What China Can Teach Us About the Future of Banking

Blockchain, Capital Requirments, Chinese banking, FinTech, P2P, Lending
"Spring Leg Frankenstein Monster Coin Bank," http://www.houzz.com/photos/20364291/Spring-Leg-Frankenstein-Monster-Coin-Bank-traditional-piggy-banks
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A few weeks ago, Citi published a quite fascinating 100-page report on financial innovations, from blockchain to P2P lending, in various regions of the world.  It’s a highly recommended and very comprehensive reading that I won’t be able to summarize in a short blog post.

From this report, it is clear that China’s financial system has adopted innovations at a much faster pace than the Western world.  And if there is a defining characteristic of the Chinese system, it is its very erratic and repressive regulatory framework, which made me once call China a "spontaneous Frankenstein banking system":

Financial regulation in China is quite a mess.  China seems to be the world testing ground for some of the most ridiculous banking rules.  With all their related unexpected consequences.

In an earlier post, I also highlighted that

China is an interesting case.  Underneath its very tight government-controlled financial repression hide numerous financial experiments aimed at bypassing those very controls.  The Chinese shadow banking system is now a well-known financial Frankenstein, with multiple asset management companies, wealth management products and other off-balance sheet entities providing around half the country’s credit volume.  The more the government tries to regulate the system, the more financial innovation finds new workarounds and become increasingly more opaque.

We already knew that the Chinese financial system was completely distorted from years of regulatory repression and crony capitalism, as a whole new report on finance in China by The Economist demonstrates (see the editorial here, and the report starting here).  Echoing my worries, The Economist calls for China to "free up" its "financial jungle."  Citi’s and The Economist’s reports now allow us to quantify the effects of those distortions.  Indeed, China leads the world in fintech and digital disruption in general; it has some of the largest fintech firms and, as Citi said, it is now "past the tipping point."

While its very large e-commerce has been a strong driver of the rise of alternative payment providers in the country, Citi points at a number of other factors that have facilitated the rise of those third-party payment companies, among which an under-developed banking system viewed by the public as quite unreliable (unsurprising given how tightly controlled banking is in China, which has stifled customer-oriented innovation), and "relaxed regulation."  Citi points out that Chinese regulators have now proposed new tightened rules for the payment sector, so brace yourself for further innovations in this space.  For now, Alipay handles more than three times the volume of transaction that Paypal does, and payment firms have more retail customers than banks have and are now expanding into offline payments.

CitiDigitalDisruptionFigure35

CitiDigitalDisruptionFig39&40

China also has the largest P2P lending market in the world, four times bigger than that of the US.  Citi analysts forecast that P2P loans are going to represent a sizeable 9% of total retail lending in China by 2018.

The driver of this growth is, typically, mostly regulatory constraints on traditional banking that triggered regulatory arbitrage:

P2P lending platforms target segments that are unserved or under-served by existing banking system such as consumer credit and small and micro business lending.  Traditional banks are not particularly good at serving this customer segments due to tougher Know Your Client/Anti-Money Laundering (KYC/AML) requirements as well as tightened lending standard post global financial crisis.

And one would add that capital requirements on certain category of customers (such as SMEs) play a large role here too, as I keep pointing out on this blog (see at the end of this post).  The same reasons are behind the development of such lending platforms in Europe and the US.  And indeed, as Citi writes:

According to China MSME Finance Report 2014 by Mintai Institute of Finance and Banking, almost 80% of SMEs were not served by the banks.  The explosive growth in the P2P lending has met the needs of SMEs which cannot get formal financing.

And:

Chinese banks are under tight regulations such as reserve requirement, loan-to-deposit ratios (LDR), KYC, AML, and so on.  There was however little regulations for the P2P lending sector.  There is also no capital requirement.

Furthermore, Chinese monetary repression is also a driver, as P2P lending allows savers to earn higher returns.  Here again, Chinese regulators are looking at ways to scrutinize and more tightly control the sector.

What are the effects of all this?  As The Economist points out, China’s shadow banking sector is the largest and possibly the fastest growing in the world:

TheEconomistPeoplesRepublicDebt

TheEconomistMinnowGiant

There is a fundamental difference between the Chinese banking system and the Western one however.  Chinese banks, despite being extremely large, have historically had no ability to grow outside of the Communist party’s grip and no ability to adapt to consumer demand as a result.  Citi points out that there were only 8.1 bank branches per 100,000 adults in China, vs. around 30 in the Eurozone and the US.  With little banking presence, fintech firms have found it easy to rapidly grow.

Yet, developed economies do have a lesson to learn from the Chinese experience.  The more regulatory constraints are put in place on banks, the more innovative ways around them will spontaneously emerge and the more complex and opaque ("Frankenstein-like") the financial system will become.  And sadly, it looks like Europe and the US have decided to follow China’s footsteps.

PS: The following chart is revealing.  Most of the financial products that are at most risk of disruption (SME and personal loans, deposits…) are also those that are the most affected by regulatory requirements and low interest rates.

CitiDigitalDisruptionFig25

PPS:  A very good introduction to the Chinese financial mess is Walter’s and Howie’s Red Capitalism. However the book was "only" updated in 2012, and plenty has happened since then, in particular in the fintech portion of China’s shadow banking sector.

[This article originally appeared on Spontaneous Finance]

  • This post is quite puzzling. My impression is that there are no "banks" in China, merely institutions that are appendages of the state. Since "loans" are often not repaid and the banking system is profoundly insolvent, what does the pace of innovation adoption matter? In monetary terms, there is no true credit leverage in China, merely fiat allocation. All fund flows eventually return to the state instead of residing in private hands. What am I missing? Maybe I just need to unsubscribe and leave you all to revel in the glory of the corporate state. As Anna Schwartz said to me may years ago, "I see statist tendencies in your writings." Be well.

    • Chuck

      The post is not at all an endorsement of the Chinese banking system. The excessive state control of the banking system is causing private entrepreneurs to attempt to circumvent regulation. Sort of like how Uber circumvented local taxi regulations. It's good that entrepreneurs are finding ways around dumb rules, but it would be far better to not have dumb rules in the first place.

    • Julien Noizet

      I am probably a little confused, but I'd be glad if you could highlight the 'statist tendencies' in my post.

  • As long as China doesn't bow to Basel, it could continue to thrive. It is an unusual system to be sure, but you probably won't see bad things happen like Mark to Market or other central bank shenanigans in China: http://www.talkmarkets.com/content/global-markets/china-could-be-the-next-basel-victim-or-not?post=92667

    • Julien Noizet

      Gary, China does seem to follow most standards set by Basel.
      Until the mid-2000s, it had implemented most requirements, including risk-weights:
      https://works.bepress.com/stefan_brehm/5/

      And this BIS report highlights China's progress in implementing Basel 3:
      http://www.bis.org/press/p130927.htm

      • Interesting, Julien. BIS says "closely aligned" which must mean independent of Basel but similar. But, wait til China realizes that Basel 3 or 4 or whatever, wants all loans 90 days unpaid to become delinquent. I can't imagine China bowing to that little change in the rules. 🙂 China knows full well what Basel 1 did to Japan.

  • gchakko

    Thanks for a fruitful insight into China's evolving banking system.

    The message hung atop the entrance of Sheyang Rural Commercial Bank in east China says a bit. “Treasure your hard-earned money, avoid the temptation of high returns, stay far from illegal financial schemes.”(quoted by Simon Rabinowitch in The Economist) The American bond culture with high returns (junk bonds included) is anathema to Chinese regulators. China government is bent on disallowing banks to loot its citizens. China will follow its own course, irrespective of wishful recommendations from West. The reason Chinese banking system compared to the West is still backward despite current digitization, is because Rural China is still under-developed as visitors from here confirm.

    The judgement that yuan’s internationalisation was premature (The Economist) is wrong for the simple reason it was introduced as a first step to promote trade within BRICS/ emerging economies and the poor world with China without the “worn-out” dollar, although lots of trade is still run in dollars at present. Further, why did banks in London open new vaults for yuan deposits if it was that premature? Another factor overseen is, both insulated economies, China, as much as India, live on domestic trade, inland commercial strength, that 2008 external crisis did not so much affect them as it did the other countries. Both are adamant in refusing Western bankers free-ride on their soil.

    Untouched is the philosophical dimension. China follows Marxism-Leninism
    a la Mao et.al. Unlike the Soviet Union, China incorporates the original content of Hegelian Dialectic – Thesis-Anti-thesis clash resulting in Synthesis, on which Marxism-Leninism is based. For Hegel historical dialectic of events will not stop at synthesis (as for e.g. the communist classless society), but will continue giving rise to antithesis again which in turn results in another synthesis. Interestingly, for Hegel, the Dialectic continues till the historical evolution culminates in the Absolute Idea, which for Hegel was God. Soviet Union did not accept that neither China in principle. China but follows an ideological slant for pragmatic reasons (e.g. Hong Kong) accommodating apparent contradictions /anomalies to experiment new solutions in its financial structure, obviously with the back-up of a repressive regime control allowing a play space to gamble and take risks with new ideas. The huge Chinese army seems awfully alert like its North Korean neighbour, in putting down citizen’s protest, be it Tibet, Uighur or Tiananmen Sq. Should mass citizens take to streets in case of a big financial bust, the PLA is there to flatten it out, something democracies cannot do, thanks to their constitutional limits. So, Chinese risk-taking is not for everybody because the Chinese set-up and history is different. Yet, with China’s supposed $30 trillion banking assets as world’s largest, making up 40% of world GDP (Rabinowitch), I see cooperation as the only way in dealing with China on international finance in our nuclear age.

    George Chakko, Vienna, 13/05/ 2016 23:35 hrs

  • ryan andrade

    Principles of Micro student here.

    Speaking from a beginner's perspective I can gather that China is aiming to challenge its infrastructure to move towards more futuristic banking approaches. However there are plenty of complications in achieving this goal such as their newly emerging economy (including the underdeveloped rural areas of the country), the regulatory obligations on existing banking models, and the influences from Western approaches to banking. On a global, long-term scale it is a benefit to everyone that China is trying to reinvent the banking wheel. But when put under a microscope of modern economics, it is very troublesome for everyone to comprehend based on previous successes/failures.

    Being a millennial, I was interested in reading about what ventures China is making into the future of banking. I related the idea of E-commerce to a popular social banking application i currently use called Venmo. The app lets you send money to your friends and post a tagline to go along with it. The tagline's are then posted to a feed that lets you read what transactions friends in your area have made. It is an interesting concept that appeals to my generation which is obsessed with sharing information. However it also seems to be typically an American trait as well. I do not know much about Chinese culture but I do not believe that they are as fascinated (or comfortable) with the free flow of information that American young-adults are.

  • sultan

    China has a huge weight on the market with over 1 billion people. But it’s sad to see Chinese banks struggle with adapting to consumer demand and can’t grow outside China with that type of economic atmosphere. There are too few banks for too many people. And this is a bit concerning. Even if it might seem like its blown out of proportion for now. But once china’s economy become influential in a global spectrum, this could become a serious problem. Banks in china have huge potentials and could add more weight and influence without government regulations on top of their ceiling.

  • Alex Gallardo

    As a microeconomics student in college, I am familiar with forms of ecommerce in the United States, and can possibly shed some light as to why companies such as Alipay and Alibaba hold such a powerful grip in the sector. Even though i am not fairly familiar with those specific companies, I'm sure they operate in a similar way that third party apps and such work here. Two that come into my mind are snapchash and venmo. Snapcash works by linking a debit card to your snapchat account. You can then type an amount of money into the apps texting service, and send it to your friends for no extra charge. However most people don't use this service, since it most people view it as untrustworthy. A staggering amount of China's population uses ecommerce since they don't necessarily trust their own banks. I completely trust my bank, and would rather have them handle my money than a random app that didn't even make its debut by handling money, such as snapcash. However of these Chinese services can provide services without charging some of the annoying fees that banks do, the consumer might actually be better off by using these services. China might be onto something.