China's internet finance companies are driving the country's banks to innovate and upgrade their digital offerings. The process should create new financial services that better fit a consumption-led economic growth model. S&P Global Ratings believes most banks will adjust to the digital disruption, although their market share in consumer-related finance will become less dominant. They will have a smaller slice of a bigger pie.

Financial technology is large and fast-growing in China. Since the launch of Alipay in 2012 and WeChat Pay in 2014, mobile-phone payments have soared to RMB320.4 trillion (US$46 trillion) from less than Chinese renminbi (RMB) 50 trillion. On the online bank front, WeBank's asset reached RMB81 billion by the end of 2017. Although still tiny compared with the Chinese banking system's assets of RMB252 trillion assets and loan balance RMB120 trillion, this represented growth of 7.5x in the first two years of operations. And WeBank's loan growth tripled last year, to RMB47 billion (US$6.9 billion).

In our view, the business model and credit impact is greater for smaller banks. Some may lack the resources to make necessary technology upgrades. As a result, they may cede underwriting control on consumer loans to tech giants using big data and behavior models. Increasingly we are seeing banks collaborate with internet finance companies on consumer loans, but these assets are under-tested through a cycle—i.e., against increasing unemployment rates and declining disposable income. While internet finance companies see smaller banks as funding partners, they have less incentive to collaborate on new products and services.

China's financial regulators have given the fintech industry space to grow, while retroactively punishing excesses, particularly if fintech is used as a guise for regulatory arbitrage. This approach has worked in certain situations while faced significant challenges in others. Peer-to-peer (P2P) lending is an example of the latter.

Payment Services: A Disruption With An Upside

We view disruption in China's payment services as a model for other transformations that could follow. Chinese nonbank digital payment providers, led by Alipay and WeChat Pay are in many ways outcompeting banks on payment services. On the other hand, these companies are helping to grow new markets for all lenders.

By transaction volume, digital payments conducted through nonbank providers overtook those transacted by banks in 2016. By the end of 2017, nonbank digital were almost double those of banks (see chart 1). In terms of value, banks still beat the rankings (see chart 2).

Chart 1

Chart 2

Technology is clearly changing consumer payment behavior in China. Payments are made easy for both buyers and sellers, with a simple cell-phone scan of a vendor's "QR" code. Thus they're accepted everywhere, from online retailers to grocery stories to flea markets. Businesses can maximize customer relationships by, for example, offering discounts if the customer adds the vendor as a social media contact. Often these payment platforms are just another function under the main online retail/social media app, maximizing clicks per day and in turn customer loyalty. Since Alipay Mobile and WeChat Pay were launched, China's bank card penetration rate has plateaued (see chart 3).

Chart 3

However, a look at the trend in settlement fees shows that growth in online payments has come at some cost to banks, as indicated by declining settlement fees as share of total fee income (chart 4). We believe the falling growth in payment and settlement fee income will likely stabilize. This is because the nonbank digital payment service providers have already saturated the small ticket transactions, further explosive growth in this area is unlikely, and businesses and the general public continue to trust banks with large transaction settlement.

Chart 4

In our view, banks are adjusting to changing payment behavior. While the amount of nonbank third-party payments grew by 480% from 2014 to 2017, banks' own mobile payments rose by 798% during the same period (see chart 5). Chasing such growth often involves collaboration with the disrupters. On platforms such as WeChat Pay or Alipay, banks cards are linked to enable consumers to make digital purchases. However, because these nonbank digital payment platforms act as the intermediary, banks receive significantly lower fee rates from these transactions.

Chart 5

Consumer Loans, The New Battleground

"Big data" and hyperconnectedness will continue to expand China's banking frontier. Individuals and small businesses with limited credit histories, for example, will increasingly be able to access banking services at their fingertips. If these new transactional relationships are not managed well, however, digital loans could increase credit risks in China.

Lending is a natural extension of payment and transactional services. Alibaba Group Holding Ltd. and Tencent Holdings Ltd., China's two largest internet companies, both secured internet micro-credit licenses soon after they started their payment businesses. Moreover, Alibaba launched the digital MyBank in 2015, the same year Tencent-backed WeBank also started operating. In 2017, the two digital banks underwrote RMB1.3 trillion in loans collectively.

These developments raise a number of questions.

Are the lending arms of Chinese tech giants a threat to traditional bank loan business?

Banking operations:   Yes, but a number of factors limit the disruption. First, accounts at the branchless digital banks have regulatory limitations on transaction volume and cash deposit-taking, which limits their retail deposit base, so their average cost of funding is typically higher. Second, these companies target smaller-ticket loans, e.g., a retail loan could be a few hundred renminbi whereas a bank consumer loan is typically in the thousands. These small-ticket loans typically repay much faster. Third, retail and small and midsized enterprise (SME) loans still make up less than one-third of commercial banks' book, contributing around 24.7% of total bank loans as of end-2016. At least for now, we estimate only a small portion of this is in direct competition with the clientele focused by the banking arm of the Chinese tech giants.

Microcredit operations:  On the other hand, the Chinese tech giants have a clear advantage in distribution and approval speed for small ticket loans, access to better behavioral and consumption data. They are quick to respond to changing market dynamics. Internet microcredit is comparatively less regulated than banks, having to answer only to the local China Banking and Insurance Regulatory Commission (CBIRC)

We see increased collaboration as a sign that the fintech threat can also be an opportunity, with synergies derived from fintech distribution strengths and banks' cheaper cost of funding. The bargaining power varies considerably, with banks coming on top when collaborating with small internet microcredit companies, and quite the opposite when it comes to the tech giants. As an example of the latter, the partnering banks underwrite most of a loan (up to 90%). The large tech firms would charge a distribution fee of around 30% of total interest to be received. In some instances, insurance companies and guarantee companies are also looped in, providing a buffer to potential credit losses. For the moment, the appeal is significant, particularly for smaller banks with a high deposit base but limited retail-distribution ability. In these instances, small banks might be exposing themselves to a high level of credit risk for rather modest return.

What are the risks to banks of increased collaboration with fintech firms?

We see two risks: (1) overreliance on third-party distribution and not "owning" the customer relationship, overshadowing retail outreach capabilities; and (2) under-tested credit performance with a relatively short proven record that not yet gone through a cycle. For now, the credit risk appears manageable. While banks do not disclose credit metrics per business line, WeBank and MyBank disclosed their nonperforming (NPL) ratios at 0.64% and 1.23% as of end-2017, respectively. This is below the banking sector average of 1.5% for similar unsecured consumer loans. Note, these two entities did not disclose past-due loan and charge-off information.

Are internet micro-loans replacing credit cards?

To some extent. For example Huabei, the online credit-card service of Alibaba arm Ant Financial, is now the second largest player in credit-card-related services by number of users (see chart 6). Huabei says that 60% of its users don't have a bank credit card. While a card's average credit line is about RMB20,000, Huabei's is well below RMB10,000. Nearly a third of credit card users are aged 25-30, while about 50% of Huabei users are 20-28. Based on experiences in developed markets, younger cardholders typically exhibit higher risks in terms of delinquency. The average age of bank credit card clients are typically older; however, with increased digital investment and online distribution the clientele overlap is quickly increasing. Credit card lending has taken a more significant share of the bank loan book, reaching 5.4% of commercial bank loans in 2012 from 2.7% in 2017.

Chart 6

Do the lending arms of Chinese tech giants companies have an information advantage?

In some areas, yes. Access to transactional, behavioral, and personal data has aided the rapid growth of digital financial services in China. The People's Bank of China's (PBOC) credit reference system is a key source of such data, with 412 million individual records as of September 2016. Tech giants gets additional data from their platforms: Tencent through social media, Ant Financial and JD Finance from online transactions.

Banks also have their own data advantages, however, such as traditional transaction records, and payroll information. They can swap information among each other, and partner with local tax offices and other government agencies to get useful data. In addition, banks also typically lend when there is a particular loan purpose, whereas the lending arms of Chinese tech giants are typically more liberal about loan purposes so long as the customer passes its credit scorecard; they also mitigate risk by limiting loan size and requiring fast repayment. We note that while these fintech tools are efficient, they are untested through a credit cycle.

Without The Right Regulatory Balance, Fintech Could Undermine Financial Stability

We view regulation as a key variable in the state of play. We believe Chinese regulators will remain open to tech-enabled banking. Digital innovation in this arena is consistent with financial inclusion for the general population, and the transition to a consumption-led economic growth model.

Both the PBOC and the CBRIC have thus far shown regulatory tolerance toward fintech companies. They have employed a "trim the edges" approach which fosters the unencumbered development of fintech companies but curbing financially destabilizing activities as they arise. We believe this balancing act between innovation and financial stability will continue. However, policymakers may find it increasingly difficult to maintain this delicate balance, given the rapid development in both the tech industry and Chinese financial system. Failure to identify and react to raising risks promptly and properly could trigger a domino effect in the country's banking system.

In a typical reactive regulatory approach, rules are only set out after the risk becomes clear. For example, payment companies were allowed to keep customers' excess balances to invest and earn interest income. New rules were issued this year, seven years after the inception of payment licenses, requiring these excess balances to be fully kept with the PBOC by Jan. 14, 2019 (see table 2).

Another example of retrospective regulatory supervision can be seen in the case of Tianhong Yu'ebao, the money market fund Ant Financial initiated. It took only four years for the fund to become the world's largest money market fund. With a net value of RMB1.5 trillion (US$218 billion), Tianhong Yu'ebao has surpassed the total-deposit amount of many city commercial banks and even some joint-stock commercial banks in China. However, it took a few iterations of new rules to fine-tune and balance the interests of investors, funds, and other stakeholders in regards to fund redemptions.

While the retrospective regulation approach did not cause any financial or social stability issues, P2P lending tells a different story. The below chart (see chart 8) show a prolonged "sit and watch" period, during which the number of problematic P2P platforms increased. Cases of fraud, money laundering, fund pooling, and aggressive debt-collection methods came to the fore before regulations were introduced that have addressed such problems. These regulations have brought more order to this sector, and at the same time significantly impeded growth.

Chart 7

We expect the "edges" will be increasingly trimmed as fintech companies have an increasing overlap with traditionally regulated areas. Some large tech giants already hold multiple regulated licenses, including bank licenses. At the same time, banks will become more tech savvy in order to meet the competitive challenges of big data and digital banking. In the fintech world, those that do not adapt fast enough to operate in a regulated environment will face a destabilized business position. Among banks, those that do not innovate fast enough will be marginalized, by either shrinking market share or decreasing profitability.

APPENDIX

Table 1

Table 2