Caixin
Sep 28, 2020 08:07 PM
FINANCE

In Depth: Top Court’s Interest-Rate Ruling Sends Shockwaves Through Financial Sector

A ruling by China’s highest court that slashed the legally protected interest rate on private loans has sent shockwaves through the financial sector — not only the informal lending industry, the main target of the change, but the entire banking system.

The ruling, published on Aug. 20, could trigger a shake-out of the private lending sector, a crucial funding source for millions of small companies and individuals, and have wider ramifications for the financial sector. It could force many microcredit providers to scale back loans and push interest rates charged on credit cards and risky borrowers below commercially viable levels, industry executives, analysts and officials have told Caixin.

The impact of the judicial interpretation on microcredit companies has been like a nuclear bomb, industry veterans told Caixin. It has prompted many lenders to stop handing out credit as they wait for the regulatory authorities to issue more clarification and guidance on the ruling, one industry insider said.

The ruling was well intentioned, aimed at lowering borrowing costs especially for small businesses who struggle to get financing. Boosting lending to micro, small, and midsized enterprises (MSMEs) and giving them access to cheaper financing have been key planks of the government’s economic policy for several years. But it has left many grey areas that have triggered concern in the industry, such as whether banks and microcredit lenders are covered, whether the ruling is retroactive, and even whether the formula used to determine the ceiling is appropriate.

China’s authorities view private lending as a necessary supplement to the formal banking system and an important tool in alleviating the financing difficulties of MSMEs. But as the scale of private lending has increased so have disputes, and each year, more than 2 million private lending dispute cases go through Chinese courts. Regulators are also concerned about the growth in loan sharks, extortionate interest rates, along with the coercive and intimidating measures some lenders take to recover unpaid debts.

As part of a broader government strategy to lower financing costs and stamp out usury, the Supreme People’s Court (SPC) last month announced it was cutting the upper limit on interest rates for private loans that would get protection in legal disputes by more than a third.

Ambiguity in rules

The ruling covers private loans by individuals and companies without a lending license. Only loans with rates at or below that level will give lenders legal protection and court support to enforce collection. The cap is now set at four times the one-year national loan prime rate (LPR) which currently stands at 3.85%, putting the ceiling at 15.4%. The previous cap was set at 24% according to an SPC judicial interpretation (link in Chinese) released in 2015, which also said that private lending rates above 36% were illegal and that rates from 24% to 36% would be tolerated by the courts as long as borrowers were willing to pay.

Lower courts have lost no time in implementing the SPC’s decision. On Sept. 4, a court in Wuhan, Hubei province, ruled against resident Zhu Hongwei, who sued Li Minxiu from Northwest China’s Qinghai province for failing to repay a loan of 150,500 yuan ($22,000) and interest at an annual rate of 24%. It ordered Li to repay the principal and the interest but at an annual rate of 15.4%.

Even banks, who are technically not covered by the ruling because they are licensed financial institutions, have been affected partly because lower courts have not received clear guidelines from the SPC which has given rise to different interpretations of the ruling.

In a lawsuit filed against a borrower for non-payment of a loan, the Wenzhou city branch of Ping An Bank Co. Ltd. sought to have the debt repaid at a penalty interest rate of 2% per month, which works out at an annualized 24%. But the court rejected the bank’s request and imposed an interest rate of 15.4%. Many legal experts have argued that Ping An Bank should not be subject to the ruling.

There has long been ambiguity about whether microcredit lenders should be classed as private lenders or as financial institutions. The China Micro-credit Companies Association (CMCA), a self-regulatory industry body, states that small-loan companies are qualified lending legal persons and their activities do not constitute private lending. But regulators have not yet given them formal recognition as financial institutions. Some courts have previously identified them as private lenders and issued judgments based on that classification and the new ruling adds to concerns about their prospects as many charge annual interest rates higher than 15.4%.

Some members have already suspended new business in the wake of the ruling, a source at the CMCA told Caixin. Everyone is taking a wait-and-see attitude before they get further guidelines from financial regulators, the source said.

The SPC’s judicial interpretation and the actions of lower courts could hasten the decline of the microcredit industry, according to some industry executives. The sector has already been undergoing a slow but steady decline due to a variety of factors including the impact of internet finance, underdeveloped regulation and management shortcomings in some companies. Central bank data (link in Chinese) show that the number of microcredit companies was 7,333 at the end of June, 218 fewer than at the end of 2019, and the value of outstanding loans fell to 884.1 billion yuan from 909 billion yuan over the same period.

At least one-third of microlenders may end up quitting the market, especially those specializing in offering unsecured loans, said Ji Shaofeng, the founder of IT startup Jiangsu Wufeng Information Technology Co. Ltd., who spent 16 years working in various roles with financial regulators.

Higher-risk borrowers

Microlenders operate in a segment of the market that tends to be higher-risk as unsecured loans are not backed by collateral. Unlike banks, these lenders are not allowed to take in deposits to fund their credit operations so they have to raise the money in other ways which is usually more expensive. As a result, their cost of capital is high and that has to be passed on to the borrower.

In addition to not being able to provide collateral, micro and small companies usually don’t have credit records, making it difficult for lenders to evaluate the risks of lending to them, which also adds to their costs and risks.

Take CD Finance Management Co. Ltd. as an example. Its overall loan cost (including cost of capital, risk control costs, and management costs) is 18.4%. Its cost of capital alone averages a little over 7% compared with an average of about 10% for other microlenders. 

CD Finance, whose shareholders include the China Foundation for Poverty Alleviation and Ant Group Co. Ltd., is focused on meeting the business needs of livestock farmers and micro and small businesses in towns and villages. The average size of its loans is around 26,000 yuan and it charges annual interest rates of 18% to 20%. But its profit margin is only about 1.4% and has long struggled to earn decent returns.

Banks who offer loans at higher interest rates to risky customers may also reduce their exposure to this segment of the market as they may not be able to recover delinquent loans through the courts if the rates they charge are higher than 15.4%.

“The supply of (small) loans with annual interest rates ranging from 15.4% to 36% may just dry up,” Ji said. “No matter how much of an effort banks make to issue loans to small and micro businesses, they may not able to compensate for the lending that’s disappeared because of the new rule.”

The new judicial interpretation fails to understand the way private lending works, a source close to the financial and economic affairs committee of the National People’s Congress, China’s top legislature, told Caixin. A key factor accounting for the high interest rates on private loans is insufficient supply and that cannot be solved by enforcing limits on interest rates, the source said.

“A limit (on lending rates) will definitely lead to lower accessibility to borrowing for small and micro companies,” the source said, adding that the solution lies in increasing the effective supply of credit.

A central bank insider agreed, pointing out that the insufficiency of small-business financing is due partly to the lack of institutions offering the service.

Lenders get apprehensive

“The most effective way to lower borrowing costs is to create competition (among lenders), improve supply (of credit) and promote legislation to protect borrowers which will improve transparency in the pricing of loans by financial institutions,” said Wang Dandan, head of the China operations of Accion International, a global nonprofit organization focused on microfinance and fintech impact investing.

Wang pointed to the Truth in Lending Act in the U.S. as an example. The law requires lenders to, among other things, provide consumers with information about their terms and the true cost of the loan, including how the cost is calculated and disclosed. But it does not tell banks how much interest they are allowed to charge.

Although the new private lending ruling does not target banks, consumer finance and auto finance companies, there is widespread apprehension about the ramifications, especially as many consumer loans carry interest rates in excess of the 15.4% ceiling.

“If any loan has an interest rate higher than 15.4%, it would be labeled as usury, so how could any traditional financial institution dare to cross that line?” an executive at one of China’s big banks told Caixin.

Banks’ credit card business may also feel the pain, as many lenders charge an interest higher than 15.4% if customers withdraw cash using their credit card, delay repayment, or paying by installment. High interest rates charged on credit cards partly reflect the high costs of running such a service, including the cost of capital, human resources and the cost of making and delivering cards.

The service fees that banks charge for credit cards are way below those of banks overseas so they must rely on installment payments to make money, Liu Bo, founder of Shenzhen Qianhai Dashu Financial Service Co. Ltd., a fintech company, told Caixin. If the new ruling results in a drop in interest rates on credit cards, some banks may have no choice but to shrink the business, Liu said.

The legal and banking communities are also concerned about Article 32 of the judicial interpretation, which states that loans issued before the new ruling took effect are subject to the new interest rate ceiling if a dispute ends up in court. The article has been heavily criticized by microlending industry insiders. Some lawyers argue that it violates the basic legal principle of non-retroactivity.

“This issue is very controversial,” a judge in an intermediate court in a first-tier city told Caixin, because it means that the interpretation must be retroactive. As long as it is accepted by the court after the release of the latest judicial interpretation, the new regulations must be followed.

If the ruling is retroactive, how are disputes going to be dealt with when they involve old loan contracts signed when the interest-rate ceiling was 24%, asked one senior manager at a microlender in eastern China told Caixin.

Amendments are needed

The significant difference between the old and new interest-rates caps protected by the courts, means that there’s likely to be a surge in private lending disputes, according to Li Xin, a partner with Beijing-based Zhong Lun Law Firm. Borrowers who have not fulfilled their repayment obligations may file a lawsuit to claim the overpaid interest to offset the outstanding principal or may initiate litigation to require the lender to repay the excess interest.

Legal and financial industry experts interviewed by Caixin are now hoping that the SPC will put out clarifications to its ruling and that more guidance will be given by regulators and legislators on the issues that have come to prominence since the judicial interpretation was published in August. Some are also calling for less government intervention and more policies to spur competition among lenders and lower borrowing costs.

The promulgation of the Civil Code on Jan. 1, 2021 presents an opportunity to make some amendments to the current judicial interpretation, one executive with a private bank told Caixin. Lower courts also need to be given clear guidelines and the scope of the ruling needs to be clarified so that judgements by local courts comply with the spirit of the ruling, the executive added.

“The more the economy slows down, the more we need to increase competition to improve the availability of funding for enterprises,” said Ding Yu, a senior advisor at the Chinese Academy of Financial Inclusion. “Intervention and protection are often counterproductive, and it may now be more difficult for micro and small enterprises to raise funds in the future.”

Formulating laws that conform to economic laws must be done in a very careful and precise way, Ding said, adding that some officials do not have a thorough understanding of the business environment of small and micro enterprises and as a result they may formulate simplistic and blunt policies.

“The task of the judiciary is to protect the fairness of rules – who is right and who is wrong, not to offer indiscriminate moral support to whoever is the weaker party. The result is a lose-lose situation that has a significant negative impact on economic and social development. It remains to be seen whether the latest judicial interpretation can achieve its original intention.”

A previous version of this story used the incorrect name for Jiangsu Wufeng Information Technology Co. Ltd., and also mischaracterized what kind of company it is. It is an IT startup.

Contact reporter Guo Yingzhe (yingzheguo@caixin.com) and editor Nerys Avery (nerysavery@caixin.com)

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