China's new draft law on financial stability, which stopped soliciting public opinion on May 6, has played a significant part in managing financial risk, and increasing financial stability has been thus initiated from a legal perspective.

There is some misunderstanding about the financial stability fund, with many mistaking it as a parachute for all financial risk and believing any investment decisions can be boldly made under such circumstances.

It should be noted that the financial stability fund is not intended to protect the interests of individual investors. It should be triggered only when major financial risks, which are big enough to jeopardize overall financial stability, are in existence. Such risks do not include market fluctuations like stock market sell-offs.

In other words, the financial stability fund should neither be responsible for preventing and defusing risk, nor help evade regular risk. It is a nonstandard means, only to be utilized in special cases.

Some define the financial stability fund as a capital pool, which is also worthy of further discussion. As opposed to deposit insurance, which is clearly defined as a means to protect depositors' interests instead of helping out banks, the use of financial stability fund is intertwined with more complicated issues. Europe and the United States have set up such funds to address their respective difficulties, and these experiences may not serve as valid references for China.

The financial stability fund should work as a kind of emergency capital reserve. When risks have endangered the entire economic and financial system and other solutions have turned out to be ineffective, the financial stability fund should step in. When the economic and financial systems stabilize, there should be other solutions to alleviate and deal with risk.

A legalized and market-based working mechanism aiming to cope with financial risk should be introduced in China in the first place. The intervention of the financial stability fund is conditional and an exit mechanism should be established in advance. For example, after a financial institution is liquidated, its residual value, if any, should be used to reimburse the financial stability fund.

The use of the financial stability fund should focus on emergencies or uncommon issues. There should not be too many details as to the specific application or utilization of the fund. Otherwise, some institutions or companies may be conversely encouraged and expand their risk exposure on purpose so that they can dodge their creditors.

Based on experiences in Hong Kong, Europe and the US, local regulators do not provide unconditional help. An exit mechanism has been established in advance to avoid any moral hazard and prevent the fund from evolving into a relief regardless of costs. The financially strapped party was responsible for the costs.

It should be noted that the financial stability is not a subsidy. The market should not develop unrealistic expectations about its efficacy. Otherwise the fund will be treated as a market fixture or even be misused by unscrupulous players.

According to the draft law, public capital such as relending from the People's Bank of China, the central bank, can serve as liquidity support to the financial stability fund. The central bank's relending can deal with risks indirectly with the fund. If financial institutions need to enrich their capital to restore their debt ratios to a normal range, the financial stability fund can inject capital into them. The fund will pay back the relending amount after it has made profits.

There is no need to set up an independent company to manage the fund. It is better not to manage the fund to avoid any unnecessary costs or profitability concerns. A well-established mechanism is more important, which means that the rules of fundraising and use should be clearly stated.

Banks, insurance companies or securities firms can be required to submit a certain amount of capital to the fund based on their respective asset value. The fund can be submitted in advance or after risks are managed. Or the fund can be submitted with short notice from local financial regulators.

The Financial Stability and Development Committee of the State Council, China's Cabinet, can designate a department to manage the fund and a special account can be set up at the central bank. Funds raised cannot be used under normal circumstances and no profitability requirement should be imposed. The ground rule is to ensure no losses and that the fund can be used whenever and wherever needed.

As for the disposal of financial risks－stressed in the draft version of the financial stability law－it is reasonable to allow local governments to use local resources and take the lead to grapple with risks lying in rural cooperative financial institutions or nonfinancial institutions.

But at the same time, we can see that a significant portion of the nonperforming assets of many local financial institutions and even national financial institutions is the result of intervention by local governments.

Such interventions can be further divided into two scenarios. The first is that local governments do not understand banks' management rules. They believe the more bank loans are provided, the better local economic development will be. They have not taken into account banks' debt levels, which are in fact local residents' deposits.

Or, they understand the rules, but they will take it for granted that the central government will help them out if there is a major crisis.

Therefore, a clear definition of local government responsibilities will help them to manage the financial sector by sticking to basic rules and prevent them from excessively intervening in financial institutions' operations.

Management of the financial stability fund can be handed over to local governments. They will therefore become truly responsible, dedicated and motivated in actively coping with financial risks by utilizing all kinds of resources. But a binding mechanism should be established in advance to prevent local governments from abusing their power.

As for cooperation between the financial stability fund and professional protection funds such as deposit insurance, it will only take place when a bank has encountered a large-scale run and deposit insurance becomes insufficient. The financial stability fund can provide capital under such circumstances to ensure the safety of deposits. They should not work simultaneously to address the same problem.

The writer is deputy head of the Shanghai Finance Institute.