The discussion and the pause of the weekend got us thinking about the questions of Chinese online finance regulation. It is 100% clear that there need to be regulations in place. The nearly RMB1 trillion in AUM across all the online finance platforms is still only about 1% of China's total retail deposits, yet risks are only increasing as the AUM continues to grow, so it's prudent to do something now.
So the question is not really if it should, but how it should be - and for that, there are no easy answers.
The easiest way is for the government to treat online finance products as they would any other deposit products, in other words, apply a roughly 20% reserve requirement. Currently, although the funds behave as demand deposit accounts, they are held by asset management companies are are not subject to the reserve requirement. Numbers from the PBOC's statistics department show that if Alibaba's Yu'ebao's 500 billion RMB of AUM were subject to the reserve requirements, the fund would need face increased costs of about 4.2 billion RMB, which would knock about one percentage point off the performance.
But is that fair? Really Yu'eBao and Licaitong (Tencent's equivalent offering) are repackaging the front-end sales, but the back end fund is similar to any other fund offered in China today, some of which do offer similar supposedly risk-free returns. There's nothing to stop other fund management companies from offering similar products to that of Yu'eBao, although they would face challenges in finding such an efficient distribution channel.
What really needs to improve is investor education. Most investors in China have never seem a financial product fail or experienced it first hand. They likely very shortly will. With Chaori, a Chinese solar-related firm, failing to make a bond payment and effectively defaulting, the seal has been broken on what could be the first of a number of defaults.
The Chinese population is not used to this in many respects - things are only meant to go in one direction. Last week, a local property developer in a smaller tier-3 city lowered the price on a residential property development to drive sales. The consumers who had previously bought at a higher prior price protested. Is this allowed? Yes. Is it reasonable? No. Of course the developer has a right to sell the property at any price they want unless contractually obligated somehow, but for the Chinese who were losing out, this was unacceptable. In the past there have been similar protests with asset management firms whose products have failed.
A lot of this is caveat emptor, something that we're used to in the west. If a financial product fails, and there is no criminal intent, then that's really the investor's problem - you need to understand the risks before you invest and that's why financial firms have pages of terms, conditions and disclosures that only increase as you get into riskier products. If the price changes on an investment product, whether it is a piece of real estate or a financial product, it changes - not much you can or should be able to do about it beyond either sell or ride it out.
With over RMB 500 million RMB in AUM, the number of people using Yu'eBao has surpassed 50 million. Imagine if the product did fail somehow and there was a run on the fund. Very quickly we would see consumer sentiment towards Alibaba turn south as people protested and demanded compensation for a product that they should have known, could have failed.
So what needs to happen?
Firstly, nothing in China is for sure in the financial industry right now. Consumers believe that bank deposits are safe because the government will stand behind the big banks. While this is likely 100% true, the national system of deposit insurance needs to be implemented.
Secondly, online finance products should not be regulated as money market or investment funds and not like demand deposits, which is how they would be in any other market. The online finance products are some of the most innovative globally today and will push the banks to innovate and change. The main difference between these products and the other existing products is the sales channel and the near instant liquidity. These are not un-replicatable products - any fund would be able to manage the same.
Next, interest rate liberalization needs to continue apace so that banks can offer similar products and services and face the challenges of a industry that is finally and truly market driven. There will be failures, but it will help the industry in the long-term.
Lastly, investor education needs to increase. Investors need to know that nothing is sure in the financial industry and with the Yu'eBao product. If you want 100% certainty, put your money in a demand deposit account to get 0.35% interest. It's not much, but if risk is your biggest concern, then this should be the choice.
The rub in all of this however is that going forward on the steps I've laid out would likely not only kill the financial industry, but potentially tank the whole Chinese economy. The problem is that the banking industry is facing so many challenges that if deposit rates did liberalize, competition for banking deposits would increase to an unsustainable level, smaller banks would lose out and the financial industry would take a big step backwards.
What will likely need to happen, unfortunately, is that the online finance funds will need to be slightly checked to insure the stability of the industry as a whole. The banks have already limited the amount of money that can be quickly moved on and off the platforms. Regulators will likely add to the restrictions by regulating the products as demand deposit style products which will drop the returns consumers will receive from the products. This will further compress already struggling returns that have gone from a high of around 7% down to 5%.
This should not be viewed as a substitute for continued reform and innovation from the banks. The large internet players have shown that they can innovate and take market share in what is an essentially completely new industry for them. With the launch of private banks right around the corner, China's existing banks would be wise to not end up in the same situation again with private banks that they are today with online finance.