By Xinxin Jiang

Source: Financial News

Lei Gu

Lei Gu holds a Doctor in Juridical Science degree, has conducted post-doctoral research in fiancé, and holds the professional credential of Senior Economist. His research focuses upon regulation of internet finance, corporate mergers and acquisitions, and misconducts and white-color crimes in securities market. Dr. Gu currently serves as the Chief Economist at Tianjin Financial Asset Exchange, Deputy Chair of China Insolvency Resolution Alliance at INSOL International, and Researcher of Chinese Academy of Financial Inclusion at Renmin University of China. Among his publications are six monographs, including Standing on the Intersection of Law and Finance and Paths of Operational Practices and Empirical Legal Issues of Floating on ChiNext, as well as over 70 papers published on China’s leading academic journals including China Legal Science and Journal of Finance and Economics.

Introduction

Regulators in China have introduced a series of new rules governing the microcredit sector in recent years. A notable example is the Notice for the Rectification of Cash Loan (hereinafter referred to as Document No. 141), which, once taking effect, made a substantial impact on the sector. Banks, trust companies, and insurance companies all severed ties with microcredit companies, halting funding supports and business collaborations, and 8000 microcredit companies throughout China find themselves in a dire strait, wreaking havoc in the market. The question is, what laws and regulatory frameworks do we need to strike a balance between fostering microcredit sector’s healthy growth and ensuring effective supervision? In his interview with the Financial News, Dr. Lei Gu, Chief Economist of Tianjin Financial Asset Exchange and Researcher of Chinese Academy of Financial Inclusion at Renmin University of China, contributes his insights into and advice on the challenges that China’s microcredit sector faces.

1

Hurdles That Hinder the Healthy Growth of Microcredit Sector

Financial News (hereinafter referred as FN): What hurdles are hindering the healthy growth of China’s microcredit sector?

Gu: There are five major challenges that the sector must overcome at present.

Firstly, the legal status of microcredit companies has yet to be clarified.

The Guiding Opinions on the Pilot Program of Microcredit Companies (hereinafter referred to as Document N0. 23) defines microcredit companies as “a limited liability company or a company limited by shares, which is established with investment from natural persons, business entities, and/or civil societies, originate small-sum lending, and do not solicit deposits from the public”. The paradox here is that while a microcredit company is an entity that specializes in originating loans and originating loans is a financial activity rather than regular commercial endeavors, the Document No. 23 only grants it a common commercial entity status with a “quasi-financial” property, rather than that of a chartered financial institution, resulting in public’s confused perceptions of the microcredit companies, even mistaking microcredit companies as “informal lenders” or, even worse, “loan sharks”, giving the industry a bad rap.

Secondly, limited financing channels is the industry’s Achilles’ Heel.

As per the Document No. 23, a microcredit company is prohibited from soliciting deposit and its major sources of funding are limited to “paid-in capital from the shareholders, financial endowment, and borrowing from no more than two banking institutions”. Under such draconic restrictions, microcredit companies’ funding sources could easily dwindle, further worsening micro, small, and medium-sized businesses’ and individual business owners’ difficulties in accessing affordable borrowings, and straitjacketing the microcredit companies’ healthy growth.

The third, restrictions on co-lending model further contain the sustained development of the microcredit companies.

The third clause of the Document No. 141 stipulates that “co-lending operations return to the origin and banking institutions not accept credit enhancement nor disguised credit enhancement such as bailout promises provided by third-party institutions that are not duly qualified and guarantee that third-party institutions do not charge borrowers interests and fees”. Such new regulations apparently constitute an insurmountable barrier to co-lending model between microcredit companies and banks.

The fourth, leverage cap is a major hurdle arresting the sector’s development.

The Document No. 23 dictates that “within the boundaries of applicable laws and regulations, the balance that a microcredit company borrows from banking institutions not exceed 50% of its net asset value (NAT)”. In other words, a microcredit company’s equity multiplier (total asset/shareholder’s equity ratio) cannot exceed 1.5, a far cry from that of banks, causing microcredit companies to be small in scale and difficult to access adequate funding.

In theory, the logic goes that a non-depository institution should be allowed to be more leveraged than a depository institution because the former does not accept monetary deposits from the consumers but originates loans out of its own purse, and even in case of failure, its shareholders would pick up the tab, involving no depositors’ fund. The Document No. 23, however, nonetheless imposes unnecessarily stringent regulatory stipulations, which in effect amount to requiring that microcredit companies serve market segments who are relatively risky and whose demands for lending are usually fractional and fragmented, yet not allowing microcredit companies to take necessary leverage. Obviously, it is not a fair deal for microlenders.

And the last but not the least, restrictions on geographical expansion hinders microcredit companies’ potential to scale up their operations.

As per the Document No. 23, a microcredit company is only allowed to conduct business within the jurisdiction of one single county or city, causing most of the microcredit companies to be unable to scale up their operations or dissipate operating and market risks, throwing microcredit companies in a vicious circle from which they can hardly escape. In reality, many legacy microcredit companies have expanded beyond the boundaries of their counties or cities, while web-based lenders have even crossed provincial borders. Local regulators in general tend to acquiesce in such expansions and market usually responds favorably.             

2

Recommendations on Fostering Microcredit Sector’s Healthy Development

FN: What new regulatory framework would you like to recommend? Particularly, how could the Document No. 23 be fixed?

Gu: First off, recognize microcredit companies as proper financial institutions as soon as possible.

The proposed Interim Ordinance on No-Depository Lending Organizations should clarify the legal status of microcredit companies as “non-depository financial institutions, rather than common commercial entities or “financial enterprises”, a rather confusing term. By doing so, microcredit companies can be effectively distinguished from informal financial players or P2P platforms, which do not have proper franchise to undertake financial service activities. Recognize microcredit companies as financial institutions de juris, just like banks, give them the same tax and legal treatments as banks, and include them into the development plan of the nation’s financial sector and financial regulatory framework. That is my first recommendation.

Second, opening up more funding channels.

From a macro vantage point, it makes no sense to restrict microcredit companies’ financing channels. They are entitled to a wide variety of funding sources, including funding from insurers, trust companies, mutual fund companies, issuance of asset-backed securities, and earmarked loans from their shareholders, as well as their own funds, financial endowment, and borrowing from the banks.

From a micro vantage point, a microcredit company’s financing means and amounts should match its risk taking and should not be subject to arbitrary and simplistic restrictions. Take co-lending as an example. With multiple years of operational experiences under their belt, microcredit companies are equipped with reasonably sophisticated risk control capabilities. Combine microcredit companies’ strength in customer acquisition and banks’ deep pocket, and microcredit companies’ service capabilities can be amplified. To sum up, for microcredit companies’ retail operations, regulators should not impose unnecessary restrictions on co-lending and an appropriate level of deregulation will help nurture their sustainable growth.

The third, set a sensible leverage cap.

According to our field study on 15 microcredit companies in six provinces and metropolises, a majority of microcredit companies have equity multipliers between 3 and 5 and only a small number have equity multipliers exceeding 10. We believe that an equity multiplier between 3 and 5 better reflects the needs of most of the microcredit companies and is in line with the sector’s current interest rate level and loss-absorbing capacity.

The fourth, uplift the ban on geographical expansion to allow microcredit companies to scale up their operations.

We suggest that the uplifting of the ban on geographical expansion follow the path going from intra-provincial to national. The People’s Bank of China and China Banking and Insurance Regulatory Commission can introduce uniform standards for market entry and supervision for microcredit companies’ geographical expansion, first allowing them to expand beyond county lines but within provincial borders, and then allowing those companies that are well capitalized and have a good record in law and regulation compliance, sterling credit rating, and sophisticated risk control systems to go national in a measured pace. In other words, lifting the ban on geographical expansion should be a bottom-up, namely from county-level to nationwide, gradual, and well-regulated dynamic process.

FN: The Provision of the Supreme People’s Court on Several Issues Concerning the Application of Law in the Trial of Private Lending Cases dictates that “should the expected annualized percentage rate upon which a lender and borrower agrees exceed 36%, the part that exceeds the aforementioned 36% APR should be regarded as invalid.” A general consensus in the financial market is that this ruling is also applicable to microcredit companies. Do you agree?

Gu: No, I don’t. This ruling of the Supreme People’s Court is intended for informal lending and to govern civil debt. Loans originated by microcredit companies, on the other hand, is neither private lending nor usury, but a commercial activity, and the interests they charge reflect the cost of fund in the financial market. There is no parallel between the two and one court ruling should not be regarded as applicable to two completely different issues in two completely different realms.

Moreover, a microcredit company is a new type pf non-depository lending institution, the establishment of which is authorized by financial regulators, and therefore, is totally different from a private lender as defined by civil law. That a typical microcredit company’s founders and shareholders are mostly privately-owned entities does not mean that the loans it originates are private lending or equivalent to private lending. It is muddying the waters. Should this ruling be applied to lending of microcredit companies and thus set a cap on interest rate they can charge, the possible consequence would be that the interest that microcredit companies charge would not be adequate to cover the cost that they incur in providing services to micro and small-amount borrowers and that the gaps they leave would attract usury, predatory lending, campus loan, and other illegal lending activities to fill up. All in all, the Supreme People’s Court’s ruling to a civil law issue is not a good reference for a commercial issue, and the Document No. 141’s arbitrary requirement that the interest rate cap as set by this ruling is applicable to all microcredit companies is contestable.

3

Specialized Regulatory Measures Needed for Web-Based Microcredit Companies

FN: Now let’s talk about web-based microcredit companies. In recent years, while growing in a breakneck pace, they have also exposed quite a few vulnerabilities, fueling public sentiment. What regulatory issues exist here?

Gu: Regulatory issues specific to web-based microlenders are as follows:

First off, grave regulatory arbitrage stems from non-resident supervision.

Some large-scale web-based microcredit companies or web-based microcredit subsidiaries of conglomerates only maintain shopfronts in their domiciles, whereas their business operations are elsewhere outside the home jurisdiction. Not only does this arrangement undermines the efficacy of supervision but also is not advantageous in achieving a fair geographical distribution of web-based microlenders, and bears the potential of incite over-competition among regional regulators.

Secondly, the requirement that web-based lending have “scenes” is overzealous.

The Document 141 mandates that web-based microcredit companies halt all lending that is not based on specific scenes, as if lending without specific scenes were like defrauding borrowers. To comply with the letters of this requirement and for their own survival, a substantial number of microlenders of non-web origin have to fabricate scenes. For example, they seek “in-depth” collaborations with ecommerce sites to introduce drop-down menus so that borrowers can choose what loan usages fit them, such as online purchases, purchases at brick-and-mortar stores, education and training, dining and entertainment, medical care and beautification, travel, etc., so as to comply with the “scene-only” requirement. Apparently, allowing borrowers the latitude of selecting loan usage scenes as they see fit is self-deceiving as the lenders have no way to follow through on how borrowers use the money, rendering the scene-only requirement toothless. 

Thirdly, the security of customers’ privacy is gravely compromised.

Date-related criminal enterprises and hostile cybersecurity breaches have become widespread in recent years and system loopholes and system incompatibility an increasingly pressing issue in recent years, threatening the security of financial transaction data. This could likely lead to data fabrication and data leakage, among other cybersecurity concerns, which may result in various systematic risks, cause material losses to consumers, and even incite massive social unrest.

And fourthly, an undue emphasis is given to the sector’s internet root.

The Implementation Measures of the Special Rectification of the Risks of Microcredit Companies’ Web-Based Lending [Letter #(2017) 56 of the Office of Web-Based Lending Rectification Office] defines web-based microlending as loans originated by microcredit companies that are controlled by internet companies and also stipulates that the charters granted to those that do not meet these criterion but are already in operation would be re-evaluated. Those provisions in effect indicate that for those that were already granted charters but are not controlled by internet companies could be regarded as non-compliant and as a result, have their charters revoked, making the lives of the legacy microcredit companies even harder.

FN: What special measures would you suggest to regulate the web-based microcredit companies?

Gu: My first suggestion is to introduce a uniform regulatory framework implemented by a central regulatory body.

The sector has to be regulated by a central-government financial regulatory authority with regional regulators supervising microcredit companies’ day-to-day operations and providing corresponding regulatory services and coordination. Microcredit companies should be classified or categorized on the basis of their registered capital, qualifications of their shareholders, technological sophistication, and NPL ratios, among other criteria. Those with higher scores would be granted fast track in terms of geographical expansion, financing channels, and leverage ratios, whereas those with lower score would be subject to more rigorous oversight. Classification or categorization should be reviewed and adjusted annually in accordance with the companies’ performance in the previous fiscal year in order to achieve a dynamic regulatory mechanism that truly reflects and is relevant to the industry’s reality.

Secondly, loan usage scenes should be re-defined.

The current regulatory framework bans web-based lenders from originating loans without specific loan usage scenes with the intention to discourage over-indebtedness and spending beyond means. However, it is no rocket science for lenders to fabricate such scenes, a fact that can be deduced from the wide spread “fake orders” or “fake praises” on the web, and therefore, the usage scene requirement should be re-evaluated. Having usage scenes is a basic element of consumer finance but not necessarily applicable to all inclusive financial services and it is not unreasonable to suggest that the scene requirement be discarded.  

And thirdly, a dual system that combines big-data credit analytics and traditional credit reference should be introduced.

The absence of a well-developed credit reference system is a major factor that not only creates lots of troubles to microlenders but also serves as an incentive to those who maliciously evade their debts. Hence, in order to foster a virtuous growth of the web-based microcredit companies, a universal and interconnected credit reference system is urgently desired, otherwise fraud and evasion of debts could never be eliminated. The alignment between the systems of web-based microcredit companies and the traditional credit reference system should be accelerated in order to achieve the interconnectedness between the central bank’s credit reference database and the emerging big data credit analytics platforms. It is reported that the National Association of Internet Finance is spearheading, with involvement of Ant Financial’s Sesame Credit and Tencent Credit, among other emerging players, an initiative to establish a new consumer credit reporting venture under the trade name Baihang Credit. This is an encouraging first step of the breaking the information silos and sharing internet users’ credit data.

And the last but not the least, it is not necessary to give undue emphasis to the internet origin.

The key here is financial services charter, not internet origin. In developed economies, internet giants such as Google and Amazon are not enthusiastic to enter the financial services sector. The right direction should be to encourage microcredit companies to adopt an online-offline approach, not unduly emphasizing their internet root. Such unwarranted emphasis may backfire. It is more desirable to concentrate on technology R&D and business model innovations based on certain operation standard so as to avoid the unintended outcome that over emphasis on internet origin may cause and allow legacy microcredit companies to improve their lending practices.