The credit squeeze in June that exposed banks' liquidity management shortcomings has given fresh impetus to the establishment of a deposit insurance scheme.

Though common in most other financial markets, deposit insurance is an idea that has remained in the planning stage in China for years. The big banks do not like it because they are loath to subsidize the smaller banks in a way that could increase their competitiveness. The regulators are not in a hurry to push it either, because they feel there are sufficient mechanisms in place, such as the reserve requirements and the cap on the loan to deposit ratio, to rein in banks.

Such complacency was shattered by the June fiasco when normally staid bankers scrambled for money in uncharacteristically ungentlemanly ways outside the sanctuary of the chummy interbank market. Some banks were known to offer exceptionally high interest for overnight deposits from the public in the liquidity crunch that drove the short-term interest rate to more than 30 percent a year at one stage.

There were rumors of individual banks defaulting on their interbank borrowings, although these were largely unsubstantiated, and media reports of massive withdrawals have understandably raised concern in the minds of many depositors about the integrity of the banking system in general and of the smaller banks in particular. Such doubts could make it even more difficult for smaller banks to compete for deposits with the large State-owned and city banks.

Failure to attract deposits would greatly constrain the lending business and other services of the smaller banks which are an important source of funding to the many small and medium-sized manufacturing enterprises in the private sector. For that reason, the role these small local banks play in channeling capital to the real economy would be greatly constrained especially at a time when interest rates have yet to be fully liberalized.

So it seems that the banking authorities are now coming round to the view that there is a need for the introduction of a deposit insurance scheme. A senior bank regulator recently said that preparation for such a scheme would be complete before the end of the year. That was the first time a target date has been mentioned since the idea was broached years ago.

Of course, objections from the bigger banks can be expected. Because of their large deposit bases, they would have to make much bigger contributions than their smaller counterparts to the scheme they believe they do not need. What irks these large banks is that the scheme could put the smaller banks on a more equal footing to compete with them for deposits.

But a deposit insurance scheme is seen to be crucial to further financial reform. It can pave the way for the raising, or removal, of the regulated maximum loan to deposit ratio. Doing so could release a large chunk of liquidity in the banking system and lift a primary restraint on the growth of smaller banks. Some bankers have argued that a deposit insurance scheme will provide sufficient protection to depositors, making the cap on the deposit ratio unnecessary.

Removal of the cap would benefit not only smaller banks but also foreign banks, which are short on deposit gathering capability in China but long on lending expertise. Some of them have said they are keen to expand into the second-tier cities and townships in the industrial heartland of the Yangtze River Delta region to service the small and medium-sized enterprises in the private sector that are not adequately served by the large domestic banks.

The domestic banks can benefit by funding the loans to SMEs through the interbank market and make a profit at minimal risk from the interest spread. They, too, can have something to gain from increased competition brought about by financial reform.

Big banks must realize that deposit insurance is essential to the protection of public interest from the sometimes unpredictable market forces unleashed by the opening-up of the banking system.