Crowdfund Insider | Spencer Li | Aug 31, 2016

After nearly eight months since the original draft was first issued, the China Banking Regulatory Commission (“CBRC”) announced the official rules for the online lending industry on August 24, 2016. The unveiling came accompanied with a few policy curveballs that few industry participants were expecting. Titled as the “Interim Guidelines” (indicating there could be more permanent policies few years down the road), certain media has hailed the newborn policies as the strictest ever in the history of online lending. However, not much has changed between the draft and final versions with one major exception: borrowers are now subject to a borrowing limit for loans on a single platform as well as across platforms.

Public reactions from industry participants were all positive and supportive as one must never (ever) publicly denounce Chinese policies. Privately, many managers are scrambling to make sense of the new rules while lamenting that regulators have dealt a death blow to the online lending industry.

Rules to Reduce Risk and Police Paperwork

When Chinese media began circulating rumors of borrowing limits in the days leading up to the official CBRC announcement, many dismissed the reports simply as a rumor. Imagine the disbelief as the policies now confirm that “natural persons may only carry a loan balance of up to RMB 200,000 on a single platform and no more than RMB 1 million across multiple platforms. While legal representatives of organizations and other legal entities may only borrow up to RMB 1 million on a single platform and no more than RMB 5 million across multiple platforms.”

In the press conference held by the CBRC, the following official response offers the following explanation for the motivation behind the borrowing limits:

“To better protect lenders’ rights and to reduce the moral hazard risk of lending platforms, we want to limit the concentration risk in loans and work in conjunction with the applicable laws and filing standards for illegal fundraising cases”

The first part of the statement is easy enough to understand, regulators want to forcibly reduce overexposure to large loans as a moral hazard problem does exist in that platforms are incentivized to make bulky loans as it saves them origination costs and helps them generate larger volumes, while lenders ultimately bear the higher risk from overburdened borrowers. The latter part of the statement however is trickier to explain and rationalize.

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According to the relevant rules issued by the Supreme People’s Procuratorate and the Ministry of Public Security, the threshold to establish and prosecute a criminal case for illegal fundraising is RMB 200,000 for individuals and RMB 1 million for organizations. What this means is that if someone illegally fundraises any amount below these thresholds, they will not be prosecuted on a criminal basis and would instead undertake a civil procedure. Therefore the logic here, as one Chinese industry blogger mused, seems to be that all borrowers on lending platforms are now deemed to be fundraising illegally and to protect these borrowers and platforms from criminal prosecution, regulators are enforcing loan limits that match exactly with the criminal case thresholds. In this sense, regulators are attempting to protect lending platforms from being implicated as facilitators in criminal fundraising cases. In addition, drawing a clear line for lending platforms will likely reduce the case load for police departments as platform compliance with the limits would lower the likelihood of criminal cases being filed by lenders. Since the Ministry of Public Security is one of the joint authors of these rules, it has been rumored that they pushed hard for the loan limits so that they can reduce police paperwork from criminal fundraising complaints. This rumor is unverified and highly speculative, of course.

Alternative Policy Proposal

Allow me to digress here as I would like to propose my own solutions to the issues that regulators pointed to as motivation for implementing the loan limits. If regulators are concerned about concentration risk in large loans, a more direct solution to protect lenders would be to mandate an investment limit per loan, thus forcing lenders to diversify their loan portfolio. Using diversification to reduce risk is frequently advertised to lenders by top lending platforms in both China and the US and should address the regulators’ concern for investor protection. However, if regulators are more focused on the moral hazard of originating large loans that benefit platforms and increase risk to lenders, I think there is an even bigger moral hazard issue that should be addressed first.

Fees

Many Chinese lending platforms collect an outrageous amount of origination fees from the borrower. Examining a certain NYSE listed Chinese lending platform’s latest annual financials, one can find an average fee rate of 20%+ being charged to the borrowers. With these fees, the resulting cost to the borrower can soar close to 40% APR, a rate of return that even small time loan sharks will find attractive.

The classic moral hazard issue here is clear: platforms can overburden borrowers and increase default risk to lenders by collecting high fees that benefit their own financial performance. Even worse, with poor disclosure from the platform, lenders are often only aware of the interest paid to them by the borrower without knowing about the additional fees that borrowers have to pay to the platform.

To resolve this moral hazard problem, I suggest that regulators seriously consider implementing limits on platform fees for borrowers or set a cap on overall borrowing costs. If not, then regulators should at least mandate detailed disclosure of fees on a per loan basis to reduce the information asymmetry between lenders and platforms on borrowing costs for loans.

Although there are existing private lending laws in China regulating the interest rate that lenders can charge borrowers, there are no regulations on the overall borrowing cost inclusive of all fees. Certain platforms have publicly justified the use of this legal loophole to continue to issue high-interest loans under the guise of platform fees. Eventually and hopefully, in one form or another, there must be policies to control fees charged by all types of regulated lending institutions. Otherwise, such irresponsible lending practices will pose a significant risk to China’s financial sector.

Issues with Enforcement

The main issue with enforcing the loan limits is that China has a severely underdeveloped credit rating system and it is often very difficult to verify a borrower’s debt burden while underwriting a new loan. Regulators and platforms would not only have difficulty in determining the debt situation of a borrower across multiple lending platforms, it will also be challenging determine whether the borrower has outstanding loans across a variety of banks, financial institutions, or individual lenders. Perhaps the new policies would further encourage the industry or other government bodies to develop systems to monitor and share credit information of borrowers.

See:

• Accessing capital in China and solutions for crowdfunded companies

• OPEN LETTER: Lifting the Veil on Peer-to-Peer Lending in Canada

To further complicate enforcement of the rules, loopholes exist for platforms to circumvent the new policies. Institutions can register multiple entities using different legal representatives and spread out loans across these entities within the policy limits. After all, the “Interim Guidelines” does not stipulate limits on aggregate online loans taken out by related entities with different legal representatives. Similarly, individuals can use spouses, relatives, and friends to borrow on their behalf and the individual as the ultimate user of the funds can serve as the guarantor. The policies were most likely designed with this loopholes in mind as regulators do want to provide some leeway for platforms to operate. Ultimately, it would be up to the local financial regulators tasked with enforcement on how they want to apply the rule within their jurisdiction. Strict interpretation and enforcement on a regional level would most likely induce platforms to migrate their place of registration to jurisdictions that have more lax interpretation of the rules. Thus it would be unlikely for local financial regulators to introduce very strict rules considering the potential detrimental effects on economic activity and tax revenues resulting from platforms migrating to other regions.

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