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by Ferdinand Schaff
With the progression of the digital revolution, online peer-to-peer (p2p) lending emerged as an alternative to traditional bank lending around the world. Bypassing banks, this innovative financial service allows people to lend money to each other directly over the internet. In China, its impact on the financial system is turning out to be particularly big. As part of the shadow-banking sector, p2p lending helps bridging a gap left open by China’s rigid state-controlled banking system by providing individuals and small private businesses with access to credit. Even if it will not, as enthusiasts claim, completely disrupt the banking industry and democratise the access to financial services, online p2p lending will advance financial inclusion and serve as a key driver for interest rate liberalisation. However, the nascent industry first has to overcome its teething problems before it can unfold its full potential and to turn into a serious force in China’s financial environment. At present, the Chinese online p2p lending market is unregulated, fraught with risk and has become a hotbed for dodgy business models.
The basic concept of p2p lending is simple: Online platforms match those who seek to invest their excess funds with those in need of credit, be it to pay for their medical bills, to buy a new car, or to start a small business. Unlike traditional financial intermediaries such as banks, p2p platforms are usually not directly involved in loan contracts. They just provide the necessary information for lenders to choose borrowers, a service for which they charge a fee. On most p2p platforms several lenders can invest in the same loan which allows them to minimise their risk by investing small sums in many different loans.
Nevertheless, online p2p lending so far only makes up a tiny sliver (less than 1 percent) of China’s total lending market, which is why traditional banks do not feel too threatened by their emerging online competitors yet. However, considering the exponential growth rates of the p2p lending industry and its potential to become a disruptive innovator, it does not take much to imagine a “David versus Goliath” scenario in which tech-savvy newcomers take on big banks using internet-based financial innovation as the slingshot. This scenario appears even more likely if one bears in mind that p2p lending is only one segment of the rapidly developing field of internet finance, comprising crowdfunding as the equity-based cousin of p2p lending, online wealth management products such as Alibaba’s Yu’ebao, online payment systems, online insurance providers and online-only banks. So even if online p2p lending stays a niche market for the foreseeable future, as part of a broader technology-driven shift in financial services it will pose a challenge to the staid business models of traditional banks.
There are two main reasons behind the rapid growth of p2p lending in China: high demand and low regulation.
Both from the perspective of borrowers and investors there is a high demand for market-based interest rates in China’s state-controlled system of financial repression. The government caps interest rates on bank deposits at a level that barely beats inflation to provide banks with cheap funds.
Chinese savers are thus eager to divert some of their money away from low yielding bank deposits. However, they have only limited possibilities to do so because of underdeveloped capital markets at home and tight restrictions on investing abroad. The loan products with market-based interest rates offered by p2p platforms are an attractive investment opportunity for average Chinese savers. Contrary to the US p2p lending market where institutional investors such as hedge funds increasingly substitute retail investors, Chinas p2p loans are funded mostly by private lenders. Data from Wangdaizhijia show that in 2014 over a million investors lent money to about 600.000 borrowers on Chinese p2p platforms with an average loan term of 6 months and a consolidated average interest rate of about 18 per cent.
While investors are hungry for such high yielding financial products, borrowers are in it simply for the lack of convenient alternatives. This is especially the case for China’s cash-strapped small and medium-sized enterprises (SMEs) that are chronically underserved by China’s state-owned banks. With the latter favouring state-owned enterprises that enjoy implicit state guarantees, SMEs frequently have to rely on private lenders in the shadow-banking sector who charge excessive interest rates. Compared to the “offline” segment of shadow banking, the online p2p lending market often is a more attractive alternative for SMEs, as it offers more competitive interest rates and a more customer oriented service. With its limited investment opportunities for savers and its restricted access to credit for vast parts of society, the Chinese financial landscape thus provides particularly fertile ground for the online p2p lending industry.
The second reason for China’s p2p lending boom is the lack of regulation. Across countries there are different approaches to regulate the relatively new phenomenon of online p2p lending. In Japan and Israel, for example, p2p lending is completely forbidden. In Germany p2p companies need to acquire a banking license or partner with banks, which severely hampers the development of the industry. US and UK regulators do not classify p2p platforms as banks, but they do require them to go through registration and approval procedures and to comply with strict disclosure rules. In China, p2p lending providers operate mostly out of the regulators’ reach: They are neither legally classified as financial institutions, nor are they governed by any industry-specific rules. The lack of regulatory barriers and the low costs of setting up a website make it relatively easy to start an online p2p business in China. In January 2015 alone, 221 new platforms were launched. The low market entrance barriers and the high growth rates of the industry have attracted many entrepreneurs who lack the necessary risk and liquidity management capabilities to run a lending service sustainably.
In addition to the mushrooming of platforms, the loose regulatory environment also led to a variety of different p2p business models. A lot of China’s p2p lending platforms deviate from the “traditional” p2p model, in which the platform itself bears no direct risk since it is not directly involved in the loan contracts and only acts as an intermediary.
In order to attract customers, Chinese p2p companies often do not restrict themselves to the role of matchmaker and information provider, but instead take on the default risk - most commonly by giving investors guarantees on the loan principle. Many p2p platforms also have business models that obscure the relationship between borrowers and lenders.
Such platforms pool investors’ money first and then channel it into loans of their choosing, or they lend out their own capital first and find investors for the loans afterwards. The legality of such practices is all but clear since in the offline world they would require special licensing from regulatory authorities.
Apart from the problem of non-transparent business models that involve high risks and are often only half legal, there are also many reported cases of outright fraud in China’s online lending industry. Such cases involve “Ponzi schemes” where one lender’s money is used to pay back another (or borrowers who use one p2p loan to pay back another), or fake p2p websites where real loans were never given out and the p2p operators run off with the investors’ money a few days after the website was launched. According to Wangdaizhijia, 17.5 per cent of p2p platforms had difficulties repaying customers or went bankrupt in 2014 (see chart). 71 of these platforms were labelled as scams. However, China’s bigger p2p providers, such as Dianrong, PPDai or Renrendai, generally seem to have sound business models and adequate risk management. At least, only one of the leading online p2p lenders, lufax.com, appeared on an “early warning list“, compiled by Dagong Credit Data, a private Beijing-based rating agency, naming 676 high-risk companies (which equals 43 % of the total) in the p2p industry.