- Technology and data access have made it easier for companies to provide loans to people who previously couldn’t get them
- Processes such as ‘securitisation’ could lead to problems similar to the 2008 US mortgage crisis
In China, technology has led to reduced costs for digital finance firms and more access to data that assesses credit risks, making it commercially viable to provide loans to previously unbankable individuals.
These benefits, however, can only be sustained if the industry is appropriately regulated.
Prior to intervention by regulators, digital finance firms such as Ant Group had benefited from regulatory arbitrage – making small changes to a business to benefit from loopholes. Although some might argue that their business is, in substance, a banking business, they have not been treated as such by regulators, as they do not have a debtor-creditor relationship with customers, so they were not subjected to the same stringent requirements.
The industry now serves more than 500 million customers, so there are new risks. Many digital finance firms profit by packaging many loans into new investment products, and selling them to financial institutions, a process known as “securitisation”.
Because the loans – and therefore the risks – are not retained by the company, there is incentive to extend as many loans as possible, even if those individuals or businesses are unlikely to be able to repay them. But if enough borrowers default on their loans, this could set off a chain reaction akin to the 2008 US subprime mortgage crisis.
Chinese regulators have sought to address the financial aspect of this problem by increasing the proportion of loans retained by digital finance firms, and the amount of capital these companies have to hold (and use to put out fires); and by capping the maximum number of loans available to an individual or business. Rather than leaving these firms to the fragmented regulations set up on a provincial level, national regulators will step in and supervise the industry through a centralised system. The proposed rules will mitigate the adverse incentives, reduce the risk of default, and reduce the number of loopholes.
Although these rules may reduce profits for digital finance firms, and so too the incentive to invest in the industry, this does not mean that innovation in the sector will stall. As regulators have sought to emphasise, technology can bring many benefits to the world of finance. Securitisation is not the only way for these firms to earn money. It might be too early to tell what these regulations will spell for the industry, but it has to be agreed that intervention is necessary for growth to be sustained in the long run.
Ant is an affiliate of this newspaper’s owner Alibaba Group Holding.