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China plans to establish a deposit insurance system that aims to protect depositors when financial institutions go bankrupt.

A reliable source said yesterday the State Council, China's cabinet, had "in principle" approved the establishment of a deposit insurance system.

The People's Bank of China is working closely with the China Banking Regulatory Commission, the Ministry of Finance and other related government agencies on the design of the system.

"The State Council has agreed in principle, but more work needs to take place," said the official, who is familiar with the plan.

"But it's going to be a long process, and don't expect it to come out very soon," said the official, who wished to remain anonymous.

The system, which requires banks to buy insurance for the deposits they take and compensates depositors with premiums, in case the banks go bankrupt, aims to raise public confidence in the banking system, reduce government spending on covering losses from bankruptcies of financial institutions, and contain moral hazards that may arise if the government fully covers losses, the official said.

As financial reform deepens, China's financial authorities are increasing their efforts to build mechanisms that will safeguard social stability when financial institutions fail.

The authorities announced the establishment of an insurance protection fund earlier this month, which aims to compensate policyholders in case of insurer bankruptcy.

The idea of establishing a deposits insurance system, which is commonplace in developed countries, was proposed in China during the 1997 Asian financial crisis, when a string of small financial institutions closed down.

The need became more urgent last year, when a few loss-making securities brokerages were shut down and the failure of an influential private company pushed some of its subsidiaries, including financial firms, to bankruptcy.

"The sooner it (the deposits insurance system) can be established, the better, because it can help maintain stability," said Qiu Zhaoxiang, dean of the Institute of Finance at the University of International Business and Economics in Beijing.

The system, which complements China's financial security network, will help reduce government expenditures with a "market mechanism," he said. A financial security network typically includes central bank lending, prudent supervision and a depositor compensation system.

China has typically compensated the creditors of failed financial institutions with central bank lending, often guaranteed by local governments' fiscal incomes. "The cost is very high," the official said.

The planned system, though still in its infancy, is likely to provide only partial compensations to creditors by setting a ceiling to prevent moral hazards, and will treat individual and institutional creditors on an equal basis, he said.

In previous cases of financial institutions' bankruptcies, individual creditors are typically fully compensated by the government to ensure social stability.

The deposits insurance system, which charges higher premium rates on higher-risk banks, will also provide strong incentives for financial institutions to operate prudently, the official said.

China is reforming its banking sector at an increasingly fast pace as the local industry opens up gradually to foreign competition.