Searching “internet finance” on Google will return results almost exclusively related to China. The term itself is relatively new, having been coined in April 2012 by Xie Ping, the sitting executive vice president of the China Investment Corporation.

The initial definition of the term was unclear, but it has come to refer to all internet-related financial services, like third-party payment, peer-to-peer lending, crowdfunding, online banking, online money market fund distribution, internet insurance, and internet brokerage.

Internet finance has exploded from 2013 to 2015. According to an index produced by the Institute of Internet Finance at Peking University, the industry in China doubled each year from 2012 to 2015.

Broadly speaking, internet finance is pursued by two groups, the first of which are the information technology (IT) companies. Alibaba — China’s e-commerce giant — provides loans to micro-, small-, and medium-sized enterprises on their platform. 

This is possible because IT companies can easily collect data on companies who conduct business on their platforms. This is a natural way to overcome the asymmetric information problem in loan distribution — it’s much harder to modify business and operational data to get better loans since net users leave their information online.

The second group is made up of traditional finance companies, like banks, that use IT to extend and improve services. In addition to internet banking, many of these companies also provide services like e-commerce. The Industrial and Commercial Bank of China (ICBC) currently has the second-largest e-commerce platform in China, surpassed only by Alibaba.

ICBC is essentially extending its brand value and technology advantage into e-commerce, which strictly speaking is not a financial service. And yet people often include these examples under the umbrella of internet finance since they are provided by traditional financial institutions and compete with e-commerce companies in the private sector.

Although internet finance originated abroad, it has grown faster in China than anywhere else in the world. Peer-to-peer lending originated in the United States about a decade ago. In 2007 Lending Club was founded, which has since become the largest peer-to-peer company in the U.S., accounting for around 80 percent of the market.

However, even after seven years of growth, Lending Club’s loan volume in 2015 was only $8 billion. Comparatively, the total peer-to-peer lending volume in China in the same year was $200 billion. So what accounts for internet finance’s prominence in China?

First, and most importantly, there is a severe shortage in the country of organizations that provide financial services. Large companies — especially state-owned enterprises — can get external finance relatively easily, but micro-, small-, and medium-sized enterprises have trouble getting access to reasonably priced outside financing.

Although financial institutions everywhere prefer large companies when distributing loans, the Chinese financial system is particularly reliant on them. Conversely, the U.S. system — marked by numerous regional and community banks — is much better set up to service all types of customers, big or small.

Second, there is an increasing demand for expanded financial services from private households, owing to income growth. Traditionally households park their money on bank deposits that yield very low returns. They have always sought invetment opportunities, like in the stock or housing market, and internet finance has only made these investments easier to pursue.

Third, development of information technologies lowers the costs of financial services and creates new business models. For example, big data collection and analysis makes it not only feasible but also profitable to extend loans to microenterprises. Traditionally, these loans have been high-risk and often subsidized by the government for the sake of positive externality. But through big data analysis, firms such as Alibaba can profit from such loans.

Furthermore, popularization of smartphones has made mobile banking and online payment extremely convenient and cost-efficient. 

However, the development of internet finance is not without risk, as we can see in the results of the rapid development of peer-to-peer loan platforms. From 2012 to 2015 the number of these platforms in China grew from 200 to 3,769, but many of the loans they distributed later turned out to be bad. Many of these peer-to-peer companies have declared bankruptcy, and many more will undoubtedly go under in the near future.

Peer-to-peer companies serve as an intermediary between investors and borrowers. However, without proper filtering techniques, investors cannot effectively differentiate good borrowers from bad borrowers. Many peer-to-peer platforms give implicit guarantees to facilitate the loan transactions, but often times the platforms can’t make the differentiation either. They are forced to take risks they end up unable to manage.

The key problem is that these companies lack the necessary risk management techniques that are the core of financial services — many even lack the incentive to build and implement risk control. They are too busy expanding their businesses.

Recently, regulators like the People’s Bank of China and the China Securities Regulatory Commission have issued trial regulation polices to encourage public discussion and feedback. The regulatory authorities have previously taken a tolerant attitude toward internet finance, but they are beginning to realize that some tightening of the industry is necessary.

But even with this tightening, the future of the industry looks promising. Large IT companies like Alibaba, Tencent, Baidu, and JD.com still have the advantages of data and technology. They can also apply for finance licenses.

Furthermore, traditional financial institutions can capitalize on their raw wealth and service advantages — one way to do so would be through development of new IT platforms to provide better financial services to more customers, or simply through purchasing already existing IT companies.

In doing so, traditional financial institutions can provide new services to existing customers and existing services to new customers, including microenterprises. This is possible for two reasons. First, IT advances lower associated costs. Second, competition stimulates innovations in management and finance techniques.

Ironically, the new IT companies who enter the finance domain may serve as the forerunners paving the way for traditional financial institutions.

(Header image: View Stock/VCG)