Redefining Financial Inclusion in China

The Rise of Online Lending

June 2018

Executive Summary

Greater financial inclusion is one of the priorities in the United Nations’ Sustainable Development Goals. It enables unbanked consumers and small businesses to capture economic opportunities. In China, millions of adults lack access to basic financial services to fulfill their aspirations. The good news is that the Chinese government has prioritized financial inclusion to achieve inclusive economic growth. Indeed, we are witnessing the emergence of financial technology (fintech) players in China focusing on enabling financial inclusion through online lending. Powered by the mobile internet, they are using digital insights to conduct highly effective risk evaluation, design tailored customer products, and distribute loan offerings seamlessly through smartphones.

Palm Drive is excited about online lending in China that is rapidly taking shape. We have made investments in this promising sector and have strong conviction about the tremendous economic opportunities and social value. This includes mobile lending platform WeLab, which is recognized by the International Finance Corporation (part of the World Bank) as a global top 100 fintech company promoting financial inclusion. We believe empowering consumers through digital transformations requires collaboration between various stakeholders, including governments, financial service providers, innovators, and investors.

Introduction

Billions of adults across the world lack access to the basic financial services they need to achieve life goals and well-being. Globally, there are over two billion unbanked adults, representing 38% of the adult population. Another 57% have access to basic bank accounts but without sophisticated services such as credit, insurance, or diversified investments. China is not alone in this phenomenon. In the last three decades, China has seen a dramatic reduction in poverty. However, financial inclusion remains a challenge. Over one in five of the Chinese adult population remains unbanked.

That said, China has prioritized and pursued financial inclusion as a national priority, and significant progress has been made in broadening its scope and ambition.¹ In July 2015, the People’s Bank of China (PBOC) and nine other ministries jointly issued the Guidelines on Promoting Sound Development of Internet Finance (Guidelines). It defines major internet finance business models (such as internet-based lending, consumer finance, payments, trusts, and fund sales) and recognizes their potential in achieving financial inclusion. In December 2015, China’s State Council issued China’s Plan for Advancing the Development of Financial Inclusion (2016–2020) (FIP). It outlines pathways to achieve financial inclusion, including through increasing the diversity and coverage of financial service providers, and innovations in the design of financial products and services. Its vision is to provide appropriate and valid financial services to all social strata and groups at affordable costs, thereby achieving inclusive growth and equality of opportunity.

These developments reflect China’s pioneering approach in achieving financial inclusion. It is commonly acknowledged that the challenges are the high transaction and distribution costs of serving low-income households and small businesses, information asymmetries that prevent efficient assessments of the creditworthiness of these underserved segments, and limited competition by incumbents within the market. Nevertheless, the high level of internet and mobile penetration is providing opportunities for innovative fintech firms willing to take on digital transformation and overcome these challenges.

This report will focus on the development of online lending in China. A key focus of financial inclusion, better access to affordable loans, will enable poorer households and small businesses to increase resilience and capture economic opportunities. Our report aims to lift the lid on China’s unique and dynamic online lending ecosystem, examining the key drivers behind its explosive growth — the particular historical, cultural, business, and financial contexts of the country. More importantly, it then focuses on how technological innovations are fostering creative new approaches to enabling access to loans for individuals and small businesses.

Key Drivers of Online Lending in China

Online lending in China is ripe for exponential growth, buoyed by several factors such as ubiquitous digital connectivity, the enabling role of technology, unserved financial needs, the affability of Chinese incumbents to partner with innovators, and a conducive regulatory environment. While these factors are present in other developing countries, their scale and rapid evolution makes China a unique market on many dimensions. These are the factors that we can look at when considering an investment in an online lender. In this section, we will elaborate on some of these factors more in-depth.

Unserved Financial Needs

In many developing countries, the middle class population and small businesses often have no access to credit because of underdeveloped financial infrastructure. Formal financial information, credit bureau data or collateral are scant. According to World Bank data², China has a low retail loan penetration of 20%, and the national credit bureau only has information on less than 20% of the population. The expansion of China’s middle class has now created a huge demand for sophisticated financial products.

At the same time, small and medium-sized enterprises (SMEs) receive only 20–25% of bank loans, while accounting for 60% of GDP. As in many countries, traditional banks are often locked in a dilemma when serving SMEs — they often require tailored solutions that are more complex than retail products. However, offering corporate solutions are not justified as they provide lower revenue streams to the provider. As a result, they find serving SMEs an unattractive proposition.

Ubiquitous Digital Connectivity

The advent of digital technologies in China is well known³. In 2016, China had 731 million internet users and 695 million mobile users (95% of total internet users), more than the US and Europe combined. China’s internet giants — Baidu, Alibaba and Tencent (BAT) — are building a rich digital ecosystem that is now growing beyond them. As a result, China is leapfrogging into the world’s largest digital finance marketplace: mobile payments volume in China reached $790 billion in 2016, and retail e-commerce transaction value was $1.915 trillion.

At the same time, China’s venture capital sector is increasingly focused on digital. The sector has grown to $77 billion in 2014–16, or 19% of the world’s total. The majority goes into digital technologies such as big data, artificial intelligence (AI) and financial technology (fintech). This is driving a tremendous amount of technological innovation in online lending.

As we will explain in more detail in the next section, technology and connectivity provide the foundation upon which innovative business models can be developed to serve individual consumers and small businesses.

Conducive Regulations

As we have highlighted in the Introduction, the Chinese government has prioritized the development of internet finance to achieve financial inclusion, guiding it toward the right track of innovation and strengthening collaboration. As a result, the regulatory environment in China has been conducive to non-financial services players thriving in online lending. In a joint study by the International Finance Corporation, CreditEase, and Stanford Business School, Ant Financial, CreditEase, Dianrong, Lufax, and WeLab are recognized among the top 100 fintech companies globally that are supporting financial inclusion across the lending and related ecosystem⁴.

One key trend made possible by the regulatory environment is collaboration between incumbents and innovators, combining the former’s established customer base and infrastructure with the latter’s technological innovation⁵. For instance, the Postal Savings Bank of China is deepening its collaboration with Ant Financial and Tencent in internet and mobile finance. Many P2P lenders are also collaborating with traditional banks to improve their credibility (for example: Dianrong and the Bank of Suzhou; CreditEase and China Citic Bank).

Technology and Financial Inclusion: The Perfect Match

In the last section, we examined the challenges consumers and SMEs face in getting financing, but also the baseline conditions that China leverages to overcome them. In particular, technology is seen as one of the most important factors in achieving inclusive growth. This section will explore non-traditional and innovative lending techniques in China, which are important in determining the success or failure of firms and their business models.

Accurate Risk Evaluation

With the lack of reliable and efficient assessments of creditworthiness in China, lending based on non-traditional data gathered from the mobile internet offers significant potential⁶. Innovative and non-traditional lenders are using big data and machine learning to better utilize both structured and unstructured data sources to deliver credit risk scoring. This allows them to underwrite customers that were locked out of the traditional banking model.

One notable example is WeLab, which has developed the WeDefend credit technology to construct a 360° borrower profile using mobile device, transactional behavioral, psychographics and SMS data. WeDefend significantly reduces the time it takes to process a loan from days and hours to milliseconds, without any requirements for collateral, prior credit history or a face-to-face interview. It provides a score to every prospective borrower called WeScore, which is the first smartphone-based credit score in China proven to be more accurate in predicting risk and fraud compared with traditional credit bureau scores.

Firms like WeLab are outperforming traditional credit scoring models as their approaches add new dimensions, such as social network behavior and mobile phone usage, to existing scores and reveal more sophisticated consumer behavior. Furthermore, as their algorithms are being deployed and trained continuously, their quality and accuracy will improve over time, bringing down the costs of assessing credit risks.

China’s unique environment of collaboration between incumbents and innovators will further extend the advantage of accurate risk evaluation using big data. As innovative providers partner with incumbents like telcos and banks, they will be able to combine the latter’s proprietary data sources to improve the data required to power their algorithms⁷.

Data-Driven Customer Insights

China’s digital savvy generation now has a higher expectations of customer experience. According to EY’s Global Consumer Banking Survey 2016, traditional Chinese banks are becoming less relevant for them. They are open to new technologies and more individualized, client-centric offerings. As for small businesses, they also have highly specific needs for work capital facilities, online supply chain financing, and invoice financing.

The advent of big data not only improves risk evaluation, as explained in the previous section, but also delivers actionable customer insights. They enable innovative lenders to understand the different financial needs of different customer segments through their digital footprints, and tailor offerings to them accordingly. An example is Ant Financial’s Taobao credit-based loans. By analyzing the comments of shoppers on Alipay and Taobao, the short-term financing needs of merchants can be anticipated and catered for. Jingdong also uses internet and mobile platforms to predict and solve the financing problems of agricultural households in rural areas during production⁸.

Minimal Cost of Distributions

The ubiquity of mobile devices is undercutting the advantages of physical distribution that banks previously enjoyed. According to McKinsey, many fintech lenders have up to a 400-basis-point cost advantage over banks because they have no physical-distribution costs⁹. Technology enables online lenders to deliver a compelling, instant, and seamless unconventional customer experience from the comfort of a smartphone.

At the same time, online lenders are experimenting on the optimal model for reaching millions of new consumers¹⁰. While some are engaging directly with consumers, others rely on the distribution channels of incumbent partners. Still others are positioned as data science companies offering algorithm-driven services to banks, telcos, and insurance companies. Regardless of the outcome, China’s technological foundation and collaborative environment will enable continued experimentation and delivery of models that can accelerate impact at scale.

Conclusion

In this report, we have examined the huge potential of online lending in China. Millions of individuals and small businesses in China are underserved by the existing financial service sector. However, the advent of technological innovation is fostering new approaches that achieve greater financial inclusion and fulfill the rising aspirations of China’s middle-class. We have highlighted several improvements that technology can achieve, namely accurate risk evaluation, data-driven customer insights, and minimal cost of distribution. Palm Drive Capital has strong convictions about the economic potential and social value of online lending in China, and we invite others to join us in this highly promising sector.


¹Toward Universal Financial Inclusion in China: Models, Challenges, and Global Lessons, People’s Bank of China and World Bank, February 2018

² World Bank’s Global Financial Inclusion Database: http://data.worldbank.org/data-catalog/financial_inclusion

³ Digital China: Powering the Economy to Global Competitiveness, McKinsey Global Institute, December 2017

⁴ Financial Inclusion in the Digital Age, IFC, CreditEase and Stanford Business School, March 2018

⁵ The Rise of FinTech in China, DBS and EY, November 2016

⁶ Creating Higher Levels of Financial Inclusion in China, MasterCard, 2014

⁷ Big Data, Small Credit, Omidyar Network, June 2016

⁸ Ibid. 1

⁹ Cutting through the noise around financial technology, McKinsey, February 2016

    Palm Drive Investor Relations

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