The Wild West of Chinese finance, represented most acutely in the peer-to-peer (P2P) lending industry, may have its days numbered. This post expands on the introduction of P2P lending in an earlier blog by looking how the authorities are trying to patch up the gaping holes in its regulation of the sector. Official documents on P2P note its positive contribution to “financial inclusion” but recognize the need for better risk management, regulations, and oversight.
The China Banking Regulatory Commission (CBRC) first began addressing the issue of P2P regulation in official speeches in 2014. The speeches marked “red lines” lenders should not cross and outlined principles for the industry. While the CBRC had no power to enforce them, much of the content from the speeches made it into subsequent regulatory documents.
It was not until July 2015, with outstanding P2P loans at 200 billion RMB, that the basic foundation for regulation emerged. China’s State Council, together with 10 regulatory agencies, issued the “Guiding Opinions on Advancing the Healthy Development of Internet Finance.” Unsurprisingly, the CBRC was officially given the responsibility to regulate online lenders, but the principles contained three unwelcome surprises for P2P platforms. They were to become “information intermediaries”, not financial intermediaries as most were and hoped to remain.
To ensure compliance and hopefully put a stop to fraudulent platform operators stealing funds, all client accounts were to be parked at custodian banks, giving banks enormous power over P2P platforms and access to much of their data. Platforms were also precluded from offering “credit enhancement” or guaranteed returns by covering losses themselves, a direct blow to the prevailing but risky business model of providing fixed returns backed by an explicit or implicit risk reserve fund used to pay investors in loans to defaulting borrowers.
These broad principles are not law in themselves, so the CBRC was left to decide on the details. In the meantime, the P2P industry more than doubled to 440 billion RMB in outstanding loans by December 2015, when it received an early Chinese New Year’s gift: 20 pages of draft regulation for comment. These rules punted the vast majority of oversight work to local authorities and “self-regulation” through subnational industry associations. One important victory for the platforms is that no maximum loan amount was set, a measure many feared would defang these upstarts to the point of preventing them from ever competing with banks. Amazingly, the industry was given 18 months to adapt to the regulations, but the real crackdown would emerge earlier than anticipated.
In April 2016, a People’s Bank of China led group of regulators began a rectification campaign for the Internet finance sector. Local governments are under orders to survey the online lenders, crowdfunding platforms, private equity funds, and more complex firms operating in their jurisdiction to get a clearer picture of what regulation is needed. Major cities stopped registering new firms in this field, stricter rules on advertisements came out, and reports even circulated of fintech firms kicked out of office buildings in busy districts due to fear that they would become magnets for protests staged by bilked investors if the platforms failed.
Figure 1: Timeline of Regulatory Action
While these measures seem to have contributed to a decline in the number of platforms, funds continue to flow into the Internet finance products. Outstanding P2P loans rose by 200 billion RMB in the first half of 2016.
It is a positive sign that the regulators have finally begun to clean up the sector. However, local governments have a difficult road ahead to fully comprehend the nature of these firms “in their jurisdiction,” because these online firms have such complex interconnected businesses from payments, P2P lending, wealth management, leasing, guarantees, and often more. They operate across cities, provinces, and now even countries. It is unlikely that a city regulator, especially outside the top tier cities, can effectively regulate such complex firms. The Chinese government urgently needs legislation to clarify and officially establish both the authority and responsibilities of the various financial regulators to close gaping loopholes that allow frauds to escape sufficient scrutiny until it is too late.
What should we expect from this industry going forward?
Further consolidation is inevitable as the rules of the game change. The pace of growth from 2013-2015, when an average of 3 platforms per day went online, was clearly unsustainable, and the number of operating P2P lenders has already begun to decline. It is likely that some large platforms with good regulatory relationships, name recognition, and existing customers will continue to expand, while most smaller platforms will either fail, get shut down, or get bought out. Despite serious remaining issues, this industry will adapt to the new regulatory regime and continue to contribute to financial inclusion by satisfying part of the enormous, pent-up demand for credit and investment opportunities in China.
 The branch of the banking regulator now responsible for regulation is even called (depending on translation) the “financial inclusion” or “social finance” department. (普惠金融部)
 A survey of 19 P2P platforms in 2015 (Assessment Report of Online P2P Lending Platforms in China-2015, SFI China Internet Finance Research Center) found that just under half had a risk reserve fund. It also found that some platforms were acting as banks, paying back investors out of their own funds in the event of repayment difficulties to hide the defaults from their investors.
 Chapter 3, section 17 still says they should “focus on small loans” and avoid excessive concentration of loans to a few borrowers, but this is much lighter language than anticipated.
 One Chinese P2P lending platform, Yirendai, has listed on the NYSE, and its parent company Creditease is buying US P2P loans with funds sourced from China