Internet Finance and Regulation in China

The rising popularity of peer-to-peer (P2P) and other types of online lending in China is to be welcomed. Internet finance fosters a more inclusive financial system where loans are more widely available to start-ups, small- and medium-sized enterprises and others who can put them to work. Aside from stimulating entrepreneurial activity and personal consumption, internet finance can also be a catalyst for broader financial innovation in China.

But there are hurdles to overcome. Due to their relatively brief track record of operation, China's P2P lenders have yet to accumulate the depth of data and experience on which traditional lenders rely. Nor can they expect much guidance from regulators and supervisors when, around the world, regulatory regimes are still getting to grips with the risks and realities of internet finance. It is a shift not just in terms of digital technology but of generations and business cultures.

As online lending gathers momentum in China, nonperforming loans (NPLs) among P2P lenders are becoming more of an issue. Given that credit risk is, to date, largely unmapped in the emerging world of internet finance, some P2P lenders now resort to emulating traditional banks. They ask for collateral or guarantees, even though these may be neither necessary nor enforceable in the online environment. At best, this is misguided. At worst, it is a step backwards that could inhibit further progress towards inclusive financial innovation.

China is at a crossroads with internet finance and, given the speed at which P2P lending is growing, should act promptly to place it on a sound footing. That is why, with the help of colleagues, I have produced this paper addressing P2P lending risk in China, and proposing practical solutions. It is intended for the benefit of regulators, supervisors and traditional banks as well as P2P lenders.

We have drawn upon exceptional access to proprietary data from five banks in China that make small loans to retail borrowers and small businesses. Through detailed statistical analysis we have identified which loan types are most likely to be nonperforming and why. Our correlations enable us to hold up a mirror to P2P platforms - which lend to very similar customers - showing evidenced-based ways to calculate their NPL risk. I firmly believe such an approach is more conducive to the healthy development of internet finance in China than simply replicating risk-control methods that exclude many would-be borrowers.

As a former banking regulator, I empathize greatly with whose job is to maintain financial stability. The challenge, always, is to prevent abuses without stifling innovation. I will be happy if the findings of this research contribute to the design - in China and beyond - of regulatory frameworks that address P2P lending risk while allowing sufficient scope for the internet finance sector as a whole to grow and thrive.

Disclaimer: The views expressed in this report are those of the authors and do not necessarily reflect those of the Fung Global Institute or the Asia Global Institute. The authors are solely responsible for any errors or omissions.