Regulations Galore Part II: Online Lending in China
The China Banking Regulatory Commission (“CBRC”) issued the highly anticipated draft rules for online lending on December 28, 2015. Ever since the State Council guidelines (“the Guidelines”) for the Chinese internet finance industry were issued in July, rumors about the timing of the online lending rules have been circulating before the big announcement finally dropped at the end of last year.
Since Chinese media reports had already leaked some of the major details surrounding the draft rules, the release of the official document revealed few surprises and was in line with general expectations. As communicated in the Guidelines, the draft rules state that online lending platforms are designated as information intermediaries for borrowers and lenders, and should not participate in the transaction in any other way. The official preface to the rules states that the main purpose of the regulations is to promote risk management and establish much needed ground rules to limit the prevalence of unsound practices and illegal activity in the industry. China’s regulatory approach can be best described as hands-off except in the cases of major risk events and outright criminal violations. Industry self-regulation is touted in the document as the ideal approach, and regulators are more interested in controlling undesired activities rather than setting legal barriers to entry (e.g., a license and permit system). Thus a list of 12 forbidden activities serves as the main focus of the regulations. However, in addition to these 12 “commandments”, many other rules are outlined and deserve our attention.
The following 12 forbidden activities are the focus of the draft rules as engaging in any of these will likely result in a complete shutdown of operations and possible prosecution by law enforcement.
- Using the platform for self-financing or for financing of related parties
- Directly or indirectly accepting and managing lender funds
- Providing guarantees to lenders or promising guaranteed returns on principal and interest
- Marketing or recommending loan investments to users that have not completed identification verification after registering on the platform
- Directly making loans to borrowers, unless stated otherwise by applicable laws and regulations
- Structuring loans into investment products with liquidity timing that differs from the original loan term
- Selling bank wealth management products, mutual funds, insurance annuities and other financial products
- Unless stated otherwise by applicable laws and regulations, collaborating with other investment or brokerage businesses to bundle, sell or broker investment products
- Providing false loan information or create unrealistic return expectations
- Facilitating loans for the purpose of making investments in the stock market
- Providing equity crowdfunding or project crowdfunding platform services
- Other activities forbidden by applicable laws and regulations
Although these 12 commandments may appear straightforward, the rules encompass a few complex issues that are not properly addressed by the text. These underlying issues will have a significant impact on platforms.
As the rules state that platforms cannot provide guarantees to lenders, CBRC officials responded to media queries that platforms are allowed to use third parties to provide such guarantees or to collaborate with insurance companies to the same effect. This qualifier would allow platforms to work around this rule by setting up a separate entity that provides the guarantee on principal and interest, which would attract many lenders.
On the topic of structuring loans into investment products with higher liquidity, thus creating a liquidity timing mismatch, many platforms may need to adjust their product offerings depending on the final detailed explanation of this rule. Many platforms offer flexible investment products based on longer term loans that allow the investor to deposit and withdraw from the product, much like a high-interest savings account. This type of investment is highly attractive to Chinese investors as the liquidity is viewed as safe and convenient. The issue that regulators have with this type of product is that it skews investors’ perception of risk, and it is likely supported by a fund pool that may be in violation of fundraising rules.
Finally, as I have mentioned in another commentary, many lending platforms are transitioning to a one-stop shop wealth management type of model. The rule that limits platforms from selling other wealth management products may be an issue for platforms making this transformation. Again it is not yet clear exactly what kind of model would be forbidden under this rule, although industry consensus seems to be that as long as a platform and related legal entities have the appropriate licenses for selling its products, they will be able to continue running its wealth management platform. Those with conservative interpretations of this rule may choose to strip out the lending platform and operate the wealth management platform separately.
Platforms should register with local financial regulators after obtaining appropriate business licenses, even though registration does not constitute an evaluation or approval of the platform’s operations. Local regulators will rate and categorize platforms after displaying the information publicly. The idea of “tiered regulation” was also introduced in the final online payment rules, which are set to take effect in July 2016. As I mentioned in my commentary on those rules, full transparency will be needed for the rating process to reduce unfair influence by platforms in the form of graft or political relationships. More detailed rules on the rating mechanism are expected to follow in separate regulatory documents.
Platforms should report loan data to an online lending central database established by the central government. Details on the central database will follow in a separate set of rules, but it is good to see this move toward building a much-needed credit reporting infrastructure for the lending industry. However, my hope is that this database is not just for the online lending industry but a single unified database for the entire financial services industry, which would be more useful than multiple databases segregated by industry.
Platforms should use fund custodianship services offered by qualified banking financial institutions. It is interesting that the choice of wording here is “banking financial institution” instead of “banks”, as the former includes many other institutions such as rural credit bureaus, trust companies, automobile finance companies, etc. Depending on what the CBRC mandates as qualified, it is possible that commercial banks, as well as other financial institutions, can serve as fund custodians for lending platforms. Again, detailed rules and criteria of qualified banking financial institutions and custodianship services will follow in separate rule documents.
Platforms should conduct annual third-party audits and submit the audit report to local regulators within four months of their fiscal year-end. There was similar stipulations to platforms in the draft rules, which follows the general principle that platforms have a responsibility to follow industry best practices and report a comprehensive set of information to local regulators, which will likely be used as parameters for the platform-rating process. Poorly rated platforms may be scrutinized by local regulators and, depending on the type of non-compliance, may or may not be held accountable.
It was disappointing to see that several of the key rules outlined above lacked much needed clarity as the reader’s desire for detailed explanations were brushed off with appending texts of “separate rules to follow”. This draft document seemed to be more of the CBRC’s to-do list rather than a set of actual detailed rules, the timing of which is also uncertain. Fortunately, the rules granted an 18-month transition period during which platforms can work toward full compliance as more detailed measures are revealed.
The Other Do-Nots
In addition to the 12 commandments, there are other restricted activities such as conducting business offline at physical locations, with the exception collecting loan information, loan review, debt collections, and management of loan collateral as well as other risk management activities. It is unclear what other activities are forbidden offline, but regulators’ primary objective here is to restrict platforms from collecting investments from lenders offline in cash or debit card format when such transactions should occur with the borrower directly on the online platform.
The other rule for greater investor protection is that platforms are not allowed to make investment decisions for investors. Each individual investment- or loan-funding decision must be made directly and confirmed by the investor. This implies that features such as automated investing will be forbidden even if the investor grants permission to the platform. Typically, automated investing features allow users to efficiently allocate their capital and diversify risk among multiple loans. Without such a feature, the result would be a degraded user experience for those looking to conveniently diversify risk, or users might simply begin to concentrate their investment in fewer loans to save the trouble of manually selecting and investing in loans. Again, additional clarification is required on this rule before the verdict is final. If the final draft leaves this particular rule unchanged, the vagueness of the language may provide a loophole for platforms to continue to provide automated investing services.
A section of the draft regulations was dedicated to outlining disclosure standards—information that a borrower must disclose to platforms and loan statistics that the platform must disclose to investors. The key data points listed as necessary for disclosure are summarized below.
- Basic borrower information: annual income, assets, liabilities, credit report
- Loan information: loan type, loan purpose, borrower location, application documents, source of repayment, repayment method, loan amount, term, interest (excluding fees), credit rating or score, guarantee situation
- Platform loan statistics: total transaction amount, transaction count, unpaid principal balance, borrower concentration, delinquent loan amount, delinquency rate, bad debt rate, lender count, borrower count, customer complaints, loss compensation for investors
None of the data points listed above were defined by detailed calculation methods in the draft rules, so some of the measures will be open to interpretation and in practice will not be standardized. A separate set of detailed standards and rules are expected to follow for these disclosure requirements. However, it’s important to note a few misses in the current rules when it comes to disclosure. Although platforms are required here to disclose the interest rate charged on a loan, the rules do not mandate platforms disclose the fees charged on the loan and the total cost to the borrower. Many Chinese lending platforms charge fees that total well over 20% APR to the borrower while only giving lenders a ~10% return thus skewing the lenders’ perception of risk for these borrowers. This sort of practice must be limited in order to provide full transparency to lenders and regulators.
In addition, the requirement that platforms must disclose the loss compensation for investors directly conflicts with the rule that platforms should not provide guarantees for loans. “Loss compensation” is not defined here, but it suggests that platforms can backstop investor losses on loans and should report this figure. Further clarification of all disclosure requirements are needed to remove any ambiguity.
Now I would like to turn my attention to some sections of the draft rules that seem a little silly, in my opinion, in term of implication and implementation.
In addition to regulating platforms, the draft document lays out a few rules for borrowers and lenders using the platforms.
The rules mandate that borrowers should not borrow from multiple platforms or other channels when the intended use for the loan is the same. However, platforms making the loans should be the ones responsible for making that decision after reviewing a borrower’s debt burden and repayment abilities. It does not make sense to restrict a borrower from borrowing from multiple channels if the capital need is there and lenders are willing to take the risk. The challenge here is that platforms must be able to see the borrower’s complete financial situation, as well as debt burden, so they can make these risk assessments before listing the loan for funding.
Another rule mandates that borrowers should not continue to borrow from a platform if they have knowledge that the platform has violated any of the 12 commandments. In my view, enforcement ought to come from regulators, and it is not the borrower’s responsibility to terminate a business relationship with platforms that have compliance issues. It’s puzzling why regulators would include such a rule as the purpose and focus of this document should be on regulating platforms.
On the investor/lender side of things, the rules assign platforms the task of babysitting investors as they state platforms must conduct diligence on investors and collect information such as age, health, financial situation, investment experience, and risk appetite. Platforms are restricted from providing any service to investors that do not undergo the diligence process. This request would be easily met with a survey for new user registration that would collect the necessary information. However, the rule following the diligence task states that platforms must analyze the information in order to categorize and manage the investors for their protection. The rules suggest that based on the type of investors, platforms should set maximum investment amounts allowed and restrictions on investment categories, which, in principle, is in conflict with the rule that platforms should not make investment decisions for lenders.
Regulators tend to be cautious when introducing new rules for an industry as they do not wish to unintentionally create backlash or volatility, such as that created by the now-suspended stock market circuit breaker mechanism that was implemented at the beginning of 2016. Central regulators such as the CBRC will often lay out very broad rules that are open to interpretation and leave it to the provincial and municipal regulators to craft specific policies based on the central regulations. This way central regulators are left blameless for any bad policymaking while the lower echelons of government are hung out to dry for interpreting the rules inappropriately.
However, provincial and local regulators have taken caution as well. They are either afraid of being blamed for bad policymaking or of being held accountable for any lack of enforcement that results in a major incident, such as a high profile fraud case. Thus, depending on the exact situation within each governing district, we will likely see varying reactions by local regulations to the final CBRC rules. Districts where online lending platforms are scarce might see more supportive local policies in order to attract platforms that will grow tax revenues. Districts where platforms are plentiful might see local governments crack down and limit platform activities. In fact, following the announcement of the draft rules, we have already seen tough measures enacted in Shenzhen and Shanghai where the governments have suspended business registration for companies that have anything related to internet finance or finance written in their business description. Existing platforms can continue to operate with no new restrictions, but these cities, where many of the current Chinese platforms are based, are looking to deter new local players from entering the space.
In Beijing, the unofficial word from major media sources is that the local government is ordering all advertisements related to lending and wealth management to be removed within city districts. This includes all physical structures and all Beijing media outlets such as newspapers and television channels. Other nationwide media such as CCTV do not fall under Beijing’s jurisdiction and therefore are unaffected. For those with ads already up in the city, the advertisers can petition the local financial regulators to keep them running.
We will likely see the governments of provinces where most platforms are concentrated react to these draft rules in the near term, namely Guangdong, Shandong, and Zhejiang. It is only realistic for local and provincial governments to issue stop orders at an administrative level at the moment as detailed policies would require more time, thought, and of course, guidance from the final rules from the CBRC, which will continue to hold us all in suspense until their indeterminate release.