China Clamps Down on Shady Internet Finance

On April 14, China’s State Council presided over a video conference with 14 government agencies on the operations of internet finance companies in China. The government announced a plan to investigate and review the operations of all internet finance entities in the country in 2016 to stamp out shady internet finance companies.

The work will be spearheaded by the People’s Bank of China (PBoC) and will be supported by the China Banking Regulatory Commission (CBRC), the China Securities Regulatory Commission (CSRC), the China Insurance Regulatory Commission (CIRC), and various law enforcement agencies. The government will also announce a series of major regulations covering Peer-to-Peer lending (P2P), online payments, equity crowdfunding, online insurance, online wealth management, or any other forms of internet finance. The government hinted that the new regulations will use a negative list approach and emphasize micro-prudential management rather than the earlier activity-specific licensure approach. The new approaches will give the regulators a lot more leeway to stop the unsound financial practices that many unscrupulous Chinese financial sector players have been engaged in the past few years. It will also minimize the possibility of overly restrictive regulations hurting the operations of legitimate industry players.

PBoC also announced on the same day the first operating plan of the investigation, “Internet Finance Risk Control Special Regulations.” The first move was to ban the registration of any new company that carries the word “finance” or its synonyms in the company name or activity descriptions. This new regulation targets three of the most notorious internet finance areas: P2P platforms, equity crowd funding, and online wealth management.

The regulations will ban P2P platforms from funding in-house projects and stop the practice of “funding pools,” in which investor funds are not matched to specific loans but combined into a single pool for various different loans. It will also ban the use of P2P loans for housing mortgage down-payments, a practice that was blamed for the surge of property prices in Shenzhen earlier this year.

The most notorious form of internet finance in China is the P2P lending platform.  From an innocuous start in 2007 by Paipaidai, the industry caught fire in 2013 with the launch of Yu’ebao by Alibaba. Yu’ebao’s success in raising hundreds of billions in a few months emboldened many investors to believe that all P2P platforms were akin to Yu’ebao. They were further lulled by the high returns promised by many of the P2P platforms that run celebrity endorsements on state television. Just like any financial fiasco, once the investors’ guard was lowered and the government took a hands-off approach, fly-by-night operators appeared and fraud soon followed. The government expressed concern on the unwieldy growth of the P2P platform last year and in December 2015 came up with a proposal to regulate the industry.

In 2013, there were 75 P2P platforms that closed down. In 2014, the number jumped to 275. In 2015, the number jumped to 896. In the first quarter of 2016, the number was 260. Most of the P2P closures were due to bad debt accumulation. However, a significant number were due to outright fraud. Some of the most notorious P2P fraud cases in the last six months include Ezubao, Dada Group, and Zhongjin Asset. For Ezubao, it managed to trick 900,000 investors out of RMB50 billion, the Dada group swindled more than RMB 4 billion, and Zhongjin more than RMB 10 billion.

According to Online Lending House, a website that tracks the P2P industry, as of March 31, 2016 there are 3,984 P2P platforms with outstanding loans totalling RMB 504 billion with an average loan maturity of 7.3 months. However, a senior fellow at Suning Financial Institute, Xue Hongyan, said that only 2,461 platforms managed to maintain regular operations in March.  It seems that there will be another forthcoming wave of P2P closures in China with potentially tens of billions in losses to investors.

For equity crowdfunding, the regulation targets platforms that promise a type of loan which guarantees returns and exaggerates the current or potential profits of investment projects. Crowdfunding and wealth management platforms are banned from selling hedge fund type investment products to retail investors who do not meet the sophisticated investors classification in the regular offline banking channel. They are also banned from selling synthetic products that come from repackaging multiple funds.

It is better late than never, and the highly unusual coordinated move by the 14 agencies will hopefully put internet finance development in China on a sound development path down the road. The looming default peak and the subsequent debt resolution will present challenges to the regulators. Additionally, whether the forthcoming regulations can plug all the loopholes and really promote the development of an inclusive new financial architecture based on internet technology remains to be seen. International experience shows that P2P and crowdfunding have been marginal products until now because of the inherent risk associated with SMEs. Chinese e-commerce and its social media success have proven that the Chinese are savvy in the use of the internet, but whether they can repeat such success in finance will be keenly watched.