The People's Bank of China, the country's central bank, has started collating public opinion on the establishment of a deposit insurance plan to better protect savers and free up interest rates.

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

The United States established such a system during the Great Depression, while more than 100 other economies such as Canada, Germany and Hong Kong have followed suit in recent decades.

The protection system aims to reduce the imbalance of information between banks and depositors, provide protection and boost market confidence. But China's decision to introduce such a system is also aimed at injecting more risk and competition into the market.

To understand the system and its goals, it is important to understand China's deposit protection practices.

Although China does not have a deposit insurance system, the government has bailed out almost every insolvent financial institute in recent decades.

From 1998 to 2003, more than 300 financial institutes went bankrupt and governments at different levels paid off their collective debt of 170 billion yuan ($27.4 billion) owed to individual depositors and investors. This practice has left an impression to depositors that all of their savings will be guaranteed by the government. But if the new system is approved, China will be going from a full guarantee to a limited guarantee.

China's unwritten rule of a government guarantee is a legacy of its planned economy, when nearly all banks and other financial institutes were created and controlled by the government.

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

And 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.

Similarly, the introduction of the deposit insurance system also conveys a message to State-controlled financial institutes that the government will not pay for their bills.

Since last year, the government started allowing corporate bonds, which were often guaranteed or invested by financial institutes such as banks, to default. Previously, the government always repaid corporate bonds when the issuers and banks were unable to cover the costs. Now it wants market players - banks, companies and investors alike－to share the risks and responsibilities.

Similarly, the government now wants to pull itself out of the unlimited guarantee of deposits to let market participants shoulder their own financial burdens.

The deposit insurance system heralds the removal of the deposit rate floor, the very last step in China's interest rate liberalization. China has long established a deposit rate floor and although the rate has been allowed to rise by a certain range, the floor has never been scrapped, allowing banks to freely decide deposit rates.

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 the effectiveness of monetary policies and weakens competition among financial institutes.

China has retained the deposit rate floor mostly out of the fear that banks will vie to increase deposit rates to attract customers.

In China, large State banks are not keen on increasing deposit rates because they have large client bases, but smaller city commercial banks and other financial institutes are eager to attract more deposits to boost their capital pools. A pursuit of a deposit scale may carry with it a larger appetite for risk, thus putting a depositor's money in possible danger. That explains why the government is reluctant to remove the deposit rate floor.

Now that a clear deposit insurance system will be established, the interest of depositors will be protected by the market system instead of the previous unwritten government rule. With that guarantee in place, the time for scrapping the deposit rate floor is close at hand.

The author is a Shanghai-based financial analyst. The views do not necessarily reflect those of China Daily.