HOW CHINA REGULATES FINANCIAL INNOVATION

by Martin Chorzempa Master (NPA/ID) Candidate HARVARD Kennedy School  CrowdfundBeat Guest post.

In this blog’s inaugural post, I outline my hypothesis about China’s regulatory approach to developments in Chinese finance. These observations are based on two years working and living in Beijing, much of which in an organization that led to frequent interaction with Chinese financial policymakers, scholars, and financiers.

Chinese reform in general has followed a time-tested method of slow liberalization, the famous “crossing the river by feeling stones” but the Internet has turned this process on its head. The internet did not exist when the command economy was in force, so the Chinese never developed a large Soviet-style bureaucracy with mountains of rules and regulations, including vested interests who would oppose all attempts at liberalization. Regulatory action is thus the opposite for the internet: the government taking no action means allowing almost anything for the Internet sector, while doing nothing in other areas meant that all burdensome restrictions remained in place.

While traditional, licensed financial institutions are tightly controlled, with bank deposit and lending rates until recently determined by the government, quantitative loan-to-deposit ratios that cap total credit from banking institutions, and a litany of others, shadow banks that dodged these pesky regulations and offered higher rates of return thrived, often with bank support or even banks selling their “wealth management products.” Especially from post-crisis to 2013, trust companies, local government financing vehicles, and other shadow banks came out onto the front page of international news, with stories of  murky investment projects and speculation as to systemic risk these mostly unregulated entities might entail.

Meanwhile, the authorities’ reactions were slow. The existing regulations seemed not to cover this type of institution, with neither China Securities Regulatory Commission (CSRC), China Banking Regulatory Commission (CBRC), the central bank (PBoC), or local authorities clear on who was responsible for regulating them or tallying up the scale and risk of the business they undertook. Once they had grown into such proportions that they may pose a systemic risk to China’s financial system, the authorities clamped down in 2013 without making the resulting rules public.

Though Chinese P2P was started in 2006, the sector began its true ascendancy in 2013, coincidentally as previously explosive growth in shadow banking began to decline (partly due to mid-2013 turmoil in the interbank markets they relied on for funding, partly due to increased regulation).

Operating Platforms wangdaizhijia to 1h2015

Data From Online Lending House (网贷之家)

The rise of P2P lending, a space that was virtually unregulated, led to free reign for some compelling innovation in China’s underdeveloped credit market, but also to some serious abuses and platforms under investigation for potential fraud over 1b RMB while others have simply taken in client funds and then run away with the funds. There are mixed reviews on the proposed regulations (link is Chinese only) from the China Banking Regulatory Commission released in December (which I will summarize in a later post), with some aspects criticized for being too harsh on the P2P platforms. However, it is important to recognize that this sector functioned with little to no effective formal regulation for almost 10 years, from 2006 to the end of 2015 (and compliance is only required 18 months later), and any new rules have to play catch up.

Another reason for the difficulty and delay is that previous and current regulations in the financial sector heavily relied on local governments to implement the rules. Many restrictions would be based on where a company can open a branch or conduct business, but these companies now can have branches anywhere the hundreds of millions of Chinese with smartphones carry them, reducing the effectiveness of these regulations. It is unclear whether a local finance official in Beijing/Shanghai/Shenzhen will have the time or authority to be doing audits of P2P loans or operations far outside their jurisdiction, so this approach may lead to low ability to enforce the new rules effectively.

Countries around the world are struggling with the regulation of financial innovation, with the US potentially too restrictive of innovation (for example, Lending Club cannot yet operate in every US state due to the idiosyncratic rules in each). The UK appears to be leading the way in creating an encouraging, well-regulated environment for these platforms, lead by the P2PFA, an industry association. China’s approach has been to come late into the business of regulation, and its effectiveness is yet to be seen. In future posts, I will delve more into the Chinese regulatory environment, including analyses of the major documents for P2P regulation. Stay tuned and check back in often!

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