Chinese lenders ready to fight back if profitability is threatened

Mainland lenders are ready to fight back if the likes of Yu E Bao pose a real threat to their profitability

PUBLISHED : Tuesday, 11 February, 2014, 1:57am
UPDATED : Tuesday, 11 February, 2014, 1:57am

Within just six months, Yu E Bao, the partnership between the mainland's Alibaba and fund house Tianhong Asset Management, raised 250 billion yuan (HK$318 billion) from millions of little guys to invest in money market funds and treasury bonds.

Other internet companies such as Tencent and are launching similar services.

All of a sudden, the market is euphoric about the beginning of the end of the mainland's stodgy and bureaucratic banks. After all, these banks are predominantly state-controlled and have never been nice to the little guys.

If it spreads like wildfire, the regulatory sympathy could evaporate

A sleek new force coming out of nowhere to challenge the entrenched banks is an exciting development.

Except that this is just a story. The reality is it is not easy to move the cheese of the banks. Not yet, at least. Let's look at some inconvenient truths.

First, despite the hoopla, the 250 billion yuan is just 0.24 per cent of the banking sector's total deposit base.

Second, none of these e-commerce firms and e-finance platforms has an established base of borrowers or banking skills. They do not even have a lending licence.

Strictly speaking, the buying and selling of money market funds by Yu E Bao is a grey area in the regulatory framework. It is a clever innovation, and the regulators have so far turned a sympathetic eye to this borderline case. But if it somehow spreads like wildfire, the regulatory sympathy could evaporate.

Third, how is Yu E Bao - or other similar operators - going to use the money it raises from the little guys? So far, its only investment options are money market funds, treasury bonds and bank deposits.

But money market funds must, in turn, invest the money somewhere, predominantly in bank deposits and treasury bonds. So, in a way, instead of competing with the banks, the likes of Yu E Bao are working for the banks.

Of course, the manoeuvre by the likes of Yu E Bao will raise the returns for the little guys, but those returns will be capped by the banks' willingness to accept the recycled money.

It is true that the work of Yu E Bao and rivals will push up the funding cost for the banking industry, but the extent of that increase is dependent on the banks' ability to pass the higher costs to borrowers.

On the face of it, the little guys are moving money from bank deposits to buy financial products. But given the size of the banking industry on the mainland, the banks collectively determine the yields and prices of financial assets.

Finally, one must ask the question: why do Google and Amazon, for all their resources and popularity, not do in the United States what Yu E Bao is doing in mainland China?

The reason is simple: the business model does not exist in the US. Why? It is because of the free-market interest rate regime.

But as much as a quarter of the funding for mainland banks is already driven by market interest rates. That is the so-called wealth management products. In this particular segment, the banks actually make a higher interest margin because, in addition to passing the higher funding costs to end-users of the money, they charge multiple service fees and higher rates.

It is conceivable that in the next five to 10 years, all the funding sources of the banks will be subject to market rates, thanks to pressure from the likes of Yu E Bao.

The banks' lending rates will move up in a parallel manner, with their profitability either unchanged or even enhanced. As we approach that point, Yu E Bao and the like will gradually lose their relevance.

By then, they either become glorious martyrs for the mainland's interest rate liberalisation, invent something else or die a slow death.

At present, Yu E Bao and the like are harmless to the banks. When they start to move the banks' cheese, the banks will fight back by simply raising interest rates, one way or another, to keep deposits and so eliminate the scope for the recycling of deposits.

The likes of Yu E Bao will still have their usefulness: pooling the money of the little guys to invest in treasury bonds and money market funds.

But that business model has no "moat": the banks can do this for their customers at a tiny marginal cost. Thus far, they have not bothered to do it. But if the need arises, who is there to stop the banks from offering even better products, given their vast capabilities to cross-subsidise between various lines of business?

After all, investing in money market funds and treasury bonds is not risk-free. One wave of losses on the back of some volatility would be sufficient to cool the euphoria we have so far witnessed.

In conclusion, the likes of Yu E Bao are doing mainland savers a great service. Their continued efforts will force the banks to gradually raise the interest rates on short-term deposits, one way or another, with the rate rise being officially sanctioned by the central bank or without.

As a result, the yield curve in the banking sector will experience a parallel shift upwards. In the long term, that means a slowdown of credit growth - and a more rational economy.

Joe Zhang is the author of Inside China's Shadow Banking: The Next Subprime Crisis? and a corporate governance adviser in Hong Kong


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