Qudian Inc. and China’s online consumer finance industry have been in hot water recently as the Chinese government seeks to reduce risk in the financial system and the “shadow-banking” sector. Following a 2016 crackdown on P2P lending, China’s online micro-credit industry boomed thanks to weak regulatory oversight, allowing companies to lend to borrowers with poor credit scores. Reports have estimated that China’s micro-credit industry is worth more than a staggering $152 billion USD. However, new government regulation threatens the future of the entire micro-credit industry.
On October 18th, the IPO of Beijing-based online micro-credit provider Qudian Inc. (NYSE:QD) raised $900 million USD on the New York Stock Exchange, the biggest U.S. public listing by a Chinese firm in 2017. However, immediately after Qudian’s IPO, Chinese media criticized Qudian’s high-risk business model and controversial loan collection processes as well as the practices of other Chinese online micro-credit lenders.
Qudian represents a large group of rapidly-growing lending platforms in China’s online consumer finance market. Lenders often take on high risks to achieve strong returns by lending at high interest rates and engaging in aggressive loan collection practices. While China has a huge online consumer finance market, the industry lacks strong regulatory framework and oversight. Given the risks, the Chinese government has increasingly stressed the importance of improving market regulations and developing a better risk management system.
What is Qudian?
Qudian launched in 2014 and is China's largest online provider of small cash credit products in terms of the number of active borrowers and the amount of transactions. Qudian uses big data-enabled technologies such as artificial intelligence and machine learning in its lending processes. Qudian, with the backing of Alibaba's Ant Financial, currently offers two main types of online credit products: cash credit products and merchandise credit products. According to an August 2017 Oliver Wyman report, Qudian's transactions in the first half of 2017 totaled approximately $5.6 billion USD and serviced more than 7 million active users, with most of transactions completed on mobile.
Priced at $24 USD per share in its $900-million IPO, Qudian opened at $34.35 USD on the first trading day but later plunged nearly 20% in one week. The China Youth Daily recently published an article criticizing Qudian’s business model with two main points:
First, Qudian relies heavily on Ant Financial (formerly Alipay) to attract new users, manage funds and monitor risk. “Two-thirds of our users come from Alipay,” said Min Luo, Qudian CEO. Approved borrowers receive cash credit in their Alipay accounts, and borrowers repay the credit drawdowns through their Alipay accounts. Furthermore, Qudian uses Ant Financial’s data to analyse a borrower’s creditworthiness based on data sources gleaned from social media and an individual’s e-commerce history.
Second, Qudian still provides merchandise loans and cash loans to college students. Qudian has long been criticized for lending to college students, who have a higher risk of defaulting. This April, the China Banking Regulatory Commission issued a regulation forbidding lenders to service college students. Although Qudian claimed in its IPO prospectus that it stopped providing credit to college students since November 2015, Beijing News revealed that students were still able to receive loans from Qudian.
Qudian’s Credit Drawdown Structure
According to a 21st Century Business Herald report, Qudian has four funding sources.
The first source is off-balance sheet financing. Banks and consumer finance companies utilize Qudian’s proprietary credit assessment model to screen potential borrowers and offer them loans. Borrowers are required to make principal payments and interest payments back to relevant institutions. When the borrower defaults, Qudian itself is obligated to pay the full overdue amount to the relevant institutions. As of June 2017, Qudian had spent $1.7 million USD repaying users’ defaulted loans.
The second source is funding from trusts. Institutions, including banks and asset management firms, lend credit indirectly to Qudian users through trusts Qudian established in collaboration with trust companies. The trust is identified as the lender under the borrowing agreement, and thus the borrower is required to repay the principal and financial service fees directly to the trust. In the case of default or when the repayments made by borrowers total less than the agreed amount, Qudian is obligated to cover the deficit. Qudian also funds certain trusts with its own capital.
The third source of funding is from P2P (peer to peer) lending platforms. P2P platforms do not lend to borrowers directly. Credit drawdowns generated through this approach are grouped into portfolios and transferred to P2P lending platforms according to specified criteria based on different platforms, and borrowers make both principal and financial service fee payments to Qudian. However, because of a relatively high cost of financing through P2P platforms and the regulatory uncertainties facing P2P platforms, Qudian stopped collaborating with P2P platforms in April 2017.
In addition to these three types of funding, Qudian also established two online small credit companies, Fuzhou Microcredit and Ganzhou Microcredit. Fuzhou Microcredit and Ganzhou Microcredit have been approved by local authorities to provide credit drawdowns to a certain level (approximately $455 million USD for Fuzhou Microcredit and $409 million USD for Ganzhou Microcredit). However, the credit drawdowns for these two companies alone are not enough to satisfy all of Qudian’s funding requirements.
Qudian currently funds all credit drawdowns it initially disburses through online small credit companies or trusts. However, in its SEC filing, Qudian acknowledged that “the amount of funds that [Qudian’s] online small credit companies and these trusts are able to provide may be insufficient to meet the growth in the amount of transactions drawdowns [Qudian] facilitate[s]” and “[Qudian] may not be able to obtain the regulatory approvals to increase the authorized amounts or to establish additional online small credit companies.”
High Risk, High Reward “Credit Facility” Services
Loans provided via trusts have been Qudian’s primary credit source since Qudian ceased operations with P2P lending platforms. In the current market, however, many cash loan lenders are not qualified to provide loans directly. Instead, these lenders act as intermediary “credit facilities," facilitating loans between borrowers and banks, trusts or other consumer finance companies.
Credit facility services allow trust funds to provide loans to the online consumer finance market, the majority of which are consumer and cash loans. Consumer loans tend to have low default rates but yield lower returns and are slow to scale-up due to limitations in consumer purchasing behavior. An exception is short-term, small-dollar amount cash loans which are relatively easy to scale up; short-term, small-dollar amount cash loans are now the second-most profitable industry in China, just after real estate. But the explosive growth of the short-term, small-dollar amount cash loan industry has increased its default rate; 30-day cash loans have on average a more than 30% default rate, while 90-day cash loans have around a 10% default rate.
According to the 21st Century Business Herald report, Chinese cash loans companies take on all the risks of their trust products. At the moment, long-term operations data shows that the profits made off cash loans are more than adequate to cover the losses.
The Good, the Bad and the Ugly of Online Lending Apps
Behind Qudian’s success is China’s huge cash loan industry. Over the past several years, hundreds of online lending platforms have grown rapidly, most of which provide short-term, small-dollar amount cash loans. The high risks and aggressive debt collection tactics of these platforms have drawn fierce criticism.
The high effective interest rates of lending platforms have long been questioned. According to government regulation, the annualized interest rate of lending products must not exceed 36%. However, most cash loans platforms charge additional service fees, which then indirectly increases the effective interest rate to as high as 100%.
Online lending platforms usually lack proper credit assessment processes to vet borrowers, which leads to a high bad debt ratio. As a result, lending platforms rely heavily on their debt collection processes to protect their earnings. Lending platforms often utilize threatening loan collection processes alongside extortionate interest rates to cover losses from bad debt. Some lending platforms require access to users’ mobile contacts and may send threatening messages to borrowers’ friends and families when a loan is overdue. Under those collection practices, many borrowers who fail to repay their loans resort to borrowing from multiple lenders.
Comparing China’s Fintech Market to the U.S.
With online lending platforms like Qudian and terms like P2P appearing frequently in the headlines, “#regulation” has become a popular hashtag in Chinese social media. A recent report from Peking University and the Shanghai Finance Institute comparing the Chinese and U.S. fintech industries concluded that even though China is a better market overall, China needs to learn from the U.S. on managing risk control and assessment.
The report concluded that compared with the U.S., China has a larger fintech market and posseses more advanced payment technologies thanks to China's huge market demands and rapid technological growth. In contrast, China’s regulatory framework is extremely weak, while in the U.S., a clear risk and credit assessment regulatory framework has been established. On the flip side, U.S. government restrictions targeting the traditional financial industry have hindered the growth of the fintech industry. “Looking back on the incidents in China’s fintech industry over the past several years, including the Ezubao Ponzi scheme and the Qudian controversy, those risks could have been controlled or even avoided if those companies had the proper credit assessment and supervisory processes,” the report concluded.
Regulation is Coming
Following in the footsteps of Qudian, three other Chinese internet finance companies - Hexindai, PPDAI and Jianpu Technology - went public in the U.S. in the second half of 2017. Other Chinese internet finance companies have announced their intentions to hold U.S. IPOs. However, new government regulations have threatened the future prospects of the entire micro-credit industry.
On November 21st, the Chinese government banned the approval of all new online micro-credit service licenses and prohibited all cross-regional operations. Following the announcement, stock prices of U.S.-listed Chinese internet finance companies plunged.
These moves signal the government’s determination to tighten its control over the micro-credit industry. Before the recent changes, licenses allowed online micro-credit businesses to freely operate across the entire country. In the absence of strong regulatory oversight, the online micro-credit industry flourished in the first seven months of 2017 as the government granted 153 new licenses. The cost of obtaining a new license (before the recent freeze) ranged from $7.5 to $15 million USD.
The market responded quickly to the new regulation. On November 21st, news broke that a cash loan company received notice of termination of services from Ant Financial (formerly Alipay, Alibaba’s financial affiliate). Ant Financial revealed to media sources that it discovered problems with some of the service users, such as charges exceeding the maximum legal interest rate and improper loan collection processes.
On November 23rd, the People’s Bank of China and the China Banking Regulatory Commission convened an emergency meeting to discuss online micro-credit lending regulation. Financial regulatory-body representatives from 17 provinces were in attendance. With existing regulation and levels of service coverage varying by locale, the government faces a massive challenge in controlling the risks of the online micro-credit industry.
According to a website managed by the official People’s Daily, the Chinese government plans to consolidate China’s online micro-credit industry into just a few state-owned companies and big firms by stripping licenses from smaller players.
A draft of regulatory framework is expected to be announced in the next few days. The Harbinger will continue following this topic and post important updates as they occur.
—About the Authors—
Caroline Chen is a David L. Boren Scholar at Tsinghua University and studies economics, international relations, and political science at the University of Southern California. Caroline is passionate about the potential of technology to accelerate economic growth in emerging markets and hopes that The Harbinger will foster cross-border innovation and opportunities.
Xuehe (Echo) Zhang studies world history at Peking University. Echo enjoys working for The Harbinger and its mission to knock down, in her words, the "Tower of Babel in the tech community." Echo also enjoys analyzing trends from a historical perspective and is especially interested in fintech, microfinance and their potential to address income inequality.
Shaolong Lin studies computer science at Columbia University with a focus on AI and big data analytics. Shaolong is an avid tech and political news junkie and hopes dispell Chinese stereotypes and myths by facilitating cross-border technological innovation and exchange.
Tianyu (Tyler) Xie is a technophile and studied economics and IT at University of Macau and University of Melbourne. Tyler is a firm believer in the possibilites of data science and blockchain and enjoys letting people know what's happening in China's tech scene.
Yang He studies computer science at Columbia University with a focus on computer graphics, computer vision, AI and big data. Besides for being a hardcore programmer, Yang is passionate about the intersection of finance and technology and spreading Chinese innovation to investors and entrepreneurs worldwide.