China banking reform: Share the wealth
Author: Winnie Liu
Asian Venture Capital Journal | 31 Jul 2013 | 15:20

China’s first step in interest rate liberalization might herald a series of reforms that make financial services more market-oriented. But where does shadow banking fit into it?

For Rong360, A Chinese online search engine for loan products, the central bank’s decision to abolish the lower limit on interest rates was cause for cheer. If the government allows greater freedom in setting lending rates, there will be greater competition among banks, and perhaps more web traffic for Rong360 as prospective borrowers consider their options.

“We see huge potential in China’s financial services sector and there’s no strong player leveraging internet in this space,” says James Mi, managing director at Lightspeed China Partners, which led a $7 million Series A round of funding for Rong360 last year.

Last week, the company secured $30 million in Series B funding. Sequoia Capital is said to have led the round, with Lightspeed and fellow existing investors KPCB and Zero2IPO Ventures also participating.

Nine in 10 loans in China are granted above the 6% benchmark rate, so the immediate impact of removing the lower limit is marginal. But as a gesture of the government’s desire for a market-oriented economy – with more of a role for small- and medium-sized enterprises (SMEs) – it is powerful. Rong360 wants to ride the trend.

A removal of the upper limit on deposit rates, which remain capped at 110% of the benchmark rate, is the next industry participants are waiting for. “If the regulator isn’t touching the banks’ deposit rate then it is not doing something meaningful,” says Michael McCormack, executive director at Z-Ben Advisors.

In this way, liberalizing deposit rates would reduce investor appetite for higher interest rate products available through China’s “shadow banking system,” which in certain areas lies beyond the reach of traditional regulation, making its impact on the sector hard to fathom.

Under the radar

Shadow banking allows borrowers to obtain credit from alternative sources to traditional banking institutions and circumvent banks’ formal underwriting standards. It took off in 2009, when Chinese government initiated a credit boom intended to see the country through the fallout from the global financial crisis. The big winners were state-owned enterprises but many smaller players missed out.

“Despite the massive increase in liquidity, demand for credit from small- and medium-sized enterprises (SMEs) was not being met,” say Per Stenvall, managing director at M&A advisory firm Stenvall Skoeld & Company. “The shadow banking system is still meeting this demand by providing loans to private companies shunned by banks, and in doing so it is playing an important role in rebalancing China’s economy.”

Moody’s estimates the balance of outstanding shadow banking products is around RMB21 trillion ($3.4 trillion), equivalent to 43% of the total system loans or 55% of GDP in 2012. Of this, nearly half is undiscounted bankers’ acceptances (off-balance sheet items) and entrusted loans (between corporates with banks acting as agents). The rest comprises loans extended by trust companies, guarantee companies and finance companies, as well as financial leasing, microcredit, informal lending and pawn shops.

Limited shadow banking activity is necessary in an emerging economy like China, but the risk-return profiles can cause discomfort: SME credit checks are difficult so lenders may never really know borrowers; and if these loans are somehow bundled into diversified wealth management products that are sold to retail investors via banks, the risk becomes all the greater.

The government therefore wants to regulate shadow banking lest it becomes a systemic risk.

Although shadow banking can be profitable, PE exposure to the industry is limited, given the amount of consolidation and regulation required, but Jon Parker, a principal for transaction services at KPMG, believes the things might be going in the right direction. “Likely investments may be microfinance enterprises and wealth management companies that can demonstrate a good track record and are able to grow to a reasonable size,” he adds.

Broader horizons

There have been other government policies targeting small businesses, and for several years now commercial banks have been encouraged to boost lending to SMEs. But the development of Alibaba Finance, which earlier this month won regulatory approval to expand its business, suggests an acceptance of non-traditional providers. Backed up by transaction history from Alibaba Group’s e-commerce platforms, Alibaba Finance might be better placed than a commercial bank to assess an SME borrower.

In this context, microfinance companies are expected to playing an increasingly important role in financing small businesses. There were more than 7,000 registered microcredit companies with total outstanding loans exceeding RMB700 billion as of June. Lending rates are capped at four times the benchmark rate, so returns of 20% or more are achievable.

However, PE firms remain cautious about the industry. Managing high volumes of loans is challenging while the legal and credit systems don’t provide sufficient protection to lenders. “Most potential borrowers are individuals or small companies with few assets,” says Johannes Schoeter, founding partner at China New Enterprise Investment (CNEI). “You can’t force them to pay or declare bankruptcy and there isn’t much collateral to go after. The borrower may just disappear or simply say – sorry I don’t have the money to pay you back.”

CNEI’s preference is financial leasing companies. Last December, it led a Series B round of funding for Juxin Internal Leasing, which specializes in lending to SMEs in the education and healthcare sectors.

Loan guarantee services are another niche play to draw interest. Shenzhen Huarong Investment & Guarantee, a portfolio company of Shenzhen Capital Group, has expanded its operations to provide short-term loans for small business owners. “Revenues for the loan guarantee business are high if the financial risks are well controlled,” says Jin Yan, an investment director with the VC firm.”