China’s ebanks: a new regime

On January 18, WeBank, China’s first online-only private bank, opened at a public launch in Shenzhen. WeBank, in which Chinese internet giant Tencent is a majority shareholder, is expected to be followed by four more online banks, in which Alibaba and other Chinese internet and asset management majors have invested. All have received the approval of the China Banking Regulatory Commission (CBRC). They will focus on lending to small businesses and blue collar workers offering their services through low-cost online platforms without any brick-and-mortar outlets.

Chinese Premier Li Keqiang, who oversaw the approval of Webank’s first $5,641 loan to a truck driver from Shenzhen, said the establishment of the bank marked a “significant step in China’s Internet finance and China’s financial reforms at large”.[i]

The launch of WeBank marks a confluence of forces—the Chinese government backing a unique, internet-based private sector effort to reform the banking sector. Potentially it can help move Chinese banking from a closed funnel of household funds flowing into the fat coffers of State Owned Enterprises (SOEs), to a flatter, more consumer-oriented structure with a potential for credit creation where China needs it most— for small and growing businesses.

Does this set a China-led stage for a potential new direction for such internet-based microfinance? While important details have yet to be made clear, like the logistics of lending, customer verification and risk management it does appear that these internet banks can potentially address major inefficiencies in the Chinese financial system.

China’s bloated SOE banks are dominated by the ‘Big Four’—Bank of China (BOC); Industrial and Commercial Bank of China (ICBC); China Construction Bank (CCB); and the Agricultural Bank of China (ABC). Together, they hold 60% of Chinese household savings—but have been inefficient throughout the reform period, starting 1978.

From this massive base, as late as 2009, 85% of all loans went to other SOEs, which have relied on this as their primary source of funding, leaving little left over for the private and particularly small to medium sized industry sector.

Despite a series of both top-down and internal reforms as well as stock market listings both on the mainland and in Hong Kong, the big four have found it hard to shed their origins. They remain closely linked to the government and related networks of SOEs, leaving little capital to lend to small and growing private businesses. This in turn has led to the well-documented rise of the “shadow banking” sector— poorly regulated, off-balance sheet loans that have been rising rapidly, and have caught the attention of the post-2008, G20-created Financial Stability Board[ii], as well as the CBRC.

Digital upstarts

Like any lumbering incumbent, they were ripe to be upstaged by an upstart.

The new internet banks are perfectly positioned to leapfrog the long and messy phase of bank consolidation, credit risk management reform, branch and staff reduction, redirection of services, and repositioning—all of which characterised U.S. and European retail bank reforms since the 1980s. And there will be transparency from the beginning –  unlike shadow banks, the highly-regulated and monitored Chinese internet will ensure a digital trail to track activity.

These new banks come with a pedigree. The companies involved in their establishment  have shaped China’s online space and found unique solutions to China’s problems. In 2000, for instance, Alibaba introduced Alipay, enabling local Chinese, most of whom who did not have credit cards, to shop online. This began China’s transformation from its characteristic mishmash of small retailers in the early 2000s to a 21^st century nation of online shoppers and retailers.

By 2014 Alibaba dominated 80% of the third party mobile transaction volume, followed by Tencent’s Tenpay. [iii] Alibaba’s Yue’e’bao fund, launched in 2013, ballooned to $80 billion in assets under management by 2014.

The China of 2015 is so familiar and comfortable with online transactions, that a 2014 McKinsey survey showed that more than 70% of Chinese consumers will consider opening an account with a pure digital bank and will consider it their primary bank[iv].

According to Porter Erisman, former SVP of Alibaba and creator of the documentary “Crocodile in the Yangtze” about Alibaba’s rise, “Whereas the US models (Amazon & eBay) didn’t fit the China market well, the Alibaba model  [of]…online finance efforts show that innovative online models in developing countries can help entire financial systems leapfrog slow and inefficient state-run banks.” [v]

China’s online space is already massive but nowhere near saturation or maturity. Only 46% or about 632 million of China’s population is online. Tencent’s Wechat already has a userbase of 468 million[vi] people, so the potential to grow is huge.

The challenges

The obvious appeal of these new tools, aside from higher interest rates and lower or zero transaction costs to the customer, is the widely affordable 1 RMB minimum (Rs.10) account opening fee.

On the deposit and consumer side, the Chinese keep an average of 60% of their total assets in savings accounts—again largely divided between the Big Four, and 72% of China’s banking transactions already occur online[vii].

The flip side is loans and borrowing—exactly where China, and most other emerging market economies—can truly benefit. Although how the Chinese e-banks will actually go about lending remains unclear, the same principles apply to depositors and borrowers – automated processes, sophisticated IT, big data, a large user base, and limited physical infrastructure. This translates into low transaction costs, lower interest rates to borrowers, and the ability to make microloans profitable: “Our target clients are people who need smaller amounts of loans from several hundred dollars to mo‍‍re than US$160,000, such as young people, micro enterprisers and blue collar workers” said Cao Tong, President of WeBank. “As we operate on the Internet, we hope the technology will help increase efficiency, cut costs and in turn give customers better rates.”[viii]

How well will the digital banks hold up in the event of a full-scale downturn? How will they manage credit risk particularly when faced with big profits and an upsurge of interest?

When Alibaba began in 1999 it began a ranking for suppliers, giving a “Gold” rating to help determine the quality of goods on offer. This solution was not foolproof and led  famously to Alibaba’s first scandal in 2011 when it was found that many of these “Gold” suppliers had defrauded customers and that a number of the Alibaba sales team had been involved.

The lending side of the new e-banks will face a similar problem.

In large-scale cyberspace-based markets, any form of verification becomes difficult to enforce. They will not have the advantage that smaller scale microfinance programmes have—that low-income borrowers wish to retain their reputations within local communities,  and seek some form of face-to-face verification between the bank and the borrower.

According to the financial magazine Caixin the Shenzhen truck driver picked for WeBank’s first loan, was selected using data from his profile on Huochebang, Tencent’s trucking site. Clearly, the internet giants have the big data that could lead to good decisions.

Nascent business

But the business is still nascent.  According to Hong Kong banking expert Wilson Chan, “Crowd funding has all types new of risks: determining veracity of information, likelihood of default, integrity of the borrower”[ix] and the quality of information all of which creates new risks that could spread through the internet.

Unlike with physical goods whose quality becomes apparent quickly after delivery, it is notoriously hard to judge a “bad loan” as the payoff is in the future and no bank wants to sully its balance sheet.

Finally, the involvement of major internet companies like Tencent and Alibaba in banking poses risks to the “non-financial economy” with unforeseen consequences in case of a sudden crunch. Alibaba’s share price has been down 15% already in 2015 following weaker earnings and new government criticism about fake goods on Taobao.

There are also many discrepancies on the regulatory side. For instance, current rules limit single stakeholders to a 30% investment in an ebank. This spreads risk and at the same time limits involvement by a single player. Wang Yonghong, the director of the central bank’s technology department, said that the new ebanks would have to follow standard banking regulations including capital adequacy ratios, provisioning, and leverage ratios but that new rules would be added.[x] At the same time, current CBRC rules require opening an account in person, which creates an obvious stumbling block. It remains unclear how this will be resolved.

Despite the risks, this model has clear appeal to India and other developing countries, where internet and smartphone penetration is increasing, but where cumbersome banking, credit, and other infrastructure and regulatory barriers make access to capital a major roadblock to growth, especially at the entrepreneurial level.

It will take some time for these banks to mature and begin to extend their reach to rural areas, where they are much-needed. But with this head start and blessing from the top, though, China is first out of the gate in a bold new move to use the promise of big data to bring banking to the bottom of the pyramid.

Jack Marr is Visiting Fellow, City University of Hong Kong’s Department of Management. He was founder of New York University’s Stern School of Business in Shanghai, and has been a Senior Lecturer at the Kellogg School of Management MBA program at Northwestern University in Chicago and a contributor to the Economist Intelligence Unit.