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Industry Research Comments|Li Nan:Ant’s Road to Redemption——how the fintech giant can save itself

 2021-05-20

Beginning with Jack Ma’s now infamous speech at the Bund Financial Summit on October 24, Ant Financial (now known as Ant Group), Alibaba’s prized fintech arm, has gone through a chaotic six months. On November 3, Ant’s projected $35 billion IPO was suspended. Then, Ma and other Ant executives were “invited for tea” by top regulators of the financial system: once in December and again on April 12. Around the time of the December session, China’s market regulators began investigating Ant’s parent company Alibaba for pressuring merchants not to sell on other platforms, which culminated in a $2.8 billion fine on April 10. 

Some observers speculated that Ma was punished directly for his remarks. Some of his supporters have even suggested that the regulators’ actions will produce a slowdown in China’s internet economy. 

In fact, the fine on Alibaba and the regulators’ December and April directives have good reasons behind them: to remove the moral hazard, conflict of interests and predatory lending in the business model of Ant. Consider the regulatory guidance released in December and April: clear, rational, and forward-looking, they demonstrate the regulators’ intentions to balance the aims of economic growth with the mitigation of financial risk. In sum, China’s big tech crackdown is a milestone in the development of a healthy platform economy and financial system. Together, the new guidelines and crackdown pave a way forward for all of China’s ecommerce and internet-based platforms that provide financial services like Ant.

 

What is Ant? 

Ant is a financial institution, providing broad-spectrum financial services, disguised as a tech company. During the first half of 2020, technology innovation contributed less than 10% of total revenue, while financial services (digital payment, consumer loans, small and micro enterprise loans, wealth management, and insurance) comprised more than 90%, 40% of which was from the loan business, according to its IPO prospectus. The filing even indicates that Ant’s risks are mainly financial. 

So why did Ant abandon the well-established brand name, Ant Financial, six months before preparing to go public, changing the name to Ant Technology Group? The company had two powerful, if underhanded, reasons to do so. The first was to boost its valuation. Tech companies typically enjoy a price-to-earnings ratio (P/E) four times as high as financial institutions. Ant’s proposed IPO price of 68.8 yuan ($10.5) per share would have produced a P/E higher than 150 (based on Ant’s 2019 net profit). And it intended to amplify the deception by listing not on the Main Board of Shanghai Stock Exchange, but on the STAR Market, China’s NASDAQ, designed to ease listings for new technology sector enterprises. 

The second and more important reason was that successfully distancing itself from the word “finance” would perhaps shield it from essential financial sector regulation. The company was able to escape — for a time.

 

What’s wrong with Ant’s business model? 

Ant claims to provide inclusive, green and sustainable loan services to small and micro enterprises (SMEs). However, again according to its prospectus, only 20% of the loans actually go to SMEs, while the remaining 80% go to individual consumers. With Ant as pioneer, most of the ecommerce, social media, ride-hailing, and other platform apps in China now offer similar loan programs. 

Inside the Alipay app, Alibaba’s flagship digital payment system, “Huabei,” masked as just another payment option, often uses red envelopes and discounts to induce consumers to spend using their Huabei credit line, while high interest rates and fees are disguised by deceptive words such as “daily interest rate as low as 0.1%.” (Huabei’s actual interest rate is close to — or even higher than — credit card rates, but the similarity ends there.) Even the name Huābei, 花呗, which means “Just Spend!” in Chinese, has a predatory ring to it. 

Another problem with Ant’s model is its basis for determining credit scores. Rather than evaluate trustworthiness based on critical factors like the consumer’s debt ratio or income, Ant relies on something counterintuitive: a consumer’s expenditure history. This means that buying more results in a higher score, a logic particularly noxious for fresh college grads who may not have built up the requisite financial know-how; Ant’s system, in other words, encourages wanton spending over fiscal prudence. 

This is typical predatory lending behavior. As we saw in the years leading up to the 2008 global financial crisis, the risky subprime loans that had all but drowned the financial system started with lax lending standards from bankers looking to turn a fortune. They spread widely in the United States and elsewhere through what’s known as the originate-to-distribute (OTD) model. The OTD model allowed lending institutions to evade risk by “passing the hot potatoes” to other investors who were not involved in the original transaction. Without lenders needing to incur the risk of their lending decision, mortgage backed securities created a moral hazard that ultimately cost the world trillions of dollars. 

Such risk evasion is also inherent in Ant’s lending practices. It’s not a surprise that the credit risk of their loans is high, but Ant figured out a way to make that someone else’s problem. Ant constructed a joint-lending scheme, partnering with small banks, in which Ant provided only 1% to 10% of the loan capital, while requiring 50% or more of the interest income, and they further passed the risk to other financial institutions through asset-backed securities (ABS). This ‘innovation’ was nothing more than a new bottle for old wine. 

Ant’s partners in the joint lending scheme have been small city or rural commercial banks in particular, which have been increasingly desperate for business, as the evolution of the digital economy has not-so-gradually reduced their business volumes. But for these banks, the joint-lending business with Ant is akin to a lost-at-sea sailor drinking seawater to slake a thirst – feels better for the moment but hastens the sailor’s demise. 

If Ant had continued to evade its rightful categorization as a financial services company, it would have continued to evade the capital requirement of 10% on lending. That would have allowed it to develop enormous leverage — more than 200x. Incentives to exercise any financial prudence in lending would evaporate. A vicious cycle of risk amplification would be inevitable. 

Three imperatives to stop the vicious cycle 

Following the December tea session, regulators conveyed three principles in the five directives to Ant: 

● First, disconnect payment service from Huabei. Borrowers must apply for loans, providing information such as income data necessary for credit risk assessment.

● Second, all financial services, especially lending, must be subject to financial-sector regulation, with capital requirements as a binding constraint to manage leverage, hence reducing the moral hazard associated with the OTD model.

● Third, Ant should restructure as a financial holding company, with Chinese walls to separate payment services, commercial banking, insurance, and investment services, leaving no room for conflicts of interest. 

However, Ant was either too slow or too recalcitrant to follow these directives. Hence, a second tea talk, in April, with stronger and more specific directives issued. On April 29, representatives of 13 platforms including Tencent, Baidu, Meituan, JD.com, Didi that embed financial services, consumer loans in particular, in their platform-type businesses were also invited to hear exactly the same directives. These 13 are just the largest of several dozens of similar platforms.

 

What’s next? 

Information technology has promoted the rapid development of business-to-consumer transactions and the entire economy. E-commerce platforms such as Alibaba, Taobao, JD.com, and Wechat Stores have reduced transaction costs between buyers and sellers, serving virtually unlimited buyers and sellers with tiny marginal costs. The incremental benefits to consumers and enterprises, especially small and micro enterprises in both urban and rural areas, have been enormous. 

One reason China in particular has done relatively better during the COVID-19 pandemic is the country’s vast network of e-commerce, mobile payment, and delivery platforms that touch every corner of society. These ensured the continued flow of daily necessities and medical supplies during the quarantine period. The benefits to society have been profound, and pioneers like Alibaba deserve great praise for leading the charge. 

But there is no free lunch. The network effect that allows Alibaba and other platforms to grow rapidly, and the subsequent benefits to the whole of society, also easily leads to a natural monopoly. In a financial system with inappropriate regulations, or when regulators have been captured by irrationally exuberant financial sector enterprises (see 2008), this monopoly may amplify the problems of predatory lending, moral hazard, and conflicts of interest. 

China’s regulators seem to be avoiding this regulatory capture. Learning from the mistakes of the past and staying mindful of the negative externalities of fintech and platforms, these regulators are carefully paving a different road in a timely manner — which regulators in every country must do sooner or later. 

Ant’s road to redemption is well marked with regulatory road signs — all the fintech and platform companies need to do is to drive responsibly, in the proper direction. 

Nan Li is an Associate Professor at the Antai College of Economics and Management, Shanghai Jiao Tong University. John D. Van Fleet supports industry relations for Antai College.