INSIGHTS: P2P lending in crisis as regulatory bubble pops

Chinese peer-to-peer (P2P) lender Dianrong, once hailed as the “LendingClub of China,” appears to be in crisis following an announcement that it is closing around two-thirds of its offline branches and laying off as many as 2,000 employees. At around the same time, it was accused of falling behind on wages and severance payment. In mid-April, the company reportedly sought $100 million in investment to meet new capital requirements.

“It was not because we did not want to or could not grow. It was because we were told not to grow,” Guo Yuhang, Dianrong’s co-founder, said in a memo addressed to employees, calling for clearer guidance and “a ray of hope for companies that stick to compliance.”

China’s online peer-to-peer lending industry has been in turmoil for the last three years as financial regulators have clamped down as part of “de-risking” efforts. Tuandai.com, a top P2P lender, collapsed in March due to turnover problems. As of February, the platform had more than 220,000 investors with RMB 14.5 billion ($2.15 billion) in outstanding loans. The company is under investigation for illegal fundraising, leading to the arrest of 41 people so far, including co-owners Tang Jun and Zhang Lin.

Bottom line:

• P2P lending is in crisis as regulators seek to deleverage and de-risk the economy.
• As of the end of March, there were 1,021 platforms operating in China—less than half the industry’s 2015 peak—and a whopping 5,595 platforms have either gone bust or have been found problematic. It has been estimated that the number of platforms may drop by 70% this year.
• The P2P lending crisis is just one example of something we see a lot: Industries get huge overnight with state backing and then go bust just as quickly when the government turns its back on them.

State-fueled boom

• Online P2P lending got big with state backing.
• Fintech innovations including P2P lending, digital finance, and mobile payments all fit well with China’s 2016-2020 financial inclusion agenda. These lending platforms quickly became an important source of funding for the private sector and the small and medium enterprises that were underserved by the traditional banking system.
• The government permitted and took steps to support the growth of P2P platforms. Many P2P lending platforms were founded by state-owned enterprises. Chinese Premier Li Keqiang and former governor of People’s Bank of China (PBOC) Zhou Xiaochuan both publicly supported (in Chinese) online lending.
• With ample support and few rules, P2P lending flourished nearly unregulated in China, starting in 2012. Hundreds of online lending platforms flooded the space—at least 3,500 companies were registered as P2P lenders by 2015.
• Signs of trouble emerged in 2013, as P2P lending became rife with fraud and risky financial practices. PBOC named P2P lending as one of the big risks in digital finance.
• But the ballooning industry continued to draw in millions of mom-and-pop investors—many of whom later lost their life savings when the bubble burst.

Cold feet

• In 2015, with the industry at its peak, P2P lending platform Ezubao was exposed as one of the largest Ponzi schemes the country has seen.
• In 2016, the government began purging the industry, taking action to regulate it and curtail the growth of smaller platforms.

Regulators imposed caps on loan sizes, demanded that platform operators deposit the funds they raise from investors with custodian banks, and urged companies to improve information disclosure.

• By 2018, the crackdown had become a reckoning: The number of platforms that halted operations or came under police investigation outnumbered those that still existed. Many investors lost their life savings as platform after platform went bust.

A predictable cycle

• According to state-run newspaper Legal Weekly, in the five years leading to 2017, China’s financial market experienced the entire life cycle: relaxing regulations, encouraging innovation, explosion of businesses, increasing leverage, high default rates, risk accumulation, increasing regulations, restricting businesses, deleveraging, stricter control of risks.
• “With institutional constraints, China often faces catch-22 situations in market empowerment. State control and protection distort resource allocation and prevent the market from establishing independent operational rules; efforts to redress these problems destabilize existing economic order, and government intervention is restored to smooth out the turbulence,” according to The Diplomat.

The moral:

• This has happened before, and it will happen again. Lax regulations and state backing allow risky businesses to flourish uninhibited—until the risks become so big that heavy-handed regulations are needed to slap them down to stabilize the market. Most investors get wiped out.
• This happens across industries; online lending, mobile payments and cryptocurrency have all had regulation-driven booms and busts. The electric vehicle (EV) industry is also undergoing a brutal consolidation so brutal that it will likely wipe out most existing players. The rise of EV industry was largely fueled by heavy subsidies, which caused the number of EV manufacturers to triple in just two years. When the government began phasing out subsidies, it caused panic across the industry.
• So when you see a new industry booming in China, ask if it’s real growth or irrationally exuberant industry policy—and if it’s going to get deflated in three years. Political and regulatory risk really matter to these markets.

What’s next?

• Authorities will exert more control over the online P2P lending industry with the roll-out of a pilot program to register China’s remaining platforms in a national monitoring system by next year. Platforms will be required to prepare and submit data disclosures to the monitoring system. Those that fail to comply will be forced to shut down.
• Platforms will have to meet prudential requirements for registered capital, risk reserves and lender risk compensation. Beijing has proposed (in Chinese) a capital requirement of RMB 500 million for nationwide operators.
• The new registration system could mean further restructuring for the entire industry, forcing smaller players to downsize or consolidate.