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Chinese peer-to-peer (P2P) lending tends to make it into English-language news only when new extremes are reached: record-breaking Ponzi schemes (Ezubao, 50b RMB/ $7.6b) or record-breaking funding rounds (Lufax $10b). This post aims to introduce readers to a more nuanced view of this fast-growing, rapidly-changing sector.
P2P lending in its purest form occurs when one individual (peer) lends to another. This practice has long been common in China, through rotating savings and credit associations (ROSCAs), lending to relatives, and of course, loan sharks.[1] However, the scope is limited to those who have the information required to evaluate and monitor borrowers, generally only those in the same community. However, the Internet has the potential to break down these limitations.
This is where the online P2P platform comes in. Using alternative data sources like social networks or verification of whether a user pays his or her phone bill, the platform vets the borrower and sets an interest rate hopefully commensurate with the risk. From the lender’s perspective, much of the trust burden is now shifted onto the platform and its risk model. So how trustworthy have these platforms been in the past?
Figure 1 Number of online P2P platforms and share of “problem" platforms
Source: Online Lending House, author's calculations
Not very. By the end of 2015, more than one-third of P2P companies had become “problem platforms,” meaning repayments had ceased, they had been investigated by the police, or the operators simply opted for “hitting the road” with investor funds in their pockets.[2] The most famous case is the alleged Ponzi scheme, Ezubao, involving $7.6 billion and over 900,000 investors.[3] How have so many fraudulent schemes managed to sneak by China’s famously tough regulatory apparatus?
Unlike in the United States, where P2P lending is heavily regulated[4], Chinese platforms operated in a regulatory vacuum until 2016. They registered themselves as some variant of “information services” companies with the local Industry and Commerce office, then opened up their websites soliciting borrowers and investors with no official standards for disclosure and no formal regulation from the central bank (PBC) or banking regulator (CBRC). Even local financial regulators interviewed by the borrower in the summer of 2015 bemoaned their lack of authority to intervene in highly suspect Ponzi-like schemes until repayments stopped and it was too late to avoid heavy losses. The platforms used China’s contract law for interpersonal lending as the legal justification for their activities, and the main risk was being charged with “illegal fundraising,” which strikingly does not seem to have a precise definition and yet has carried a death sentence.[5] One large firm issued its loans in the name of its founder as if it were a personal loan, and then transferred the rights to investors on the online platform.
This loose environment was a double edged sword. It made it easy for bad actors to defraud unwary investors but also created room for companies to build new financial products in traditionally underserved areas like consumer finance and small business loans despite the lack of credit reporting agencies and FICO scores that exist in developed markets like the United States. Interest rates were higher than those offered by banks, but returns to investors were much higher too. The average return of 13.29% in 2015 would look more than enticing for Chinese retail investors; it amounted to 8.5 times the paltry 1.55% return on 6-month time deposits at ICBC and 2.5 times the average bank wealth management product return of around 5%. Business boomed, and outstanding loans exploded from a paltry 26.8 billion RMB ($4.3b) in 2013 to an eye watering sixteen times that amount, 440 billion ($71b), only two years later.
Figure 2 China’s online lending: outstanding loan balance
Source: Online Lending House
All numbers tend to be big in China’s financial sector, so how big is this in context? The increase in outstanding balances is equal to just shy of 3% of total loans reported by the People’s Bank of China in China’s total social financing in 2015. This may not seem that large, but it is important to note that the loans from P2P firms appear not to have been counted in that data, meaning reported credit growth has been underestimated in the official statistics by a few hundred billion RMB. Chinese authorities have realized the risk posed by an alarmingly large, lightly regulated sector, and have begun to crack down. The next post in this series will outline how the industry is changing in the face of coming regulation that aims to reduce their ability to profit from regulatory arbitrage.
Data note: The aforementioned lack of standardized reporting rules means that reliable statistics on P2P lending are hard to come by. The statistics used are from wdzj.com or “Online Lending House,” which has a direct plug-in to most major P2P platforms that gives them day-to-day updates on interest rates, loan origination volumes, and more. There are concerns about objectivity, including allegations of inflating loan numbers of individual platforms in exchange for payment, but they also are unlikely to be able to include loan originations by a long tail of smaller regional/local platforms. Despite all of these issues, the loan numbers from 2015 on this site exactly match those used by a PBC statistical office presentation in 2016, a sign that the PBC currently regards this as the best available data source. By next year, there will likely be P2P lending data included in the official figures, as the PBC is establishing a central database for online lending.
Notes
[1] Tsai, Kellee (2004) “Back-Alley Banking, Private Entrepreneurs in China.” Cornell University Press.
[2] Chinese call this 跑路，or “paolu”
[3] For a selection of news stories centering on this case, see http://janzilinsky.com/how-chinese-investors-lost-money/
[4] CFPB for borrower disclosures, State-by-state rules for investor eligibility, SEC for registering securitization of “notes,” and much more.
[5] The Chinese is 非法集资feifajizi. According to a piece by Peng Bing in 2014 in the China Banking Regulatory Commission’s “Financial Regulatory Research” Journal (#30), “law has not at all given a precise definition of illegal fundraising” p.14, author translation.
