China Banks Drained by ‘Vampire’ Internet Funds

Photographer: Yu hongen/AP Photo
A Yu’E Bao online fund account.

It has been labeled a “blood-sucking vampire” by a prominent commentator on state-run television. Executives at China’s largest banks have called for regulators to curb its rapid expansion.

The focus of this ire is Internet financing, specifically Yu’E Bao, the fund pioneered nine months ago by Alibaba Group Holding Ltd.’s online-payment affiliate Alipay. Its ease of use, involving a few taps on a smartphone, has drawn deposits from 81 million customers, more than the population of Germany, as they chase returns higher than China’s banks can offer. The total exceeded 500 billion yuan ($80 billion) as of Feb. 28, according to the official Xinhua news agency, double the amount reported by Alipay in mid-January.

At least six other technology firms, including Baidu Inc. (BIDU) and Tencent Holding Ltd. (700), have embraced Internet financing with similar products offering returns as high as 10 percent and threatening to drain more cash from China’s banking system. Bank executives, unable to stop the outflow of their cheapest source of funding because interest rates on comparable deposits are fixed by the government at 0.35 percent, are calling for more regulation, saying that lack of oversight and risks related to account security, yield volatility and liquidity management threaten China’s financial stability.

More Regulation

“Now it’s time to step up regulation for the industry’s own good,” Yang Kaisheng, a former president of Industrial & Commercial Bank of China Ltd. and now an adviser to the China Banking Regulatory Commission, said in an interview this month at the National People’s Congress in Beijing. “The emergence of Internet financing is inevitable in China because it serves the grassroots better, but whoever is engaging in financial services, no matter online or off-line, must comply with regulations. If someone stays out of oversight for too long, the chances of it disrupting financial stability will increase significantly.”

Yang’s view was echoed at the annual meeting as legislators, bankers, government officials and billionaires called for more rules to protect users and mitigate Internet-financing risks, including oversight by China’s banking regulator. Money-market funds into which Yu’E Bao and others channel investments currently are regulated by the China Securities Regulatory Commission. Internet financing is overseen by the People’s Bank of China, the central bank.

Legitimate License

Internet companies should be required to have a legitimate banking license to offer financial products and services, Zhang Jianguo, president of China Construction Bank Corp. (939), the nation’s second-largest lender, said in an interview on the sidelines of the meeting.

China’s policy makers are pushing for unprecedented changes in the banking system, including deposit insurance and deregulating interest rates, to give markets a bigger role in the economy. Cheap funding costs have enabled banks to fuel industry overcapacity and excessive borrowing by state-owned companies and local governments.

Alibaba, which plans to seek an initial public offering in New York, is among 10 firms that will be allowed by China’s banking regulator to set up private banks under a trial program. The license would let it establish a partnership with another company to engage in commercial banking. Unless Alibaba incorporates Alipay into the new structure, the operations of Yu’E Bao wouldn’t be covered.

Alipay, Tencent

The central bank, in its first regulation of Internet financing, on March 14 blocked plans by Alipay and Tencent to offer virtual credit cards and payments using so-called Quick Response codes, citing security risks. The codes are black-and-white squares containing product or company information similar to bar codes that can be read by smartphones.

“We believe that regulation in line with industry growth will promote long-term development of the Internet financial system,” Ada Tsang, a spokeswoman for Alibaba, wrote in an e-mail in response to questions. “We appreciate regulators’ recognition, support and encouragement of our innovation.”

Yu’E Bao, which means “leftover treasure,” pools individuals’ money to invest in a money-market fund run by Tianhong Asset Management Co., in which Hangzhou, China-based Alibaba, the nation’s largest e-commerce company, owns a majority stake.

‘Lazy People’

Yu’E Bao’s seven-day average yield has fluctuated between 4.3 percent at its June 17 debut and a high of 6.8 percent on Jan. 2, according to the fund manager’s website. Yesterday it was 5.5 percent on an annualized basis, with no minimum deposit or time period required, giving users the ability to move money into or out of their accounts 24 hours a day -- unlike banks, which typically offer such transactions only during business hours and take more than a day to settle them.

The product is an “investment for lazy people,” and its popularity reflects a strong financial need that has been neglected by banks, Wang Dengfeng, who manages the Yu’E Bao fund at Tianhong, said in an interview in January.

China’s state-controlled banks have been losing share of the nation’s 48 trillion yuan in household savings. The four largest firms controlled 50.8 percent of the country’s yuan-denominated household savings as of Jan. 31, down from 52 percent a year earlier and 55 percent in 2012, data from the People’s Bank of China show. Cheap deposits have for decades helped keep profits high as rates fixed by the government created a 3 percent spread between what lenders can collect on loans and what they pay on one-year time deposits.

Not Fooling

“Why is all the money going into Yu’E Bao? Because banks fail to pay what savers deserve. You can’t fool them,” Ma Weihua, a former president of China Merchants Bank Co., said during a group discussion at the National People’s Congress. “Yu’E Bao is forcing banks to face up to the challenges of interest-rate deregulation.”

The drain from the banks prompted Niu Wenxin, a managing editor and chief commentator at China Central Television, to attack Yu’E Bao in his blog on Feb. 21, drawing 11.5 million views and sparking nationwide debate.

“Yu’E Bao is a vampire sucking blood out of the banks and a typical financial parasite,” Niu wrote. “It didn’t create value. Instead it makes a profit by pushing up the whole society’s borrowing costs. By passing some teeny-weeny benefit to the public, it makes massive profit for itself and lets the entire society foot the bill.”

Alibaba’s spokeswoman Tsang declined to comment on the characterization.

Dwarfing Equities

With the help of Yu’E Bao and similar products, China’s money-market funds, which for years have been struggling to get banks to distribute their wares, attracted 953 billion yuan as of Jan. 31, an increase of 67 percent from a year earlier, according to the Asset Management Association of China, an industry group. That accounted for 0.9 percent of the nation’s total deposits.

Money-market funds could reach 8 percent of total deposits in five to 10 years, May Yan, a Hong Kong-based Barclays Plc analyst, estimated in a March 6 note to clients. That’s much faster than the 30 years it took to peak in the U.S., she wrote.

The number of Yu’E Bao users has dwarfed the 67 million retail investors in China’s stock market after 23 years of development, Australia & New Zealand Banking Group Ltd.’s China economist Liu Li-Gang wrote in a note today.

Yu’E Bao and other Internet products, by investing most of their money in the interbank market, drive up financing costs for borrowers, especially small businesses that need to pay more than 10 percent for loans, Yao Yang, director of the China Center for Economic Research at Peking University, wrote in a March 6 commentary on Project Syndicate.

Unsustainable Rates

“These unsustainable high rates are transmitting major risks to the economy,” Yao wrote.

Still, Premier Li Keqiang said in his first annual report to the National People’s Congress that China will promote the healthy expansion of Internet banking. People’s Bank of China Governor Zhou Xiaochuan said the central bank won’t ban products like Yu’E Bao. Instead, regulation will catch up with development, he said.

“The PBOC is tolerating investors seeking higher yields, but it’ll make sure it won’t get out of control,” Roger Schneider, Frankfurt-based senior director at Fitch Ratings’ Fund and Asset Manager Rating Group, said in a phone interview. “Obviously, if you drain money out of deposits and rechannel it to the interbank market, it makes the flow of money more expensive.”

‘Cannibalize Deposits’

Yu’E Bao and other money-market funds could raise banks’ funding costs by three to five basis points and reduce their profit by 1 percent to 2 percent in 2014, according to Barclays’s Yan. In five to 10 years, they could cut banks’ profit by as much as 17 percent, she wrote.

Some banks have responded by rolling out similar products with same-day redemption or imposing restrictions on the amount of money that depositors can transfer to Internet money funds as part of a strategy to “cannibalize deposits but retain the customer relationship,” Simon Ho, a Hong Kong-based Citigroup Inc. analyst wrote in a March 11 note to clients.

China Minsheng Banking Corp. (1988), the nation’s first privately owned lender, in October started a fund available through a smartphone application, Ru Yi Bao, which allows a minimum investment of 1 yuan and same-day redemption. The product’s seven-day average yield was 5.3 percent yesterday. ICBC (1398), the nation’s largest lender, recently introduced Tian Tian Yi, or “everyday return,” with similar features, available only through its branches in eastern Zhejiang province.

Internet Strategy

Agricultural Bank of China Ltd., which has the largest branch network in China, set up a team to work on an Internet-finance strategy and will introduce its own online product soon, Vice President Li Zhenjiang said in Hong Kong today. The bank also reported slowing profit growth in the fourth quarter.

Like Yu’E Bao, these products are also money-market funds, created in conjunction with fund-management units the banks partly own, with the cash flowing out of ordinary savings into so-called negotiable bank deposits at a higher cost. Fund-management companies can wring better returns from banks on large deposits than individuals and won’t be penalized if they withdraw the money ahead of its maturity.

Such advantage enabled China’s money-market funds to have better liquidity than other fixed-income investment products and enjoy higher returns at a time when banks’ demand for interbank deposits is increasing, Xu Hanfei a Shanghai-based analyst at Guotai Junan Securities Co., wrote in a Feb. 24 note. Lenders have significant liquidity risks because of the unpredictability of early withdrawal, he wrote.

Negotiable Deposits

“Some banks, due to their own risk preference and liquidity condition, may be willing to take high-cost funding from negotiable deposits, but not all of us do,” Yang, the former ICBC executive, said. Negotiable deposits, as part of interbank funding, are not subject to the 20 percent reserve requirement imposed by the central bank on other savings, making them attractive to some cash-strapped lenders.

At least three of China’s biggest banks have refused to take negotiable deposits from Yu’E Bao, the Economic Observer reported on March 7, without identifying which ones. Spokesmen for the four-largest lenders declined to comment.

Minsheng Bank Chairman Dong Wenbiao said during this month’s National People’s Congress that Internet financial products should set aside reserves as they do for normal deposits to avoid default risks because technology companies lack risk-management systems and specialized capabilities.

Operational Risk

“The biggest risk is continuous large inflows and unexpected contingent large redemptions,” Fitch’s Schneider said. “However, there’s operational risk, which can also be substantial. If there’s a breakdown on the server or in the mobile network or for any other technical problems, where investors basically cannot access their money as requested, this may potentially trigger an uncontrolled wave of redemptions, particularly if such news is spreading.”

In February, the China Banking Association held a meeting with its members to propose regulations for Yu’E Bao, including capping the return it can pay and incurring penalties for early withdrawal of negotiable deposits.

Meanwhile, the China Securities Regulatory Commission plans to require money-market funds to set aside provisions to cover unpaid interest, as 90 percent of these funds were invested in negotiable deposits, and any repayment risks in the interbank market will spill over to fund buyers, Caixin magazine reported on Feb. 23.

Sweeping Changes

President Xi Jinping is pushing financial changes that may be the most sweeping since Deng Xiaoping loosened government controls in 1978 on everything from energy pricing to banking.

The central bank in June 2012 began allowing banks to offer deposit rates capped at 110 percent of benchmark rates. The regulator left the ceiling intact even as it removed the floor on lending costs in July 2013, saying changes to rules for rates paid to savers were the “most risky” part of liberalization.

China’s banking industry, with its protected interest-rate spread, earned a record $228 billion in 2013, according to the regulator. That compared with $159 billion of profits at almost 7,000 U.S. banks, Federal Deposit Insurance Corp. data show.

Zhou, the central bank governor, said at a March 11 press conference that deposit rates will be liberalized in one or two years. Interest rates will initially rise as controls are removed, he said.

Internet financing products can be a “catalyst to accelerate China’s deposit-rate liberalization,” ANZ’s Liu wrote. “However, it is still too early to conclude whether the online financial products will bring about more risks to the whole financial system.”

Mobile Banking

China has already become the world’s biggest mobile-banking market, with 60 percent of customers completing some transactions with a smartphone or tablet, compared with 45 percent in the U.S., according to a December survey by consulting firm Bain & Co.

“Internet-based financial services will continue to develop and will spur improvement and development of traditional banks,” billionaire Liu Yonghao, who owns animal feed-producer New Hope Group and was one of the founders of Minsheng Bank, said in an interview during the National People’s Congress. “But these services must be standardized and regulated to protect consumers. There have been few policies, if any, that regulate these providers.”

Chinese banks have offered wealth-management products to retain savers, with such investment vehicles rising to a value of 9.9 trillion yuan as of September 2013, according to JPMorgan Chase & Co. Unlike Yu’E Bao and similar funds, the investments require a minimum 50,000 yuan and typically at least 30 days to mature. Most are invested in government bonds and other fixed-income securities.

Shouldering Risk

While investors in money-market funds haven’t suffered losses since their start in 2003, they shoulder the risk of fluctuating returns, which can drop to negligible levels. By comparison, banks’ wealth-management products have implicit guarantees from the issuers to deliver the indicated rate of return in the sales prospectus.

“So far a lot of buyers of Internet financial products are not aware of the risks they are buying into and many of them look at it the same way as banks’ wealth-management products,” Li Daokui, a former adviser to the central bank, said in an interview this month. “We need to let them know what it is and where the return comes from.”

Rates on the interbank market climbed as high as 10.8 percent in late June and hit 8.8 percent in December as Chinese banks hoarded funds to meet quarter-end regulatory requirements, according to data compiled by Bloomberg. As liquidity eased since January, the yield on interbank borrowing fell to an almost two-year low of 2.2 percent on March 12.

Consecutive Decline

Yu’E Bao’s return had declined for 39 consecutive days as of March 24. Its 5.5 percent rate was just above the average 5.3 percent of more than 200 wealth-management products issued by banks in the week ended March 21, according to Chengdu, China-based Benefit Wealth, which tracks the data.

“Investors must understand money-market funds are not risk-free investments,” Fitch’s Schneider said. “Money-market funds offer diversity, if you compare it to just putting all your money into one bank, that’s a clear advantage. But one needs to look further into the portfolio.”

To contact Bloomberg News staff for this story: Jun Luo in Shanghai at jluo6@bloomberg.net

To contact the editors responsible for this story: Chitra Somayaji at csomayaji@bloomberg.net Sheridan Prasso, Robert Friedman

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