A new wave of dynamic internet finance companies is taking on China’s lumbering state-run banks. But will tightening regulation nip this revolution in the bud?
China’s financial sector used to be famous for its poor service and imperviousness to innovation. Even today, when customers go to make a transaction at one of the country’s big state-run banks, they often take a bag of snacks with them—they know they’re in for a long wait.
But things are changing fast in the Middle Kingdom. A new generation of digital finance firms is taking the country—and the global markets—by storm in everything from digital payments and micro-lending to insurance and wealth management.
Nothing illustrated the arrival of China’s innovative financial technology—or fintech—industry on the world stage better than the initial public offering (IPO) of online insurer ZhongAn in September. The listing was not only the first ever worldwide by a digital-only insurance provider; it was also the second-largest Hong Kong IPO of the year at a hefty $1.5 billion, behind only the $2.2 billion raised by Guotai Junan Securities, an investment bank, in March.
Backed by internet heavyweights Alibaba and Tencent, as well as insurance juggernaut Ping An, ZhongAn’s high-tech approach is leaving its analog rivals in China’s insurance market in the dust. The company has sold 5.8 billion policies to 460 million customers in just three years, according to a September report by the Financial Times.
“ZhongAn has developed a capability for agile development and deployment of products to many different ecosystem players,” says Hugh Terry, a Singapore-based actuary and founder of The Digital Insurer website. “They can launch and test quickly according to consumer feedback and the low-cost nature of the platforms allows them to serve a large market segment.”
ZhongAn’s IPO looks likely to be just the beginning as fintech revolutionizes the once-staid Chinese financial system. With a tech-savvy populace, heavy investment from Chinaʼs internet giants and ample government support, China provides the perfect breeding ground for fintech and the country already leads the world in digital payments and peer-to-peer (P2P) lending. The worldʼs three most innovative fintech firms are Chinese, according to a new report by KPMG.
“Thereʼs an openness in China to fintech that we donʼt see in a lot of developed markets,” says Jamie Lin, a venture capitalist and co-founder of the Taipei-based AppWorks, Asiaʼs largest startup accelerator. “In the United States, many people are still writing checks.”
The pace of Chinaʼs fintech growth has been dizzying. Chinaʼs fintech venture-capital investment reached $6.4 billion in 2016, surpassing the US and comprising 47% of global fintech investment, according to an August report by management consultancy Oliver Wyman. In a March report, Barronʼs Asia forecast that fintech in China could generate $65 billion in sales by 2020.
“One of the reasons that fintech in China has grown rapidly is a general lack of regulations, so they can take what might be hard to do in the US and expand quickly,” says Carl Wegner, APAC head of R3, an enterprise software firm that works with the finance sector. Additionally, “due to the size of the market, a small idea can have millions of users and profitability.”
Oliver Wyman suggests that China could play a transformative global role in fintech. That would stand in stark contrast to the technological travails China has experienced in recent decades, when it has been seen as “a follower of the developed economies.” Instead, with its rapid adoption of disruptive technologies and big-ticket investments, China already is playing a vanguard role in fintech and has “the potential to shape the global fintech landscape,” the report says.
A Perfect Storm
At first blush, it seems odd that fintech would develop faster in China than developed economies. After all, China is not known for financial innovation. But thatʼs precisely the point: the shortcomings of the Chinese banking system have allowed fintech to grow much faster than in wealthy countries with mature finance sectors.
Given Chinaʼs limited credit infrastructure, its banks have historically preferred lending to large firms. That has left many small- and medium-sized enterprises (SMEs) and retail customers unserved. Oliver Wyman points out that just 10% of SMEs can properly access credit in China. Globally that figure is 31%. In 2016, unsecured consumer loan penetration in China only accounted for 9% of GDP. In the US, it was 15%.
Meanwhile, surging smartphone penetration has made the mobile internet ubiquitous in China. According to the China Internet Network Information Center (CNNIC), 95.1% of Chinese internet users—695.3 million people—accessed the internet on a mobile device in 2016, up from 69.3% five years earlier.
A survey cited by the Communist Party newspaper The Peopleʼs Daily in June points out that Chinese people spend more than three hours a day on their smartphones. Only Brazilians are more attached to their handsets, the report said.
Given Chinese consumersʼ preference for accessing the internet with their smartphones, “it becomes easy for them to use their phones to take out a loan or invest in a wealth management product,” says Zennon Kapron, founder of the Shanghai-based financial technology research firm Kapronasia. “Itʼs a natural extension of how theyʼre already using the device.”
Of course, fintech could never have grown so quickly if Beijing didnʼt want it to. “Itʼs been a wait-and-see-approach,” says Kapron. “They take their time to regulate new technologies that are beneficial to the financial industry.” Digital payments increase transparency; P2P loans provide credit access to individuals and companies that canʼt get it from a traditional bank, he adds.
“The Chinese government will only intervene when the market is near maturity and malpractices are growing out of control,” says Lee Cheng-hwa, a senior industry analyst at the Taipei-based Market Intelligence & Consulting Institute (MIC). “This will both foster the development of new fintech applications and speed up market expansion.”
Among fintech applications in China, mobile payments are the most widespread. The market grew 381% year-on-year to RMB 58.8 trillion ($8.89 trillion) last year, and is expected to grow at a 68% annual clip through 2019, according to a June report by Beijing-based iResearch. Mobile payments comprise nearly 75% of Chinaʼs total online transactions, iResearch says.
For Jennifer Wang, an advertising sales manager based in Wuhan, the most populous city in central China, her smartphone has become her wallet. “Paying with my phone is fast and safe,” she says. “Itʼs more convenient than using cash.” With her handset, Wang pays for everything from groceries and taxi rides to movie tickets and clothing. Within the WeChat app, she pays with WeChat Wallet. To buy goods on Alibabaʼs Taobao and TMall marketplaces, she uses the company’s Alipay payment service.
Alibaba and Tencent dominate Chinaʼs mobile payments market. In the quarter ended June 2017, Alibabaʼs Alipay service held a 53% market share based on payment value while Tencentʼs Tenpay (which includes WeChat Wallet) had a 39% share, according to research firm Analysys International.
With market capitalizations around half a trillion dollars each (Alibabaʼs is at $450 billion while Tencent is $540 billion), the two Chinese tech juggernauts have easy access to ample inexpensive capital. Thatʼs allowing them to diversify far beyond their original businesses of e-commerce and PC games and messaging, respectively.
“In China, the biggest tech companies tend to buy out most of the smaller companies,” says AppWorksʼ Lin. “They may try to crush you first, and if that doesnʼt work, then they will make you an offer.”
“The big guys are doing very well in China—itʼs actually like the situation in the US,” he says, noting the expansive reach of Amazon, Facebook and Google.
In online lending, another ascendant fintech segment in China, the nationʼs internet giants have also taken a leading role. In January 2015, Tencent created WeBank, Chinaʼs first online-only bank. Alibaba followed suit with MyBank, which focuses on rural consumers, internet startups and sellers on Taobao and TMall. In August, Chinaʼs financial regulator gave the green light to Baiduʼs joint banking venture with Citic Bank: Baixin Bank, which will offer exclusively online services.
WeBank and MyBank are data-driven banks, focusing on unsecured loans, notes Kapronasiaʼs Kapron. “They take advantage of the data and technology from their shareholders Tencent and Ant Financial,” he says. The data allows them to evaluate a borrowerʼs creditworthiness and decide the amount of a loan in minutes or even seconds, he adds.
The online banks have released little official guidance regarding their financial performance. A February report by The South China Morning Post notes that WeBank had extended RMB 160 billion via its non-collateral Weilidai platform through the end of November 2016. WeBank expected to breakeven or make a small profit last year, the report says. Meanwhile, Alibabaʼs MyBank had loaned RMB 45 billion to customers and served about 800,000 SMEs as of February 2016.
Within Chinaʼs online lending segment, peer-to-peer lending (P2P) or micro-lending has grown explosively, outstripping the growth of the internet giantsʼ online banks. Online micro-lending platforms are not bound by the same capital requirements as traditional banks. They connect retail borrowers with investors; the former gets direct financing and the latter attractive investment products.
In a July interview with the Federal Reserve Bank of San Francisco, Ning Tang, founder and CEO of CreditEase, a trailblazing Chinese fintech firm, said that the company launched P2P lending in China in 2006 to meet the needs of an underserved market segment.
“I couldn’t find banks willing to lend to a group of vocational school students for their tuition,” even though each student only needed $1,000, he said. Chinese banks “were not in a position to do that.” CreditEase developed the peer-to-peer model so that individuals could extend credit to each other, he added. The company has since become one of the world’s leading fintech players, expanding from P2P lending into wealth management and robo-advisors, as well as a major backer of fintech startups.
In its August fintech report Oliver Wyman notes that private asset securitization helped facilitate Chinaʼs online lending boom. “Securitization provides a mechanism to grade private credit assets for risk and match them with investors seeking the same level of risk,” the report says.
By the end of 2016, Chinaʼs P2P lending market had grown to RMB 2.16 trillion ($324 billion), comprising 16% of total RMB new loans, nearly double the amount a year earlier, according to a March report by EY (formerly Ernst & Young).
With regulation in China often lax, it should come as no surprise that some malfeasance has occurred along the way. The most notable case uncovered thus far is the Ponzi scheme operated by Ezubao, based in the eastern province of Anhui, which was once Chinaʼs largest P2P lending platform.
Launched in July 2014, Ezubao attracted investors rapidly by offering an eye-catching 9-15% rate of return. Before its collapse in early 2016, Ezubao defrauded 900,000 investors out of RMB 59.8 billion ($9.14 billion). In September, a Beijing court jailed Ezubao founder Ding Ning for life and handed down prison sentences to 26 others involved in the Ponzi scheme.
In some cases, lenders made risky bets on unreliable borrowers. Hongling Capital, one of Chinaʼs earliest P2P lenders, financed large-scale projects—sometimes exceeding RMB 100 million—while matching investor money. The projects were often subprime, which is why banks had refused finance. The Huishan Dairy Company, which received a RMB 50 million loan from Hongling Capital, defaulted on its debt in March.
In September, Hongling Capital announced it would exit the P2P lending business within three years. At the time, it had RMB 20 billion in assets to settle, including RMB 5 billion of non-performing assets and RMB 800 million of bad debt.
The Hammer Falls
The trouble-ridden online lending business has prompted Beijing to heighten regulation of internet finance. In August 2016, the banking regulator forbade P2P firms from taking deposits as well as selling wealth management products and asset-backed securities. The new regulations also require that P2P platforms use third-party banks as custodians of investor funds.
Further, the regulations restrict individuals from borrowing more than RMB 200,000 (roughly $30,000) from a single online lender and RMB 1 million overall from various P2P platforms. Companies are limited to borrowing RMB 1 million from one platform or RMB 5 million in total.
In November, Beijing widened the crackdown, outlawing unlicensed lending and putting a cap on borrower costs. China has more than 2,000 P2P platforms, but just a few hundred have government licenses.
Heightened scrutiny of Chinaʼs online micro-lending sector follows the recent IPOs of Ant Financial-backed Jianpu Technology, PPDAI Group and Qudian in the US. In China, many netizens have criticized the predatory lending practices of micro-lenders on social media, according to Bloomberg View.
While she is comfortable with digital payments, advertising sales manager Wang is wary of using internet finance to get a loan or store her savings. “I prefer traditional banks,” she says. “Theyʼre more reliable.”
In Chinaʼs online micro-lending sector, “things have gotten a little out of hand,” says Kapronasiaʼs Kapron. Beijing is clamping down to protect consumers from predatory lenders, he says, adding: “They want to keep the people happy.”
Frank Fang, a senior research manager at International Data Corporation (IDC) in Beijing, expects Beijing will continue to tighten supervision over digital finance in the future. “Internet finance must be included in the scope of financial regulation—just like the traditional industry,” he says. “It can be expected that future [internet finance] regulation will certainly become more standardized and strict.”
Consolidate and Conquer
Despite tightening regulations on Chinaʼs internet finance sector, investor enthusiasm remains high. In December, The Wall Street Journal reported that online lender Dianrong is planning to list on the Hong Kong Stock Exchange in 2018, in a flotation that could raise a minimum of $500 million. The report also mentioned Chinese P2P lender Lufax, one the worldʼs biggest internet finance firms, is mulling a 2018 IPO.
Beijingʼs decision to more strictly regulate internet finance shouldnʼt be misinterpreted as opposition to the sectorʼs development, says AppWorksʼ Lin. “The way things work in China is that thereʼs a period of openness followed by a period when the authorities tighten their grip and weʼre seeing that with internet finance now,” says Lin.
On the whole, fintech provides the Chinese authorities with tools to solve social problems, he observes. “Itʼs providing liquidity for SMEs and lots of services for retail consumers, filling gaps in the market.”
And to what degree will fintech disrupt Chinaʼs traditional banking sector? Kapronasiaʼs Kapron says that the traditional industry has already “lost out” on third-party payments. Thatʼs largely because credit cards never gained a strong foothold in China. Instead, Chinese consumers have moved directly from cash to digital wallets.
In its fintech report, EY notes that traditional Chinese banks are becoming less relevant to their customers—especially people under 40. In the companyʼs Bank Relevance Index, China’s score of 69.5% was the third lowest in the world, against a global average of 75.1%. An increasing number of young Chinese consumers access financial services for the first time through fintech-developed platforms, the report says.
Leona Wang, 31, who works for a global media company in Shanghai, uses both traditional banks and fintech applications, but prefers to keep her savings with online finance providers. “You get a higher interest rate with online platforms,” she says.
Cognizant of the challenges posed by fintech, Chinaʼs traditional banks are looking to tie-ups with its internet giants to co-develop digital finance platforms. Kapron notes that Alibaba, Tencent, Baidu and JD.com all formed strategic partnerships with large state banks this year—with China Construction Bank, Bank of China, Agricultural Bank of China, and Industrial and Commercial Bank of China, respectively.
“The banks all see the potential growth in artificial intelligence and cloud computing,” he says. “Developing this segment will mean a long-term boost to the economy, and possible improved financial security systems.”
As Chinaʼs banking and tech giants join hands, consolidation across different segments of the internet finance sector will continue, says AppWorksʼ Lin. “Thereʼs going to be less room for the smaller guys,” he says.
And there is another good reason this is likely to happen. “The Chinese leadership wants the [internet finance] industry to be more consolidated,” Lin adds. “Itʼs easier to control that way and that means itʼs good for social stability.”