Summary:
China has accelerated its market-based legal reforms in recent years to prevent and defuse financial risks in its financial system. China's banking sector has established a relatively comprehensive market-based interest rate system using laws and regulations that have strengthened the decisive role of the market in controlling capital flow. Moreover, the China has relaxed restrictions on foreign investment and increased market competition in the banking sector. China has simultaneously improved banks' exit mechanism, canceled implicit government guarantees, and promoted the gradual establishment of a deposit insurance system (DIS) in building a legal risk-prevention mechanism for the banking sector. In 2015, China formally promulgated and implemented the “Regulations on Deposit Insurance.” In 2016, the deposit insurance rate was transitioned gradually from a fixed rate to a differential rate based on bank risk, which is consistent with market principles and protects depositors' interests. Therefore, we analyze the role of market-based and legal reforms in the financial sector to prevent and defuse financial risks, in addition to exploring the coordination effects between different reform measures. We use a spatial model to compare the welfare effect of the DIS implementation in cases with and without implicit government guarantees. We focus on the impact of market competition on bank stability under the DIS. The model explores depositors' savings choices when the bank's stability is its private information. We analyze the market equilibrium with interbank interest rate competition and venture capital games. We find that the DIS can reduce banks' risk-taking behavior and performs better than implicit government guarantees. However, implicit government guarantees generate an adverse-selection problem. Although the guarantees can protect depositors, they also reduce depositors' requirements for bank stability and encourage banks to pursue high-risk and high-yield assets, which reduces their stability. A risk-adjusted premium DIS can effectively increase bank stability by linking insurance premiums to the bank's risk. The positive effect of the risk-adjusted premium DIS on bank stability and social welfare becomes more significant with more intensive competition in the market. When the market allows for free entry under the risk-adjusted premium DIS, intensified competition may cause inefficient banks to pursue high-yield assets in the short run, which reduces their stability. In the long run, high-risk banks will exit the market and more-efficient banks with low risk will enter and enjoy a sizable market share. As a consequence, the risk-adjusted premium DIS helps increase the banking sector's stability by protecting depositors' interests when their banks exit the market. Therefore, China should combine well-designed risk-adjusted premium DIS with policies that strengthen market competition and protect depositors' interests. This would reduce the potential cost for the government of preventing and defusing bank risk, which increases social welfare. We contribute to the literature in three ways. First, we analyze the risk and welfare effects of the implementation of the DIS considering implicit government guarantees. Second, in contrast to the literature on the implementation effect of the DIS, we focus on the coordination between the DIS and deposit market competition. Our approach supplements the literature on DIS and policy coordination. Third, we use a spatial model to describe interbank competition and apply it to the deposit market with asymmetric information. We simultaneously consider free-market entry in the long run and explore the effects of market competition in both the short and long run. Our conclusions have significant policy implications for accelerating the market-based reform of China's banking sector and improving the current DIS. In the long run, the China should adhere to and improve the market-based DIS in addition to maintaining the currently high level of deposit insurance coverage. Moreover, the China should improve risk measurement techniques, accurately and reasonably determine risk-adjusted premiums, and increase information disclosure to reduce information asymmetry. Competition policies should be coordinated with the DIS to improve policies and exit mechanisms to enhance the banking sector's overall stability. While improving the efficiency of market competition, the China can also better protect depositors' interests and maintain social stability.
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