On October 13, 2016, the State Council released seven new sets of regulations and launched a major campaign against irregular online financial businesses. The campaign involved 17 ministries and offices, including the People’s Bank of China (PBoC), the China Banking Regulatory Commission (CBRC), the China Insurance Regulatory Commission (CIRC), the China Securities Regulatory Commission (CSRC), the National Development Regulatory Commission (NDRC), the Ministry of Industry and Information Technology (MIIT), the Ministry of Finance (MOF), the Ministry of Housing and Urban-Rural Development (MOHURD), the State Administration of Industry and Commerce (SAIC), the Ministry of Public Security, the Supreme Court, the Supreme People’s Procuratorate, the Office of Legislative Affairs of the State Council, the State Cyberspace Administration of China, the State Complaint Reception Office, the Propaganda Department of the Chinese Communist Party Central Committee, and the Social Order Department of the Chinese Communist Party Central Committee.
The scale of the operation, involving so many government agencies on a financial issue, is unprecedented in recent years and it exposes the serious problems which China’s online financial businesses are facing. In the past few years, many Fintech players have exploited the Chinese government’s tolerance on internet-based innovation and engaged in financial activities that bypassed regulations, or in some cases, involved outright financial fraud. The campaign targets online funding platforms that take advantage of the different regulatory standards in different industries to offer risky funding and lending. The campaign puts new stringent rules on five key online financial activities:
1. Peer-to-Peer (P2P) lending
The government has prohibited the practices of cash pooling, loan granting, and deposit taking, and has now limited the platform operator’s role to just providing a matching place for lenders and borrowers, acting only as an information rather than a credit intermediary. The platform operator is not allowed to initiate any deposit taking, fund managing, loan granting, or selling of third-party wealth management products. The government has also outlawed the earlier practice of combining different online platform participants’ funds into a single account and authorizing the platform operator to act as a fund manager in lending. As of June 2016, there are more than 2,300 registered P2P platforms with RMB 621 billion in outstanding loans. The number of platforms and outstanding loans are 98 percent and 12 times more than the corresponding figures in June 2014. Many P2P platforms had charged rates in the range of over 20 percent and the funds raised had been loaned for stock or property speculation. Credit and operational risks were both very high, and more than 1,000 P2P platforms were in distress in the past 12 months.
2. Crowd equity funding
The platform operator is no longer allowed to engage in self fund raising or loan granting in the name of equity funding. The platforms are barred from being involved in asset management or the debt/equity swap business. The platforms are only allowed to act as information intermediaries.
3. Online sales of high-cash value insurance policies
These are life insurance policies that allow policyholders to get a high cash refunds upon cancellation. This type of insurance policy is more short-term than long-term, and in the last three years many new insurance companies have use such products to entice business inflows. Online insurers are no longer allowed to sell their insurance products on platforms not regulated by the CIRC.
4. Third-party payments
The government now prohibits third-party payment platforms from keeping settlement-related funds in their discretionary accounts, and these settlement-related funds must now be kept in commercial banks. These funds are not allowed to be used for purposes other than settlements. The PBoC will establish a central clearing platform for third-party e-payments (e.g. China NetPay) to centralize the management of client reserve funds and gradually eliminate payment firms’ interest income from those reserve funds.
5. Online asset management
The government will impose strict licensing requirements and a qualified investors scheme on online asset managers. Online asset managers cannot accept business from unqualified investors and they cannot sell private placement products such as trusts or private equity products to the mass market online. Internet firms with multiple financial licenses will also be asked to put up firewalls to curb risks associated with related party transactions.
The government has set a stringent timeline on the implementation of the campaign, and the new rules are expected to be in place nationwide by March 2017. The current campaign is the most aggressive since the Chinese government decided to look into online financial activities in 2015. It also presents a challenge to the coordination between local and central authorities, as well as coordination between the various departments at both the central and local levels.
Challenges in Implementing the New Rules
Since the breakdown of the strict separation between commercial banking, insurance, and securities in the early 21st century, China has witnessed the emergence of the universal banking model, with the Ping An Group being the most notable case. The issue of regulatory arbitrage constantly haunts regulators and the current involvement of 17 ministries/offices under the State Council is an apparent attempt to resolve the regulatory vacuum issue. However, the challenge of coordination among so many departments is itself a serious challenge to the State Council.
At the same time, online financial activities have the unique characteristic that they are both national and local activities. A common pattern is that funding activities are conducted through the internet on a national basis but the lending activities are done on a mostly local basis. Effective monitoring of online financial activities requires both macro-level central coordination of different ministries and localities as well as micro-level local verification. This operational coordination issue is another challenge to the State Council.
Of the five types of activities targeted for control, online insurance sales, third-party payments, and online asset management all involve large-scale players which are fewer in number and possess relatively better in-house risk control mechanisms. At less than RMB 200 million, the size of the crowd equity funding market is relatively small and the asset trend is declining. The challenges that regulators face will mostly come from P2P. Aside from the coordination challenges in the implementation of the new policies regulating P2P, there are events which emerged recently in the US that challenge some basic assumptions behind the business model of P2P lending.
Recent US Experience in P2P Lending
P2P lending was pioneered in the US around ten years ago. Online services that match lenders directly with borrowers allow the lending platforms to operate with much lower overhead costs than traditional financial institutions. As a result, lenders can earn higher interest incomes compared to traditional channels, while borrowers can borrow at affordable rates much faster, even after the P2P company collects fees for providing the matching platform and completing credit checks on the borrowers. In addition, the low cost of internet transactions allows small personal or business loans which were earlier seen as uneconomical to be financially viable, meaningfully extending the universe of loans. The P2P idea caught fire and was heralded as a solid proof of Fintech innovation that improved the inclusiveness of the community.
The P2P business in the US also witnessed some operational issues like poor credit monitoring and operational lapses. However, it was generally assumed that the business model was sound and strong players with good operational control would ultimately survive and bring a new era to consumer banking. The world’s largest online P2P company and the acknowledged most sophisticated US P2P company, Lending Club Corporation, successfully sold 66.7 million shares to the public at USD 15.00 in 2014. The stock opened sharply higher than the initial IPO price when it started trading on December 11, 2014.
However, the euphoria surrounding P2P financial innovation did not last long. The increasing volume of P2P loans forced P2P platform operators to start packaging their loans for sale to third parties such as Jefferies Group LLC. These third-party buyers of P2P loans started to look closely at the quality of the loans and demanded higher rates, as the delinquency rate on P2P loans had shot up with the expanding portfolios. As shown in Figure 1, Lending Club’s shares are now trading significantly lower than the IPO price of USD 15.
Figure 1. Lending Club’s Share Price from Dec 2014
The worsening bad loan situation at Lending Club and a blotched loan sale forced its CEO Renaud Laplanche to resign in May 2016 and the company had to tighten its credit policy and raise interest rates to compensate its loan buyers. Despite all the measures taken, the company announced the second time this year (October 13) that it was stepping up collection efforts on delinquent loans.
The collection problem associated with Lending Club is not an isolated case. Another venerable P2P platform lender, CircleBack Lending Inc., announced recently that it has stopped making new loans. The company was forced to stop extending loans after more of its borrowers failed to repay their debts and funding dried up. In CircleBack’s regulatory filing, the company stated that “we have continued to observe higher delinquencies in populations characterized by high indebtedness, an increased propensity to accumulate debt, and lower credit scores. Although the trend can now be observed across grades, it is less notable in lower-risk grades and more notable in higher-risk grades”.
Challenges Facing the P2P Model
CircleBack’s filing highlights issues with P2P lending. Its customer base concentrates on lower grade customers who do not find it easy to get loans in the first place. These higher-risk borrowers are vulnerable in any economic downturn, and facilitating their access to loans actually increases their propensity to accumulate debt. China’s new rules placing P2P platforms as information intermediaries could compound the credit profile problem as the platforms will no longer be responsible for any ensuing defaults.
The P2P lending model faces a classical economic adverse selection issue. The borrowers under the model are inherently risky type of borrowers. The current regulatory measures promulgated by the Chinese regulators are designed primarily to address the operational risk issues and somehow ameliorate the credit issues. However, new ideas and solutions should still be examined in the case of Chinese P2P business after the revelation of the US problems.