Apart from protecting depositors, the new system is set to bring about profound changes to the banking sector. Small banks, in particular, face an uphill battle in maintaining their capital sources as depositors tend to put their money in major banks that are "too big to fail".

According to the deposit insurance rules, the insurance institution can cover savings of up to 500,000 yuan. It means people who have more than 500,000 yuan in savings in small banks will have to consider moving their money elsewhere.

This will force small banks to further raise their deposit interest rates (smaller banks generally offer rates higher than the big ones to attract depositors) and improve their operational efficiency to earn more profits from lending. Otherwise, their profit level will drop and their operations will be unsustainable. The major banks, though, could benefit from money transfers from smaller financial institutions, leading to rising capital concentration in the banking system.

China's top five banks account for about half of the sector's assets and 60 percent of the total profits. In contrast, in the United States, the largest 25 banks account for about 40 percent of the overall banking assets.

Following the deposit insurance system, the asset concentration level in China may rise further, leading to the problem of "too big to fail" if regulators cannot properly regulate the sector in accordance with the upcoming new changes.

Nonetheless, the deposit insurance system is a major reform marking the shift to a more market-oriented regulatory model, which is crucial for a transitional economy such as China.

Until now, the State acts as the lender of the last resort and shoulders a de facto responsibility of bailing out any insolvent financial institution, creating the problem of moral hazard. Taking advantage of that hidden rule, depositors did not care much about which banks are safer while the banks were hardly worried about the sustainability of their operations. Also, some reckless financial institutions engaged in risky deals with a view to making more profits only to incur unaffordable losses and become insolvent.

The new insurance scheme will force such financial institutions to better abide by regulations and pay more attention to operational risks, thus improving the overall competitiveness of Chinese banks.

The author is a senior writer with China Daily. [email protected]