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China¡¯s financial risk mitigation has entered a critical phase, in which the overlapping risks of small and medium-sized financial institutions, bond defaults among real estate developers and local government debt collectively pose significant challenges to financial stability.

The China Financial Stability Report 2023 reveals that all 337 high-risk financial institutions are small and medium-sized banks, with total assets amounting to RMB6.63 trillion (USD941.6 billion). Meanwhile, bond defaults by real estate enterprises occur frequently, with several real estate enterprises entering bankruptcy.

In addition, local government debt remains high at about RMB50 trillion. These compounded risks heighten the complexity of resolving financial institution failures.

China¡¯s current Enterprise Bankruptcy Law offers sparse guidance on financial institution bankruptcy, but draft revisions to the Enterprise Bankruptcy Law (the revision draft) now address the sensitive issue. Accordingly, this article examines key provisions of the revision draft related to protecting funds and creditor priority.

Article 200

Article 200 of the revision draft specifies compensation rules for various protection funds:

1. 1. After compensating rights holders or acquiring creditor rights, protection funds shall have the right to recourse against the financial institution;
   2. For compensation or an acquired amount, funds shall enjoy the same priority of repayment as the compensated party; and
   3. If other laws have special provisions regarding priority of creditor¡¯s rights, those special provisions shall prevail.

This clause fills the gap in existing laws concerning recourse rights and the repayment priority of protection funds, providing a clear legal basis for participation of various protection funds in risk resolution.

Functions, compensation priority

A tiered financial protection fund framework has been developing since 2000, starting with sector-specific protection funds for securities, insurance and trusts.

In 2015, the deposit insurance fund (DIF) was introduced pursuant to the Deposit Insurance Regulations, followed by provisions for a financial stability fund (FSF) in the second revision draft of the Financial Stability Law in 2022.

As such, China has finalised a multi-level architecture for its financial protection framework.

The financial stability fund. Established as a backstop for significant financial risks, the FSF operates in tandem with the deposit insurance fund and other industry-specific protection funds.

The deposit insurance fund. The DIF serves multiple functions.

• • Risk indemnity and security. Article 5 of the Deposit Insurance Regulations requires the DIF to provide full repayment for deposits up to the maximum compensation limit (currently RMB500,000), while sums beyond this are recoverable from liquidation assets. During the Baoshang Bank crisis resolution, the DIF assumed the institution¡¯s corresponding liabilities, providing comprehensive coverage for all personal savings deposits, corporate deposits and interbank liabilities up to RMB50 million. For corporate claims above RMB50 million, a tiered calculation method was applied, with 99.98% of corporate creditors fully reimbursed.
  • Early risk detection and remediation. Through tools such as risk-based differential premiums, comprehensive risk monitoring, systematic rating frameworks and a structured early intervention mechanism, the DIF proactively identifies and mitigatess risks within financial institutions. Corrective actions may involve mandating additional capital, restricting asset expansion and deleveraging.
  • Financial risk disposal. In Baoshang Bank¡¯s resolution, the DIF executed prompt intervention and, together with financial regulators, implemented a comprehensive takeover. Backed by funding from the central bank and DIF, the overall creditor recovery rate achieved about 90%. The DIF participated in establishing Mengshang Bank, took an equity stake in Huishang Bank, and facilitated the transfer of Baoshang Bank¡¯s assets, liabilities and business operations to successor institutions.

Insurance protection fund (IPF). Supported by premium contributions from insurance companies, the IPF¡¯s primary responsibilities encompass ¡°policyholder relief¡± and ¡°insurer resolution support¡±.

• • Policyholder relief. On the revocation or bankruptcy of an insurer, the IPF fills the gap in policyholders¡¯ unsettled claims, ensuring minimum recovery ratios. For non-life insurance contracts such as property and casualty insurance and short-term health coverage, where liquidation proceeds are inadequate to satisfy insurance debts, the IPF tops up the difference in statutory proportions. For life insurance policies with long-term and personal features, the IPF prioritises assignment of policies to the assuming insurance company. If the assuming company faces a deficit from the transfer, the IPF will offer remedial support.
  • Insurer resolution support. The IPF offers liquidity assistance, including loans to ease immediate financial strain. In terms of governance intervention, it assumes a shareholder role by acquiring equity in distressed insurers or injecting additional capital, which contributes to enhanced corporate governance and business performance. Notably, during the 2006 New China Life Insurance crisis, the IPF took a 22.53% ownership interest and directed the reorganisation. In the context of policy assumption, the IPF contributed to the risk disposal of Anbang Insurance by assisting in asset divestiture and the formation of a successor entity (Dajia Insurance) to assume compliant policies. Throughout the receivership proceedings for Tianan Property Insurance and Huaxia Life Insurance, the IPF has consistently participated in risk resolution efforts, supporting the maintenance of essential insurance operations.

Concerning the priority of compensating bodies, the DIF and other protection funds across sectors can settle claims to financial consumers through direct compensation, authorising an agent institution or extending guarantee support. When authorised institutions make payments, they will be entitled to the same order of repayment as the beneficiary.

Conflicting priorities

In specifying the order of repayment, article 126 of the draft revision elevates social insurance contributions to the same priority as employee claims. This clashes with existing specialised financial legislation. The Commercial Bank Law mandates in article 71(2) that in liquidation of a commercial bank, personal savings deposits (principal and interest) must be paid preferentially after covering liquidation expenses, outstanding employee wages and labour insurance costs in sequence. Also, under article 91 of the Insurance Law, insurance claims rank below employee claims but above overdue social insurance contributions.

Repayment priorities for personal savings deposits and insurance claims under these laws are thus at variance with the revision draft, so subsequent amendments to priority warrant close attention.

Du Wenle is a partner at Han Kun Law Offices. He can be contacted by phone at +86 158 9987 8492 and by email at wenle.du@hankunlaw.com

Pang Yadan is an associate at Han Kun Law Offices. She can be contacted by phone at +86 188 1099 6303 and by email at yadan.pang@hankunlaw.com