Vague does it: China's P2P regulation is probably the best in the world

by Joe Zhang, Chief Strategy Officer, China Risk Finance, Shanghai.

The LendIt Conference to be held in New York in mid-April has asked me to moderate a panel discussion on China. What should I bring to the table?

I want to sing the Chinese government's praises, something I do not often do. In 2011, I quit my job at UBS to run Wansui Microcredit in Guangzhou, China, and suffered my fair share of frustrations. In 2013, I published a book, "Inside China's Shadow Banking: The Next Subprime Crisis?", to chronicle my experiences. In that book (published in English, Chinese, and Korean) I was harsh on China's government and banks, and even the Chinese public.

So why do I suddenly want to praise the Chinese government? Since I relinquished managerial duties at Wansui to a fellow shareholder in late 2012, I have ventured into the P2P sector, as I believe that it offers a solution to the insurmountable challenges I had faced at Wansui Microcredit.

As Chief Strategy Officer at China Risk Finance, a leading P2P firm based in Shanghai, I have participated in many discussions with regulatory officials and industry peers. As of today, the Chinese government has been accommodating to the P2P sector and its evolution. Despite the urging by die-hard central planners and conservatives, both the PBoC (the central bank), and the CBRC (the bank regulator) have resisted the temptation to impose any formal rules. This inaction is very wise although un-Chinese.

Indeed, the CBRC has quietly removed a ban, put in place in 2011-12, on banks and trust companies dealing with the P2P sector. That regulatory about-face has enabled the banks, trust companies, and P2P firms to experiment with asset-backed securitisation and other funding arrangements, such as entrusted lending and the outsourcing of lending services.

Do not be scared by innovations just because the global economy has not fully recovered from the subprime crisis in the US. As I argued in my book, excessive credit growth in China in the past 36 years is far bigger a threat to the banking industry than the tinkering on the edges by a few thousand harmless P2P operators and microcredit lenders. After all, they are merely a drop in the ocean of total credit. Calling them challengers to the old order in the credit market may be overstating their significance.

As I argued in my book, the PBoC and the CBRC are to blame for formulating ill-conceived regulations on microcredit companies (MCCs) and then handing its enforcement over to local governments in 2008. The regulations are overly restrictive, and they have created tens of thousands of small MCCs that are unable to grow and benefit from economies of scale. Six years on, while almost everyone in the country can see the problems with the regulations, it is hard to change them. Vested interests, inertia, and bureaucratic procedure all conspire to keep the very damaging regulations firmly in place for many years to come.

Fortunately, regulators may have learned a lesson from that fiasco. In the past four years, the PBoC and the CBRC have resisted their own urge to regulate P2Ps, except constantly stressing one simple rule: P2P firms (and MCCs) must never take deposits (or build a pool of funds). Even in the event of publicised scandals and illegal activities in a large number of P2P firms, the PBoC and CBRC have resisted intervention, thus creating a "buyers beware" system of market discipline from the very beginning. This has avoided issues of "moral hazards", and probably increased the costs of P2P firms building trust amongst their constituencies.

Some critics argue that the current lack of formal regulation has contributed to the chaos and illegal activities in the P2P sector. I disagree totally. Lending and borrowing among private individuals in China has always been legally permissible. P2P firms simply assist or intermediate between these legally permissible activities, without taking a principal role. Therefore, it is natural that P2P firms stay un-licenced.  They should be regulated in the same simple fashion like marriage match-makers, real estate agents, and corporate headhunters.

A lack of regulations is not necessarily a bad thing: consumers know (or will know very soon) what they are getting from service-providers. The market's invisible hand often proves to be more efficient and cheaper than a heavy-handed approach by the government. Elaborate regulation often does more harm than good. Once in place, any regulation will prove to be hard to revise, as seen in the MCC industry. For such a young and fast-changing sector as P2P, it is logical for the government to sit on its hands and just observe. After all, an elaborate and expensive web of regulations in the US did not deter Bernard Madoff and other swindlers from committing their misdeeds.

Consumer protection sounds like a good reason to regulate MCCs and P2P firms, but compliance costs can stifle innovation and hurt the very consumers, both borrowers and funds providers, a regulation is designed to protect. It is true that some unscrupulous P2P operators defraud consumers but they are quickly exposed and often punished by the judicial system.

The government's inaction so far has been very conducive to innovations and infrastructure-building by the private sector. Thousands of P2P firms have mushroomed in China in the past four years, and some well-capitalised players in the private sector have begun to build comprehensive credit databases on citizens and businesses. That is a much-needed benefit to the public and operators alike.

My forecast (and maybe my wish) is that China will not impose any formal regulation, or even a licensing requirement, in the P2P industry in the next five to ten years.