Fintech is being utilised and promoted to address inefficiencies in the current financial system in China. The government is encouraging innovation and measured experimentation in the fintech space – regulators need to closely monitor developments as we have seen numerous times before that innovation in the financial space can, and often does, lead to problems in the future.
Innovation is taking place across a number of different traditional banking segments including deposit funding alternatives, credit origination, data analytics and payments. Not since the invention of the credit card have we seen financial innovation like this offered to the consumer and small to medium sized enterprise (SME) segments and this is a phenomenon taking place around the world as onerous regulatory requirements and government encouragement drives the industry forward.
What does this mean for existing banks in China? We believe there is “a place for everyone” in China’s evolving credit framework with larger banks starting to concentrate more on investment banking activities and smaller banks taking active roles in developing SME and digital strategies, and wealth management capabilities. Major developments in data analytics and personal credit reporting businesses will help improve transparency and risk pricing and should ultimately lead to lower credit quality risks in the system and a lower equity risk premium.
Some of China’s internet giants will become key players in the segments of consumer, SME and microfinance – areas currently underserviced by banks. Elsewhere, we are concerned with the multitude of new niche businesses which are loosely connected to the fintech space – a lot of capital is currently finding its way into untested and unprofitable business models. This risk is by no means confined to China.
Let us quickly look into why this is all happening now. There are two key reasons across developed markets that were not in place during and following the last internet boom when industries such as retail and music saw the biggest disruptions to profitability and existing business models.
- Onerous regulatory measures imposed on the banking industry following the global financial crisis (GFC) in 2008
- Developed market policy rates close to zero; leading to lower rates of return on invested capital and an abundance of global capital flows searching for yield.
China is slightly different as it is undergoing a long period of financial liberalisation, which, as we have seen in a number of prior cases, usually results in some form of shadow competition for incumbent banks – the fact that this is happening in the age of the internet makes it a unique case.
- Deposit rates remain suppressed relative to other forms of short term investments – the following chart shows the different rates of return available to households across various financial assets currently being offered. China still allows ‘guarantees’ on many of these products leading retail investors to believe they are risk free – we believe this will change as products reach critical mass – something we are already witnessing in trust products.
- System Credit Allocation – China is still largely a state based, central command driven credit economy. Major banks have been reluctant to lend outside of SOE channels which to date are still perceived as risk free lending. Credit starved SMEs and private companies have had to seek alternative channels for funding (this lead to the emergence of trust products, Person to Person (P2P) and wealth management products (WMPs)).
- Govt policy – The government wants innovation across a number of sectors but chief among them is the internet revolution to improve inefficient industries. System credit allocation is one such inefficiency in China… This has resulted in the issuance of five new private bank licenses – to be primarily used for SME and retail lending (two are internet based (Tencent-Webank and Alibaba-MYbank) and the remaining three are more traditional).Tencent’s offering, WeBank, was the first internet bank officially to launch in January 2015. Premier Li Keqiang signalled the importance of this development by personally attending the bank’s launch ceremony and supposedly pushed the final approval button for the first loan issued.
Chart 1: Rates offered across various retail financial assets (%)
Source: Bank reports, financial product providers, BofAML, Nikko Asset Management
Fintech evolution and what it means for traditional banks:
There are multiple strands to fintech but we confine our discussion to four broad areas of competition for traditional banks:
- Deposit Franchise and Alternatives
- Credit Origination
- Data Analytics, Management and Credit Risk
- Third Party Payments
We believe competition in this space is inevitable and those banks that do not currently hold a deposit franchise (defined as current account or savings accounts of which the majority are primary accounts of corporates or individuals) or are not focused on deposit alternatives (eg. WMPs, Insurance) will see the greatest pressure on their cost of funds. The creation of WMPs, MMFs, Trust products, Insurance savings products and Equity/Infra/PE Funds are providing consumers with multiple alternatives across the risk spectrum. Household balance sheets are overwhelmingly positioned in bank deposits much like they were in Japan and the US before financial liberalization. US households now place very little of their financial assets in bank deposits:
Chart 2: Household Financial Assets (ex Property) – end 2013
Source: Goldman Sachs, Nikko Asset Management
Alternatives are growing quickly from low bases – some of which banks can actively take part in (WMPs, Bancassurance) while others are currently only offered by internet providers and other institutions (MMFs).
Chart 3: Life Premium Market Share
Chart 4: Alibaba's MMF: Yu E Bao
We are of the view that consumers will be reluctant to accept lower (or even the same) rates on deposits housed with internet companies vs. traditional banks – particularly in China where banks are state-owned. The cost of funding advantage some banks have is unlikely to change which leads to a different risk appetite on the lending side with banks able to target lower risk clients. Banks may well find themselves funding internet or niche banks much like co-operatives or specialised financing companies in India, America and many other countries.
Credit Origination - Internet vs. Traditional Banks
Internet banks are focusing their attention on unsecured consumer and private/micro companies which represent only 4% and 9% of the total credit system respectively. This is in part because of regulatory guidance but also, importantly, because of the cost of funds. Internet companies currently rely on interbank markets and credit markets for funding which comes at a much higher cost (4-6%) relative to bank deposits (avg. <2%). The cost of funds restricts them from pursuing mortgages in which the interest spread is not attractive enough.
Higher risk segments of unsecured consumer and Micro/SME are currently underserviced by traditional banks (which previously gave rise to many areas of the shadow banking system). We see SME/Private/Consumer segments having higher loan growth potential over the next 5-10 years. Internet banks are another means of ‘shining light on the shadows’ by bringing more of these loans onto more formal, albeit new, channels and this should help lower system risk perceptions. In this space there are ample credit opportunities for both traditional banks and internet companies and see them operating in different sub-segments.
Elsewhere in Asia – Banks taking on a more formal role
Greater inefficiencies lead to more opportunities for fintech in our opinion. Under-developed banking systems in countries with larger geographical footprints have a lot to gain from fostering fintech’s expansion. For Asia this includes India, Indonesia and Philippines and these countries together account for 1.5bn people (21% of the global population). Telecom operators are key players in this financial expansion with Vodafone’s MPesa payments system in Kenya becoming a widely accepted model to aid financial inclusion.
Indian private banks investing in this space can be big beneficiaries as technology helps them to enter more rural markets without the additional branch and personnel expenses – this also forms part of the government’s drive for financial inclusion. Indonesia and the Philippines also fit this demographic and geographical profile but we find less evidence to suggest that banks or governments are looking into this in a meaningful way.
Data Analytics, Management and Credit Risk
This is the area we believe could add most value to banks in the long run in terms of improving credit risk management, improving cost and income efficiencies and ultimately lowering the equity risk premium for the banking sector.
Using “big data” to aid credit decisions, to enhance risk management capabilities and to better allocate resources (also industry data feeds) should be a system-wide goal for any banking regulator in our opinion, and we would note that China has given approval for eight companies to prepare for personal credit reporting (scoring) businesses – these may become the Experians or Equifax’s of China in the future and will hopefully lower the overall risk premium in the sector by improving credit allocation within the consumer segment. The only issue is how freely this information will be dispersed to banks and other credit providers as they are currently predominantly operated by private financial institutions and internet companies.
Third Party Payment Providers
This one is relatively easy – the banks have lost. While banks may once have been considered for some role in this segment, developments would suggest this market will be dominated by Alibaba and Tencent – in China third-party payments already make up more than 75% of transactions vs. 15% in the US, according to research from GS:
Chart 5: Internet Shopping Payment Volume by payment type (%)
Source: Goldman Sachs
And Alipay’s Total Payment Value (TPV) already dwarfs PayPal (note that PayPal is 50/50 US vs. international payments:
Chart 6: Total Payments Volume (US$bn)
Source: Goldman Sachs
The internet revolution is coming to the financial sector, addressing inefficiencies in current system and business models. In China’s case we are witnessing a combination of financial liberalisation with an internet revolution in the financial sector. We believe there is “a place for everyone” in China’s evolving credit framework. Larger banks will have to concentrate more on investment banking activities, smaller banks on wealth management and digital strategies, and internet companies will come to be dominant forces in unsecured consumer credit and SME lending.
Not since the invention of the credit card have we seen financial innovation like this offered to the consumer and SME segments but regulators need to remain prudent to ensure problems do not arise down the road.
Ultimately we believe this is a positive development as it should enhance risk management capabilities and move more shadow financing activities back to formally regulated sectors, which should ultimately lower the equity risk premium for Chinese equities.