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Thursday, August 29, 2019

Making Online Finance Available to All

By Sheng Songcheng

A new regulatory system must be established to prevent a recent boom in internet lending services from destabilising the financial system. Rapid innovation in online lending to meet the short-term credit needs of marginalised groups, and a shift in focus by peer-to-peer (P2P) platforms to institutional clients, has led to a sudden explosion of new providers and increased the risk of bringing chaos to the sector.

Recent months have seen a large number of small and medium-sized online P2P platforms go bankrupt, and larger credit-worthy rivals shift focus to target institutional clients. The concept of P2P lending is no longer limited to a central marketplace matching individual consumers who have spare money to deposit and investors/individuals who need capital. P2P platforms now serve as bridges connecting businesses and financial institutions (2B/2F), and the operations of leading platforms are gradually stabilising. At the same time, credit enhancement by third parties meeting regulatory requirements has been made mandatory, as an extra risk mitigation tool. Converging with the mainstream practices of the world’s major online lenders, such as LendingClub, these new reforms are helpful for reducing industry risks and making internet finance truly inclusive.

According to data released by several US-listed Chinese fintech companies, loans to institutional investors by leading internet platforms have grown exponentially since last year, accounting for nearly 50 per cent of the total lending of most platforms – and it is expanding dramatically. This is thanks to newly introduced restrictions on lending to individuals by P2P platforms, and the proactive adaptation by leading platforms to evolving market trends by expanding services for institutional clients, such as referral services.

I.  Rooting out inferior platforms to restore health to the industry

Although the number of online lending platforms has dropped from more than 6,000 at its peak to nearly 900 today, this still represents a significant glut, and is much more than regulators can handle. A further reduction to around 100 is expected. At present, banking regulators are overburdened with the supervision of traditional banking business, and local financial regulators and banking industry associations are under-staffed to provide meaningful support. It is therefore difficult to implement effective regulation of the online loan industry in the short term. A large number of inferior platforms must be rooted out to help reorganise the sector.

According to statistics, there are over 4,500 banking institutions engaged in the traditional business of credit provision in China. Only 20 are state-owned banks and joint-stock commercial banks operating nationwide. The rest are local banks and credit co-operatives with outlets spread across townships. Large numbers of non-bank institutions are also stretching regulatory resources thin. There are about 20 consumer-finance firms providing small loans to consumers and small businesses, and around 260 online microfinance providers, along with numerous informal lenders.

Online P2P platforms act as intermediaries, allowing lenders to offer credit directly to borrowers. Currently, regulators have not yet imposed many restrictions on them. Many platforms are expanding loans beyond their own operational and risk control capacity. Some small and inferior platforms have not even put in place any meaningful risk control system, and their risk management measures are just cosmetic. Risks are gradually accumulating in the industry.

Supplementary to brick-and-mortar financial institutions, online P2P platforms should promote financial inclusion through the provision of short-term credit to poor and marginalised rural populations and to micro- and small-sized businesses. They should stick to an asset-light model consistent with their intermediary role providing small loans for borrowers, leveraging their strengths of being online platforms equipped with information and communication technology. However, in reality, some inferior platforms pool lender funds and engage in self-financing and implicit insurance, creating a space between the lender and the borrower in breach of their business mandate. Rooting out these lenders is essential for the healthy development of the industry, and to make online finance truly inclusive.

II. The way forward: expanding the institutional borrower base

For some time, fintech and traditional finance have seemed to be in conflict with each other. But in practice, they can complement and mutually reinforce each other to create value and mutual benefits.

To mitigate risks on the lender side, online P2P platforms are expanding their client referral services and cooperation with licensed financial institutions, and shifting their focus from individual lenders to professional institutional lenders which are more experienced in terms of risk identification, response and tolerance. Although investment by retail investors may not amount to much, it sometimes represents a large proportion of their savings, making retail investors more sensitive to risk, and more vulnerable to defaults. Their large numbers mean that any potential default can lead to big problems.

It is time for P2P platforms to broaden their institutional lender bases. In recent years, trusts, consumer finance companies and other non-bank institutions have experienced a severe shortage of quality assets in which to invest, coinciding with the net outflows of funds from fintech businesses. However, the problem is that the capital cost of these non-bank institutions is relatively high, leaving little space for P2P platforms to offer benefits to clients, which defeats their purpose as proponents of inclusive finance.

In addition, P2P platforms should stick to an asset light strategy and start to expand the borrower base. They should diversify their borrowers to include clients in modern service and intelligent manufacturing industries who have short-term microloan needs, funding the innovation and expansion of micro and small-sized businesses and self-employed businesspeople. In this way, P2P platforms can repair their bad reputation of profiting from individual over-consumption, and build a positive image of promoting the development of the service and manufacturing sectors and only sharing in the profit of their institutional borrowers, consistent with macro-policy guidelines and regulation.

III. Identifying market segments to facilitate industrial reorganisation

After shifting their focus of operations to institutional clients and microloans, online P2P platforms need to be clear about the difference between their business and traditional lending. They should be especially required to establish their market positioning and operating/risk control models. This is a prerequisite for building a new industrial framework complete with modern fintech regulatory standards.

As pure intermediaries providing information services, online loan platforms earn money by directly matching lenders and borrowers, while charging a management fee. They are similar to brokers in the inter-bank money market and stock exchange market. As such, regulatory rules for them should be developed by reference to the prevailing standards for stock exchange brokers, rather than based on rules applicable to the commercial banking sector, simply because they collect and dispense credit assets.

The online lending markets differ from capital markets (e.g. bonds and equities) in that they cater to different customer groups, make different uses of capital and have different life cycles. It is unwise to dismiss the legitimacy of the nascent internet finance market and the necessity of further developing it simply because of the existence of well-established, easy-to-regulate money and capital markets. Moreover, China’s existing multi-level financing market system is far from perfect, with component markets which lack the incentive to diversify customers. A well-regulated informal online finance market can be a welcome supplement.

Overall, only by establishing a new regulatory system for online lending that meets the short-term credit need of marginalised groups and facilitates a shift of P2P platforms’ focus to institutional clients, can we prevent innovations causing chaos in the market and triggering unrestrained proliferation of internet finance and instability in the financial system. In this way, a new internet finance environment can be created which fully protects stakeholders’ interests and brings truly inclusive finance a step closer, whilst paving the way for an online finance industry reshuffle.

Sheng Songcheng is a Counsellor to the People’s Bank of China, the Executive Deputy Director of the CEIBS Lujiazui Institute of International Finance (CLIIF) and an Adjunct Professor of Economics and Finance at CEIBS. For more about his research and teaching interests, please visit his CEIBS faculty profile here.