November 9, 2017 1:02 pm JST
Joe Zhang

In China, subprime isn't a dirty word

Fast-growing fintech brings benefits as well as risks

In China, subprime credit is on a tear. At least 10 startup lenders will each generate more than $200 million in net profit this year. At least four lenders have filed plans for initial public offerings in the U.S. following in the footsteps of Qudian, which raised $900 million in its Oct. 18 listing on the New York Stock Exchange. More than a dozen others are looking to IPO in the U.S. or Hong Kong over the next year.

Things are frantic on the regulatory front as well. Amid a spate of negative post-IPO reports in Chinese media about the high interest rates charged by Qudian and its previous targeted marketing to students, regulators have been reminding subprime lenders of legal interest rate caps, investigating their business practices and raising the possibility of new rules.

The outcome of this game of cat and mouse between the lenders and the regulators could have far-reaching implications for China's economy and banking. Subprime however should not be a dirty word. Lower credit scores should not deny anyone access to credit.

In China, a new generation of subprime lenders is relying heavily on new financial technologies, or fintech, to serve higher-risk borrowers, ensuring that fintech is not just a tool to serve the rich.

Instead of disrupting the business of Chinese banks, fintech is helping them by drawing away subprime borrowers.

The collective work of the vast number of nonbank financial institutions in China's subprime credit sector has partly shielded the country's commercial banks from capital destruction. Their shouldering of subprime debt has helped avoid a systemic crisis in China's traditional banking sector over the last four decades, leaving the banks to focus on state enterprises, who are understood to be backstopped by the government even though many have fallen behind on their loans, and other prime customers.

Observers the world over have been surprised by the longevity of China's rapid expansion of credit. When the country's subprime credit sector does collapse in the future, as is likely given the pace of its expansion, it is likely to leave Chinese banks relatively unscathed as was the case during similar previous downturns.

Consider the crash of the Chinese microcredit sector. In just three years, some 15,000 authorized microcredit lenders lent out between 3 and 4 trillion yuan ($450 billion-$600 billion). Then the industry faced its reckoning beginning in 2011 as lenders discovered that customers had taken out loans from multiple microcredit companies and were then overwhelmed. As uncollected debts multiplied against a framework of rigid regulation, a third of the microcredit lenders collapsed and another third barely survived.

The turmoil though was largely confined within this corner of the Chinese financial system, with losses borne by the private businessmen and wealthy families who had invested in the microcredit lenders. Count me among them. There was little spillover impact for the nation's banks and the public and government generally showed no sympathy for the investors' pains.

Much the same has been seen over the years with the failure of trust companies, rural and credit cooperatives and more recently, loan guarantee providers and peer-to-peer lenders. Since 2013, hundreds of P2P lenders have failed each year and the survival rate among guarantee companies has been even lower, yet neither sector's trouble has had significant wider impact. Even in the year ending this past August, another 887 P2P lenders shut down, according to one industry watcher's count, but the consequences were borne primarily by their investors only.

If you look closely at the cooperative arrangements between China's banks and its nonbank financial institutions, you will have no doubt who has the upper hand. Since the banks negotiate from a position of strength, they always take the senior tranche in structured credit deals while nonbank financial institutions have to take higher-risk, subordinated tranches.

Regulatory catch-up

China's regulation of the financial sector is incoherent and full of pitfalls. Specifically, oversight of online lending has been criticized as too weak and ineffective. With regulators unable to keep up with rapid change, the environment has been conducive to experimentation and the development of new services.

This detachment is not a result of the government or public being philosophically supportive of innovation or competition. Only four decades ago did China emerge from years of operating a backward command economy. The authorities did not inherit a well-structured regulatory regime. Eventually, this became a boon for the new economy, including online lenders and fintech companies.

In China's huge, diverse credit market, banks have been regarded by the public as safe. A constant stream of cheap and even subsidized deposits helps to keep them liquid. The suppression of bank deposit rates at artificially low levels by regulators has been an effective subsidy for those borrowers the banks have been willing to entertain. It has also driven savers to invest in money market funds and wealth management products, in turn stimulating the growth of nonbank financial institutions.

As of the end of August, Chinese banks and other depository institutions had assets of 188.8 trillion yuan. Microcredit lenders and loan guarantors each held total assets of around 3 trillion yuan while P2P and online lenders had 1.2 trillion yuan in assets. All told, subprime represented about 15% of all Chinese financial assets and these assets have been growing around 15% a year versus 10% growth for banking assets.

The whole paradigm has encouraged the expansion of credit. The process has not been without its benefits in quickly monetizing what was a command economy, and a largely agricultural one. But it has caused massive inequality, with savers subsidizing bank borrowers, rural residents subsidizing city dwellers and ordinary citizens subsidizing the rich. Access to large quantities of cheap credit has often been a crucial factor in financial success.

Coming convergence

China's fintech entrepreneurs make a lot of noise and speak in fancy buzzwords while stimulating credit and experimenting with all sorts of structured schemes. Having previously kept their distance, the bankers are becoming their willing accomplices.

New banks such as WeBank, backed by Tencent Holdings, show how these developments are coming together. WeBank makes huge numbers of tiny loans based on its intimate knowledge of users of WeChat and other Tencent services, who together represent nearly half of China's population. Thanks to this advantage, its rate of nonperforming loans was just 0.32% at the end of last year.

Given time, many small and mid-sized banks around the country will likely outsource their consumer credit operations to the likes of WeBank. Already more than 30 banks around the country have partnered with WeBank, usually funding 80% of each loan.

Other leading online lenders such as 51Credit.com and Qudian have the same potential but lacking a banking license, they are less convincing potential consolidators than WeBank, at least for now. The outlook for any of these players would change if it acquired an existing bank or received a license. Condescending regulators today though do not feel comfortable about giving banking licenses to such wild heroes from the bush.

Essentially, WeBank and its peers are using the tools of fintech to tame some of the risk of subprime lending. This serves the interest of the authorities in making credit more widely available while also, for now, doing well by their shareholders. Faith in these lenders will be tested when the next downturn comes, but the overall stability of the country's financial system does not look likely to be shaken.

Joe Zhang is chairman of China Smartpay Group and a director of China Rapid Finance and China Huirong Financial Holdings. He is also a director and shareholder of Guangzhou Huadu Wansui Micro Credit and the author of the new book "Chasing Subprime Credit: How China's Fintech Sector is Thriving."

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