China Rethinks Safety Net for Its Banking System

This morning the New York Times published an article about how "China Rethinks Safety Net for its Banking System" (Link here). This article goes in-depth to show how China is considering banking reform to not allow for bailouts of banks in trouble and hopefully create a new habit for banks at making smarter loans to both companies as well as individuals. This reform will help to make banks take responsibility for bad loans and the consequences that come along with these because of the governments unwillingness to bail them out. Neil Gough states in his article:

With the introduction of deposit insurance on Friday, Beijing is looking to shake the public’s faith, namely the long-held belief that the government will bail out troubled banks. In short, China is trying to introduce risk into the system.

As China moves to restructure its state-run economy, such banking reform is considered critical. To help bolster consumer demand and wean itself off growth fueled by cheap credit, China needs banks to take a more market-driven approach. That means making smarter loans to companies and individuals — and accepting the consequences when they don’t work out

Since China started opening its economy in the late 1970s, Beijing has played the role of financial arbitrator and ultimate guarantor. It has used banks to promote industries and companies deemed important to the state, propping them up in times of trouble.

When Hainan Development Bank collapsed in 1998, China’s central bank made sure no depositors incurred losses, by transferring their accounts at full value to the much larger Industrial and Commercial Bank of China. Now, the government is signaling a willingness to pull away, at least selectively. On April 21, for example, China’s huge domestic bond market experienced its first default ever by a state-owned company

Officials at China’s central bank have closely studied the situation in the United States in the 1980s, when government deregulation of interest rates contributed to what became known as the savings and loan crisis. Banks and other lending institutions became locked in competitive increases in deposit rates, which drove them to make increasingly risky, high-interest loans. By the mid 1990s, nearly 3,000 United States financial institutions had failed.

Chinese regulators are hoping to avoid a repeat of the American experience. To help keep banks in check, China’s deposit insurance scheme will require the banks to pay a two-part premium: a fixed minimum rate, plus an adjustable rate based on the riskiness of their lending practices.

Now with these new reforms banks are forced to look at who they loan out to because of the lack of possible government bailouts for the banking system. What are your thoughts? Do you agree with this reform? Is this something that the US should consider going forward to avoid another future financial crisis?