China plans to deploy billions of renminbi from a national deposit insurance fund to resolve a group of failed provincial banks, setting an important precedent for its approach to a future financial crisis.

The People’s Bank of China has agreed to share the cost of refunding customers with the local government in Henan province, clarifying the circumstances in which the deposit insurance system will pay out, according to two officials aware of the discussions.

The deal between local and national officials is an important step towards strengthening China’s financial system because knowing that insurance will pay out should reduce the incentive for depositors to withdraw their money from vulnerable banks.

Rising debt levels, weak local government finances after the pandemic and the recent run at the US’s Silicon Valley Bank have added urgency to China’s push for a stronger national safety net.

“This shows Beijing is still firmly committed to de-risking and moral hazard reduction,” said Rory Green, head of China and Asia research at TS Lombard. “It is a key test case for the national deposit insurance fund.”

Under the emerging deal between the local and national authorities, the PBoC will mobilise more than Rmb10bn ($1.4bn) — about one-fifth of the currently available deposit insurance funds — to repay customers at Yuzhou Xinminsheng Village Bank and three others.

The rural Henan banks took in billions of renminbi from online customers across China but collapsed in summer 2022 after the discovery of widespread fraud over a decade. Their collapse became a political issue at the height of the pandemic as depositors demonstrated on the streets to demand their money back.

Because the money was lost to fraud rather than bad lending, there was ambiguity about whether China’s deposit insurance scheme would be triggered. Under the planned deal, costs will be shared between deposit insurance and the local government. Online deposits are deemed to be protected in full up to a Rmb500,000 cap, while the amount that larger depositors get back will depend on how much police can recover from the fraud.

The emerging plan reflects an effort to lower tensions between China’s local and central governments when dealing with financial crises. In the past, the central government pushed the regions to absorb the costs of rescuing local financial institutions.

“The previous situation was like a patient who just discovered a serious disease, yet the attending doctor was trying to run away from it,” said one official. “But the illness should be treated by the doctor, not the quack who barely has any knowledge.”

China’s national fund was set up in 2015. It insures almost 4,000 banks and held Rmb54.9bn at the end of 2022.

But the circumstances in which it pays out to depositors are decided on a case-by-case basis, with authorities preferring to limit its use to cases where wider contagion in the banking system is feared. The fund was first tapped in 2021, when the PBoC took over Baoshang Bank, spreading fears about the health of regional banks.

Michael Pettis, a finance professor at Peking University and senior fellow at Carnegie China, said deposit insurance would be less effective in a situation where bad loans were spread across the financial system. “If it is just a few banks that get into trouble then the scheme will solve the problem,” he said. “If the loss becomes systemic it can’t possibly work.”

The People’s Bank of China, National Administration of Financial Regulation and Henan government did not respond to requests for comment.