The Chinese government has allowed unregulated online participants to innovate and grow in a sector traditionally dominated by state banks. Systemic risk has increased by not imposing strict and comprehensive regulatory regimes.
Internationally, financial services represent the most regulated area of technology in history; and unlike other areas like social media and ecommerce, financial technology faces extensive regulatory regimes imposed by both traditional banks and authorities. But, that isn’t necessarily visible in China where online payment processors like Ant Financial and WeBank have sprawled into banking products and services. The inability or lack of willingness to impose and enforce extensive regulatory regimes on them could threaten the growth and stability of the economy and financial system.
Before governments develop and enforce regulations, they need to produce policies and understand what activities and participants will be regulated. That is the essence of China’s regulatory management problem concerning online banks and payment firms. Those two concepts and business models have become so intertwined and convoluted that they require redefinition in order to be properly regulated.
Alibaba owns Alipay based in Hangzhou and Tencent’s WeBank is headquartered Shenzhen. Both have attracted borrowers mostly comprising individuals and small and medium enterprises. Both client groups lack the credit histories and collateral for traditional, state-owned banks, which were originally set up to serve state-owned enterprises.
It seems unlikely that a centralised command economy like China would issue confusing policies in banking and financial technology. The rest of the country’s economic activities are heavily and clearly regulated. Yi Gang, the governor of the PBOC (People’s Bank of China), recently criticised mainstream banks for failing to finance small and medium enterprises, which account for 80 percent of jobs. So the two technology giants’ online lending activities are consistent with government demands.
However, the business models applied among WeBank and Ant Financial and traditional banks vary tremendously. WeBank uses technology to link the smallest entrepreneurs with banks, and claims it does not compete with banks. Alibaba’s affiliate Ant Financial is described as a wealth manager; its lending activities disrupt traditional financial institutions in the cause of championing financial inclusion for small businesses.
Examining how these two quasi-banks fund their operations reveals more regulatory pitfalls. WeBank claims they use their balance sheet to finance about 20 percent of the loans and they syndicate the remaining 80 percent to local banks who do not possess the online capabilities to find these type of clients. So WeBank occupies a brokerage role that could be described as a version of P2P (peer-to-peer) lending.
Yet, WeBank is much more profitable than Western P2P platforms, most of which have not turned a profit. Last year, WeBank made a net profit of CNY 1.4 billion (USD 209 million) and an ROE (return on equity) of 19.2 percent – far ahead of most international banks who struggle to maintain 10 percent ROE.
Alipay and Ant are both private companies, but their model relies more on leveraging local capital markets, which inevitably involves competing with banks for deposits. Lending is partly funded by borrowing from the asset backed securities market, where it has become China’s largest issuer.
Chinese authorities have been contemplating controlling these activities by imposing strict capital controls and deposit taking restrictions that are similar to those imposed on banks. However, a lobbying battle has ensued between banks and the online lenders.
And that regulatory and economic conflict shows the political challenges of determining priorities for governing financial markets. Beijing’s command style supervision over its economy and markets has never fully accepted the concept of a free market based on private lenders and investment bankers having a big role in the allocation of capital. That is one reason global investment banks have been restricted from operating in China. But, it appears that the PBOC did not anticipate that the threat of domestic financial instability might come from within.
Ant Financial Services Group has become the world’s biggest financial technology firm, leveraging Alibaba’s innovations to evolve a cashless economy. Yet, China’s traditional banks complain that Ant Financial destabilises and sucks away their deposit base. They claim the outcome is that they must pay higher interest rates and reduce customer services by shutting branches and ATM machines.
But, China needs its big banks to survive and prosper in both the domestic and global banking system. They provide clearing and financing services for international trade. As listed entities that are implicitly backed by the national government, they provide a vital window for foreign investors.
Global technological changes may seem to be pushing banks into a demise like those ancient Galapagos Islands turtles. They are part of the ecosystem, but they must be carefully handled and kept in regulated pens. They could die of old age, but everyone is scared of what happens if they vanish as a species.
Chinese authorities have tried to limit and regulate Ant Financial’s reach, but the actions are more ad hoc rather than cohesive policies like preventing Ant’s system from being used by institutions to market loans. Regulators have issued rules requiring large money market funds to significantly reduce holdings of risky assets that allow them to pay high interest rates.
The most sensitive issue that executives at both Ant Financial or Tencent are reluctant to discuss is their capital requirements. This is similar to Western asset managers, as Basel has raised a debate on whether to regulate asset managers with capital requirements like banks. Before financial technology was empowered, it was much easier to regulate and define banks and non-banks.
In the 1990s, PayPal and eBay showed that the most lucrative part of an ecommerce platform is the online payment processing system. It allows the operator to selectively grab the most lucrative businesses of banks – payment transfer, credit fees, and asset management. Once people move their money from conventional bank accounts into virtual accounts or wallets, it doesn’t often return to the traditional banking system.
US regulators have been careful to contain their payment platforms like PayPal to their core payment process businesses, not allowing them to strip too much business from banks. Plus, the payment system in the US requires banks to play a key role in the process, whereas in China, online payment firms operate outside of banks’ operations.
Chinese regulators need to define which party is pricing the risk and based on what information. If banks become outsiders to that data, then the hazard of inaccurate credit information increases the risk of a financial collapse.
The Chinese government has allowed unregulated online participants to stimulate innovation in a sector dominated by state banks. But, systemic risk has increased because strict and comprehensive regulatory regimes have not been imposed.