveys a message to state-controlled financial institutes: the government will not unlimitedly pay the bills for them.

In addition, the system heralds the removal of deposit floor, the last step of China's interest rate liberalization. China has long placed a floor deposit rate. Although the rate is allowed to be lifted by a certain range in recent reform measures, the floor has not been scrapped, which means banks are not allowed to decide deposit rates by themselves.

The controlled interest rate system has been a problem haunting China's financial system. It hinders the formation of market-orientated rates, creates an artificial interest rate gap for banks, reduces effects of monetary policies and weakens competition among financial institutes.

China has scrapped lending rates, but retains the deposit floor, mostly because of fears that banks will vie to increase deposit rates to attract depositors. In China, big state banks are not keen to increase deposit banks thanks to their large client base, but smaller city commercial banks and other financial institutes are eager to attract more deposits to boost their capital pools. A pursuit of deposits may come with large risk appetite, thus putting depositors' money and interest at risk. That explains why the government is reluctant to remove the deposit floor. It is afraid it will be dragged into unlimited responsibility of insuring all depositors.

Now that a clear deposit insurance system is to be set up, depositors' interest will be protect by the market rule instead of the previous unwritten government rule. With that guarantee in place, the time for scrapping the deposit floor is coming closer.

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