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Internet Finance Drives China Banking Reform

by | July 2nd, 2014 | 09:06 am
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There has been a significant amount of buzz regarding the rapid growth of internet finance in China. The scope of internet financial products includes money market funds, insurance products, third-party payment platforms, peer-to-peer (P2P) lending, and other more exotic investment products. In other words, internet finance is springing up largely beyond the remit of the traditional banks.

The pace of growth has been rapid enough to inspire fear and resentment on the part of the banks even though the total amount of money invested in internet financial products is still small relative to the enormous size of the traditional financial sector. The emergence of internet finance in China raises several key questions: What is behind the growth of internet finance? What are the risks and benefits from investing in these products? And what will the impact be on the rest of the financial system?

The growth of internet finance in China is being driven by a mixture of innovation and regulatory arbitrage. Internet finance companies are offering mobile and web-based ways to pay, save and invest that are radically more convenient than what was available previously. This represents an improvement over the service provided by China’s large state-owned banks.

However, better customer service alone cannot explain the rapid growth of internet finance . Regulatory arbitrage also plays its part: China’s financial system is still subject to significant price distortions due to government interference. The central bank maintains a ceiling on deposit rates that is frequently set at or below zero when measured in real terms.

This represents a miserable return when the economy is growing in excess of 7 per cent. Internet finance companies have found a way to correct this problem, pooling customer funds in a money market fund and then purchasing interbank deposits at a much higher negotiated rate. The higher rates are passed along to the customers, which is why savers have been flocking to internet funds.

The risks and benefits of internet finance vary by type of product being offered. Well-known third-party payment platforms, such as Alipay, present little risk to customers and are a convenient way to make purchases online. Internet-based money market funds are slightly more risky, but generally safe as most of the assets are invested in interbank deposits.

As long as these deposits are being invested with large and well-capitalized banks, there is little chance that they will default. P2P lending by contrast is much riskier and has already resulted in defaults and site closures. Other more exotic investment products offered by internet finance companies are equally risky.

The entire internet finance industry is overshadowed by continuing regulatory risk. China’s regulators are divided on how to respond to the internet banking phenomenon. The securities regulator is generally supportive, the banking regulator is generally opposed, and the central bank walks a fine line between the two. Savers heavily invested in internet financial products face the risk of an abrupt change in regulatory stance that would dramatically curtail the availability and liquidity of internet financial products.

The impact on the financial system as a result of the growth of internet finance is potentially significant. In money terms, the amount invested in internet financial products is still small relative to the enormous size of China’s traditional financial system. Yet if only size were important, there would be no explanation for the large backlash on the part of the banks towards internet lenders.

As last June’s credit crunch showed, China’s banks are deposit rich but liquidity poor. Competition for deposits at the margin is fierce, demonstrated by the issuance of wealth management products and high bids for auctioned fiscal deposits. Internet funds represent a new competitor for end of quarter deposits that help banks meet their loan to deposit ratio requirement. The growth of third-party payment platforms also represents a direct threat to union-pay, China’s quasi-monopoly bankcard organization that is owned by a consortium of banks.

Competitive pressure on banks from internet finance companies has the potential to foster both healthy and unhealthy competition. Healthy competition will take the form of banks competing by offering better customer service, increased web and mobile functionality and more consumer-oriented financial products. Signs of this are already emerging as banks begin to offer their own internet-based products.

Fostering this type of competition will require more institutional change on the part of the banks as well as flexibility on the part of financial regulators. Unhealthy competition will take the form of chasing funds by offering unsustainable rates of return on wealth management products, worsening moral hazard by increasing the number of implicit guarantees and seeking to block financial innovation through regulatory lobbying.

Internet finance has the potential to be a large catalyst for reform and efficiency gains in China’s state-dominated financial system. Most internet financial products are relatively transparent and offer greater opportunities for participation by normal investors compared to other parts of the shadow banking system, such as trust investments. The ultimate outcome of China’s internet finance experiment will depend on the degree of regulatory acceptance as well as whether policies are put in place to guide competition between banks and internet lenders in a healthy direction.

This article originally appeared in the Financial Times’ Beyondbrics blog.