It's time to bell the cat

Supervision needed to regulate Internet finance sector from excessive exposure to risks

Internet finance is one of the hot topics that figure prominently at the annual "two sessions" of China's top legislators and political advisers.

Former president of the Industrial and Commercial Bank of China Yang Kaisheng, Bank of Beijing Chairman Yan Bingzhu, former head of the China Banking Regulatory Commission Liu Mingkang and several other prominent bankers, have in recent times been vocal in their demands for regulating the Internet finance sector. Incidentally, the first three people are all members of the National Committee of the Chinese People's Political Consultative Committee, China's top political advisory body.

Among others who have made similar pleas are Zhou Xiaochuan, the central bank governor, who said on March 4 that the People's Bank of China is exploring various steps for regulating the fast-growing Internet finance sector. His comments come close on the heels of a statement by China Securities Regulatory Commission that it was also working on similar measures.

All these developments reflect one thing. That is, the steady rise of Internet finance is indeed a tough challenge to normal banks, which have enjoyed a monopolistic position for a long time and made easy gains from the artificially set interest rate gap.

Internet finance companies have already made a difference by shaking the foundation of banking monopoly. As an industry, Internet finance emerged a few years ago with peer-to-peer lending websites offering a platform for individual and small businesses to get loans from retail investors.

These platforms proved to be popular with small businesses that had faced innumerable difficulties in getting funding from banks. In the early days, these platforms did not raise too much attention as they were small and the clients not traditional banking customers.

Things changed last year, when another form of Internet finance, as represented by a product called Yu'ebao, started gaining popularity. Yu'ebao roughly means "leftover treasure".

The product, jointly launched by Internet giant Alibaba and Tian Hong Asset Management, involves Alibaba collecting idle money from individual consumers for Tian Hong to invest in the money market. Since the product offers higher returns than regular bank deposits, it started gaining popularity.

Since its launch in June 2013, Yu'ebao has attracted more than 81 million users, with aggregate deposits of about 500 billion yuan ($81.5 billion, 59.4 billion euros). Other platforms also jumped into the game and soon the market was awash with similar products from Baidu and Tencent.

Most of the money raised by products like Yu'ebao are reinvested in banks as contracted deposits, and thus allow depositors to enjoy a higher interest rate than regular deposits.

What has made the banks apprehensive is the fear that all of their regular deposits may become higher-rate contracted deposits and erode their advantage in attracting deposits at artificially low rates.

To tackle the competition, banks, even big state-owned national lenders, have increased their regular deposit rates to the upper end of the floating band, something they have rarely did since the band was introduced.

The banks are apparently unhappy about this development, and have instead chosen to pin the blame on Internet finance, claiming that since the sector is outside the ambit of regulation it would lead to higher leverage levels and greater risks for the banking sector.

Whether these accusations are fair is open for debate, but one thing is without doubt. That is, Internet finance has shed light on the unreasonable existence of the dual-track interest rate system and banking monopoly.

China has two sets of interest rates. The first set of rates, controlled by the government comes in the form of the deposit ceiling. The other is the set of interest rates determined by market players in a rather free manner.

Banks can attract deposits at a government-set annualized rate of about 3 percent, but fund managers have to raise money from investors at a market rate of about 8 percent. The gap means that banks, which already monopolize banking resources, can automatically enjoy an interest gap of 5 percentage points. They can lend the money to other lending agents such as fund managers to make net interest gains with ease.

Such a situation resulted in other market players having to pursue even higher return rates to stay afloat. With better and stable returns, the property market and government-backed fixed-asset investment projects naturally become the investment darlings. Since most of the credit went to these two sectors, asset bubbles and government debts ballooned, and left many small businesses and real-economy sectors in a lurch. What this meant was that small businesses would need to pay interest over 20 percent to get financing.

Products like Yu'ebao, which enable moving deposits within the banking system have helped bypass the deposit rate ceiling and paved the way for its ultimate removal, which many experts feel is the last step in China's interest rate liberalization.

What's more, the competition that Internet finance has brought to banks also shows the need to dismantle the banking monopoly by allowing diversified forms of financial players to enter the industry.

In this sense, the rise of Internet finance is in line with the reform strategy of China's leaders. Premier Li Keqiang's frequent meetings with top executives of Internet giants spelt out his wish to use Internet innovation to propel reforms. That may also explain why products like Yu'ebao have not been banned even if they are prompting banks to wage a hard battle to retain depositors. Recently, officials from the China Securities Regulatory Commission and the central bank have made it clear that such products are legal and would not be subject to any crackdown.

But this is not to say Internet finance should be free from supervision.

Instead, due regulations should be placed on the fledgling sector to prevent it from running away and inducing financial risks.

As more individual investors withdraw their money from banks and join the bandwagon of Internet finance, problems pop up, and there are at least three of them.

Most of the Internet finance companies do not have a sound reserve system to ensure the interests of retail investors.

Internet finance players mostly earn money by charging management and service fees and through bridging borrowers and lenders. They are not banks, so they are not legally bound to be placed under a reserve system, as commercial banks are required.

But considering the fact that Internet finance players also raise money from individuals, it is reasonable to ask these players to establish a similar reserve system to ensure investors' interests in case of default. The reserve may come from the players' own money or from part of the money they raise. But the required reserve ratio need not be as high as banks should have since Internet companies face a much narrower interest rate gap than banks.

Apart from the reserve system, Internet finance companies are often lax in disclosure of information. Unlike banks, they do not reveal the specifics of the products or the risks involved to retail investors.

Some Internet finance companies are rather bad at risk control and are illegally involved in the lending business. This is more common among P2P (peer to peer) lending websites.

According to p2p001.com, 75 P2P lending websites closed last year. They accounted for more than 10 percent of the total. But 13 new ones were set up in the first two months of the year, bringing the total number of P2P lending websites to 626 by the end of February.

Several massive fraud cases that involved P2P financial websites this year also spoke volumes about the irregularities they face. These include excessive exposure to high-risk industries, poor investment portfolio management, false promotion, illegal lending and the absence of a sound credit-rating system.

Due to the lack of supervision, some websites were sometimes involved in fraud cases. In one of the most recent cases, three P2P websites, in Shenzhen, Hangzhou and Shanghai, were closed this year for suspected fraud to the tune of 700 million yuan.

The situation also prompted Baidu CEO Li Yanhong, who is attending the two sessions, to say that supervision from authorities is indeed needed. Internet companies are not financial experts, he said.

In addition, Internet finance companies should also continue to innovate. Otherwise, they may soon face market competition.

Products like Yu'ebao, for example, must cut their reliance on contracted deposits and diversify their investment channels to make sure their return rate is higher than the regular deposit rates. If not, they will soon lose investors.

The author is a Shanghai-based financial analyst. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 03/07/2014 page13)