Chinese Online Lenders Need to Have Flesh in the Game
Last month I attended LendIt Europe in London (Oct. 20-21) to learn more about developments in the marketplace lending industry in the UK and in broader continental Europe. LendIt has once again done an excellent job organizing the conference and brought together a wealth of information conveyed through thoughtful and open conversation. Fincera will be a gold sponsor at LendIt USA 2016 in San Francisco, and we look forward to sharing our experiences at this flagship event.
One recurring topic at the conference that caught my attention was the idea of “having skin in the game,” which refers to platforms putting their own capital at risk so their interests would be aligned with investors that purchase loans as investments on these platforms. Putting capital at risk is a very relevant topic to platforms in China and is also very relevant to the pending regulations for the industry.
At LendIt Europe, Funding Circle CEO Samir Desai kicked off the event with a keynote speech that emphasized the uniqueness of marketplace lending and the power of marketplaces. Desai used an example by writer Tom Goodwin illustrating the value of marketplaces in the digital age: “Alibaba, the world’s largest retailer, holds no inventory. Uber, the largest taxi company, has no vehicles. Airbnb, the largest hotel chain, owns no real estate.”
Desai stressed that marketplaces are incredibly efficient; therefore, platforms can focus on creating and delivering a better customer experience. Marketplace lending platforms have the same advantage because they do not take on balance sheet risk and are thus extremely capital efficient. Not putting a platform’s capital at risk also eliminates systemic risk because there are backup service providers that can wind down the loan books and return capital to investors, even if a platform goes bankrupt.
Throughout the rest of the event, various industry participants expressed different views on the idea of “having skin in the game.”
Anil Stocker, CEO of MarketInvoice, expressed that all marketplace lending platforms essentially have skin in the game because all of them have reputation at risk, which directly affects their equity capital invested in the platform. If a platform fails to price and manage risk effectively on behalf of investors when originating loans, the platform would ultimately lose market share and the bulk of its valuation.
During another presentation, Cormac Leech, principal at fintech-focused investment bank Liberum, suggested that although founders of the platforms may have massive equity stakes in the platforms and effectively have skin in the game, it may not hold true as the industry matures and new CEOs are brought in to manage these platforms. Leech believes that a portion of these CEOs’ compensation, including salary and bonuses, should be tied to loan performance to better align their interests with that of investors.
Representing the investor’s perspective, institutional investors, such as Bill Kassul of Ranger Capital and Simon Champ of Eaglewood Europe, expressed their views in a Scaling P2P Lending with Institutional Capital panel. Kassul noted that although they look for platforms that invest alongside investors, there are other ways to create “skin in the game” by including incentives or claw-back clauses in the servicing contracts with the platforms. If the loans the platform sourced do not perform well, investors could then claw-back servicing fees accordingly. Kassul suggested that institutional investors do not necessarily care about platforms putting capital at risk. While having hard dollars down is a “nice to have,” he believes that institutional investors should be the fuel behind the platforms, which should then be allowed to focus on originations, servicing, and underwriting. Champ echoed this idea and added that investors should be cognizant of a platform’s capital-light structure and use other incentives to align interests.
On the other end of the opinion spectrum, Stuart Law, CEO and founder of Assetz Capital, a small business lender in the UK, firmly believes that platforms should have a lot more capital at risk. Law’s view is that platforms are all innovating to take market share from banks, so platforms must not make the same mistakes these institutions previously made. Banks collapsed in the financial crisis because their equity capital at risk was too thin at 3-5%. Law expressed that although UK regulations don’t quite make it conducive for platforms to put large amounts of capital at risk, his firm Assetz plans on bringing capital to the table, and they intend to do this at a level 10x better than that of banks.
Applications to the Chinese Market
I believe there is no doubt that Desai’s view of marketplace platforms being more capital efficient and generating a lot of value on both sides of a transaction is true. However, in the context of the Chinese market, there are two important dynamics that make it difficult to implement the true marketplace lending model: 1) the investor/lender base is composed entirely of retail investors and 2) underwriting methods are largely unproven.
The US and European lending marketplaces are mostly funded by sophisticated institutions that are capable of evaluating and managing risk. In the Chinese market, retail investors are far less sophisticated and often easily swayed by one thing: a high advertised investment return. In addition, the nature of the products being offered on marketplace lending platforms to retail investors are fundamentally different from those being offered to consumers by an Alibaba or Uber.
As an example, what happens when one receives a bad product or service on one of these common marketplace platforms? On Alibaba’s platforms, you can negotiate with the vendor or directly with Alibaba for a refund and/or write a bad review. If you have had a bad experience with Uber, you probably eventually got to where you wanted to go, and as a user, you have the power to rate each experience/driver and can contact Uber customer service with any complaints. Compared with losing money on an investment in a P2P loan, the psychological effect of these types of customer experiences is much different, especially when many of these loan products have been heavily advertised as very safe investment options.
With a marketplace lending platform, if you buy a bad loan, your money is essentially lost without any sort of service or product, good or bad, in return. Although loan portfolio diversification can minimize the risk of large losses in a normal scenario, it is the crisis scenario that we should focus on for the Chinese lending market. Given that basic financial infrastructural services, such as credit reporting, have not been implemented in China, alternative data sources are driving underwriting methods, and these methods have not yet proven themselves in a full business cycle.
Therefore, without platforms in China putting their own capital at risk, the country may be in danger of having this side of its financial system evolve into a network of originate-and-distribute machines that spread credit risk into the greater system to be borne by retail investors. Unlike the scenario that Desai mentioned, there are no backup service providers in China to wind down existing loan books in case of a platform bankruptcy, and even if there were, Chinese retail investors would demand their money back immediately and would not be willing to wait for a timely wind-down.
My view is that, at their most basic level, marketplace lending platforms in China are not true marketplaces. They are vendors that curate products and sell them to a financially inexperienced public; therefore, they need to be held responsible to a certain degree and be able to provide a refund to customers when necessary.
When it comes to the process, it’s quite easy for lending platforms to take on this responsibility because they can discern 100% whether a loan is bad, while it’s difficult for other marketplaces to make the same kind of determination—whether a vendor did indeed sell a bad product or whether an Airbnb apartment was really filled with garbage—without spending the time and effort to investigate the matter (otherwise simply taking the customer at his/her word). It doesn’t make sense for Alibaba to offer a refund on behalf of a vendor for every customer who claims they received a broken TV, but it does make sense for a lending platform to reimburse customers for a bad loan because they are fully aware that a borrower has defaulted.
With crucial differences in infrastructure and investor composition from Western markets, I don’t believe the pure marketplace model would survive a downturn in the Chinese economy. Even with just a few bad losses, Chinese investors make their displeasure known, and regardless of whether a platform takes on balance sheet risk, the reputational damage would be enough to shut it down. Platforms should be extremely motivated to prevent this from happening by focusing on loan performance and preparing for the worst case scenario. In a crises scenario, the best countermeasure would be for platforms to have sufficient capital to backstop these losses for investors.
Having “Flesh in the Game”
Our view at Fincera is in line with that of Stuart Law from Assetz. As drivers of banking 2.0, a world where we should put more capital at risk and be fully prepared for the worst-case scenario. The Chinese economy continues to face uncertainty, and it would be irresponsible not to provide guarantees to retail investors when our underwriting model has not yet been proven through an entire business cycle. We should go beyond having “skin in the game” and put “flesh in the game” as well.
While we may not be able to take full advantage of the capital efficiency that goes along with being a pure marketplace as described by Desai, in the near term, this is the most socially responsible way for us to do this business. In the long term, as our underwriting model is tested through business cycles and as infrastructural services for the financial sector in China become more developed, we will be better prepared to gradually move toward the marketplace model. However, keeping a sufficient amount of capital at risk will continue to be important for our business.
From a regulatory perspective, I mentioned in previous blog posts that the State Council guidelines on the industry in China suggest that P2P platforms should serve as “information intermediaries” only and not provide any guarantees to investors, suggesting that platforms should not have any capital a risk. With this policy, I believe regulators are trying to prevent the spread of fraudulent or bankrupt platforms in the industry, which has been a rampant problem causing billions in losses to retail investors in China. However, a more effective way of stemming this problem may be to require platforms to have a high level of capital at risk so that frauds and less sophisticated players will be weeded out by the requirement. The media has hinted that this type of requirement may be included in new regulations as leaks of draft regulations stating that platforms are required to have at least RMB 50M in paid-in capital (PIC) have surfaced.
In my opinion, having an absolute requirement on PIC is not enough, regulators should mandate capital requirements, similar to those set forth in the Basel Accords, in ratio with the volume of loans that platforms originate.
In summary, it is important to recognize that with the current state of the Chinese market, where infrastructural services such as credit reporting and loan servicing is poor or non-existent, lending platforms should be focused on optimizing and testing their underwriting methods and offering more security for retail investors’ capital. Platforms should not be focused on creating the most capital-efficient operating model that will maximize value for themselves and their equity stakeholders. To best align the interests of platforms with that of retail investors, platforms should put more of their own equity capital at risk.
As infrastructure improves and institutional capital increasingly becomes a major funding source, a purer marketplace lending platform will become more viable, and it may be more acceptable for platforms to expose a little less skin in the game.