On April 18, five village and township banks in the central provinces of Henan and Anhui did the unthinkable: Claiming “system maintenance,” they abruptly blocked depositors from transferring or withdrawing their money from their accounts.

Overnight, tens of billions of yuan were effectively frozen; some 400,000 account holders in provinces and cities across the country were affected. One entrepreneur lost as much as 40 million yuan. A single mother’s life savings disappeared. Medical bills became unpayable. Those who gathered in Henan to protest saw their local health codes mysteriously turn “red” — indicating a positive COVID-19 test or close contact with a COVID-19 patient — preventing them from traveling or entering the bank premises to withdraw their money in person.

The scandal soon took on national proportions, and not just because of the abuse of the health code system. This wasn’t a fly-by-night operation: The five banks were fully accredited and had marketed fixed deposit products to consumers all over the country via established and trusted fintech platforms like JD.com’s JD Digits and Baidu’s Du Xiaoman Financial.

The possibility that even accounts in the formal banking system might be scams has shaken public faith in the country’s banking system. A police investigation pointed the finger at the chairman of the banks’ corporate parent, the Henan New Fortune Group, but many depositors are still waiting to see what percentage — if any — of their money can be recovered.

At the policy level, the incident has cast a pall over a cornerstone of China’s “inclusive finance” campaign. Village and township banks first emerged as a distinct class of banking institution in China in 2006. At the time, the country’s large, brand-name banks were generally only willing to lend to state-owned enterprises, firms contracted to build government infrastructure, or companies that could show the kind of rapid growth needed to keep up with banks’ own high interest rates. One of my research participants told me that, as late as 2005, a private chemical plant he worked for with an annual income of 700 million yuan (then about $85 million) struggled to obtain bank loans at reasonable interest rates.

Village and township banks were meant to help address these gaps. Based in rural areas, they offered basic services to residents of China’s vast and largely unbanked countryside. After a short, three-year pilot period, the scheme was fast-tracked. Over 200 village and township banks were established in 2010 alone; by late 2021, there were 1,651 registered village and township banks nationwide, accounting for 36% of all Chinese banking institutions.

In economically developed coastal provinces like Zhejiang, village and township bank performances were relatively strong, but the majority of the banks, especially those in less-developed parts of central or western China, struggled. Residents of these regions have significantly lower incomes than on the coast and there are fewer rural enterprises with which to do business. Unable to compete with the brand recognition of more established commercial banks, village and township banks generally attracted clients rejected by other institutions.

In the face of these difficulties, much of the foreign and state-owned capital that had initially backed village and township banks faded away, leaving private capital dominant in an increasingly messy, competitive market.

Nevertheless, village and township banks were made a central part of a 2015 plan by the State Council — China’s cabinet — to promote inclusive finance. The goal was to reach people and businesses the traditional bank credit business was unwilling to cover, such as small- and micro-enterprises, farmers, low-income urban residents, and the poor and disabled, thereby boosting social equity.

The reality proved far more complex. Village and township banks have had a hard time competing with larger state-owned commercial banks. To poach depositors away from established competitors, they must offer higher interest rates, but the only way to cover these outlays is to charge higher interest on loans, which costs them their best potential customers.

Around this time, some village and township banks saw a possibility of survival in another key inclusive finance initiative: online banking and financial technology platforms. It was the peak of the peer-to-peer (P2P) lending craze and online platforms were marketing themselves as “financial innovations” for facilitating loans to small-, medium-, and micro-enterprises.

Many village and township banks, facing growing competition and under pressure to meet the needs of the inclusive finance campaign, sought to cash in on the fintech boom to fund their operations. They partnered with online financial platforms, allowing them to use their financial services licenses — and the air of legitimacy the licenses provide — in exchange for the ability to market “online deposit” products to the platforms’ national user base.

The scheme was relatively simple: depositors would sign up for a special deposit account with a bank through a third-party platform. Their savings would then be transferred from their primary account — typically at a larger commercial bank — to a new account at a smaller institution like a village and township bank.

For depositors, the benefits were obvious. The smaller banks, hungry for deposits, offered high interest rates — typically over 4%, compared to less than 3% at larger banks — to anyone willing to park their savings in an account. There was little reason to see the accounts as risky: Although interest rates were higher than average, they were still far below those promised by the now defunct P2P industry. And the institutions were all accredited banks included in the country’s deposit insurance scheme.

Strictly speaking, village and township banks are not supposed to take in deposits or hand out loans outside their base of operations. Because they are overseen locally, if they encounter problems outside their jurisdiction, it can have ripple effects elsewhere. But online fintech platforms let them quietly market their products to users across China.

The result was a shadow banking system in which small village and township banks, meant to serve local residents, were attracting funds from a wide range of users all over the country, causing regulatory problems and greatly increasing the risk of a cascading crisis.

Even before the Henan case, the government recognized the problem and moved to rein in online deposits. For example, in late 2020, 10 platforms, including Alipay and JD Finance, were ordered to delist all online deposit products.

That village and township banks had been involved in the industry and were exposed to the risks was not a secret. In early 2021, banks were banned from offering long-term fixed deposit products on third-party financial platforms under a new regulatory policy. But at least some institutions found ways to skirt the new rules. Several of the banks implicated in the recent scandal launched self-developed apps targeting online “savers.”

To reassure clients, many village and township banks used misleading language to imply their services were government-backed or approved. High-risk loans were reframed as “inclusive finance”; high-interest financial products were packaged as ordinary and safe “deposits” that were securely insured. This public-facing language, which promised legitimacy and credibility, covered for the banks’ “hidden script”: a reckless pursuit of risky profits. It also lowered people’s natural skepticism of tech-related scams. In the Henan case, in which app users’ money was supposedly saved through a bank app designed to look official, even bank employees failed to realize that the money was being redirected.

As recently as a few months ago, village and township banks were hailed as innovators in the field of inclusive finance. That praise has dried up during the Henan crisis, but the risks remain. This isn’t China’s first case of bank-related malfeasance. Now that the alarm has sounded, regulators must seriously examine and address the deep-seated problems plaguing the country’s financial institutions. Otherwise, depositors will keep falling for the same old tricks.

Translator: Matt Turner; editors: Cai Yiwen and Kilian O’Donnell.

(Header image: A farmer counts the money he earned from selling crops in Loudi, Hunan province, 2014. Nai Jihui/VCG)