Peer-To-Peer Lending In China by Henry Zhang, CFA – Matthew Asia
While I was on a recent research trip in China, I overheard something in an elevator that was quite worrisome. Two young office workers, who happened to be sharing the same elevator with me, were discussing an investment product that one of them had purchased a few months back. “The product offers 30% interest and pays interest monthly,” she told her friend. “I’ve already received several monthly payments. And I think it is trustworthy…”
I was quite astonished by the conversation as I walked out of the elevator, and wondered whether such a product could be real, especially in light of the fact that China’s one-year deposit rate is only 1.5%.
Lending platforms known as peer-to-peer lending, or P2P, began taking off in China last year and have attracted much investment as well as controversy. Investors in China, frustrated by the low rates offered by traditional banks, have responded to underground banking—also known as shadow banking—in hopes of finding better returns. Because P2P utilizes online platforms and allows efficient access for borrowers and lenders, the model has been quickly adopted by underground banking systems and has attracted significant venture capital. Over the past two years, the number of P2P companies in China has nearly tripled, from 880 to about 2,600 by the end of 2015, while outstanding P2P loan balances reached about US$67 billion. P2P quickly became an important channel for satisfying the capital needs of small businesses and borrowers—an area long underserved by conventional banks. However, the government failed to quickly adopt clear regulations to oversee the surge in the P2P industry related to Internet financing until the end of 2015, leaving various loopholes for some novices and disreputable entrepreneurs to exploit and quickly profit from. As a result, investors have witnessed a sharp increase in incidences of fraud. As of April 2016, about 40% of all P2P companies experienced some serious problems, including embezzlement and executives who have bilked investors and then disappeared. In one such scheme, P2P lender Ezubao defrauded more than 900,000 investors out of about US$7.6 billion.
Development of the P2P industry in China, compared to that of the U.S., is still in a nascent stage. Before there were regulations in place at the end of 2015, P2P lacked basic risk control standards. Instead of keeping investors’ funds at custodian banks, many P2P companies kept money at their own firms, inevitably raising the risk for embezzlement and Ponzi schemes. On the credit infrastructure front, China’s consumer credit has a relatively short history, and the credit system is still fledgling. Unlike the general adoption of the FICO credit score system in the U.S., there is a lack of standardization around credit scores in China. Different lenders use different proprietary models to evaluate personal credit, and the information is not well centralized. The lack of credit infrastructure has abetted an environment ripe for fraud.
But despite some of China’s headline grabbing P2P scandals, both the regulatory environment and business quality are improving. The new set of rules released by the government targeting P2P lending at the end of last year should offer much-needed investor protection as well as operational guidelines for P2P operators.
Existing P2P companies have been given a grace period to remedy their businesses should any violations be uncovered. In addition, P2P lenders are refining their models through building up more credit data for their clients. Finally, a national comprehensive credit system is in the making and is expected to be finished by 2020. As the industry gets better regulated and the market becomes more mature, P2P will continue to serve as an important funding channel for small business and borrowers, and few P2P companies with core competencies will stand out and consolidate the market.
Henry Zhang, CFA