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China’s shadow banking system is moving online

Chinese commuters cross a pedestrian bridge during rush hour in Beijing.Chinese commuters cross a pedestrian bridge during rush hour in Beijing.
In China's massive shadow banking system, almost anyone can lend money for a substantial return.GREG BAKER/AFP—Getty Images

It’s not an overstatement to liken China’s shadow banking system to an enormous beast. It exists outside regular lending channels. Somewhat ominously, it also lies beyond the control of the country’s powerful regulators.

Shadow banking in China has reached a staggering $4.4 trillion, or about 20 percent of the country’s total bank assets, according to estimates by the Chinese Academy of Social Sciences published in May—substantial enough to rival the country’s formal banking system, and broad enough to be a key economic driver for the world’s No. 2 economy.

Increasingly China’s shadow banking is migrating online. There are now more than 2,000 websites such as brokering peer-to-peer, or P2P, transactions. The idea is simple: People can lend their money to strangers for virtually anything—a new car, a wedding dress, inventory for a home-based business—and in return they enjoy rates of interest exceeding 20 percent, significantly better than the 3 percent they would earn by parking their money in a traditional Chinese savings account.

“P2P as a platform efficiently matches the demand of investors looking for high return options with small and micro businesses who need quick funding but have been very much excluded from formal lending practices,” says Sandy Shen, research director in Gartner’s Shanghai office.

Online P2P lending is not unique to China and has an older history in the West. (One example of many: Lending Club, which offers personal loans and has accepted investment from Google (GOOG).) But the practice is finding its biggest audience in the world’s most populous nation after the country tightened bank credit in 2010 following a bout of stimulus spending to counter the global financial downturn.

Interestingly, the default rate on P2P micro-loans is only slightly higher than the bad-loans ratio reported by China’s biggest financial institutions.

“There are sincere and honest players that try to serve the borrowers and lenders in an efficient way,” Shen says. “Internet finance in general is a wake-up call to financial institutions that they can no longer sit back doing business as usual and expect profits keep rolling in.”

P2P lending, for example, is raising the cost for banks of acquiring funds. This in turn is forcing established lenders to experiment with interest rate liberalization and new business models.

The People’s Bank of China, the country’s main regulator of financial institutions, seems to like the fact that Internet-based finance (which includes P2P lending) is shaking up the country’s banking system. At the same time, it seeks to impose some regulatory authority over the sector and put consumer protections in place. A shock to China’s online lending and wealth-management system—such as the collapse of a leading e-commerce or Internet company and ensuing panic—could seriously damage mainstream banking and the economy as a whole, some critics warn.

“Financial regulation has failed to keep up with Internet finance’s rapid growth,” says Takeshi Jingu, a researcher at Nomura Research in Beijing. “From banks’ standpoint, the new online products could lead to an outflux of retail deposits and decreased fund sales.”

Still, it’s unlikely that Chinese authorities will unveil regulations for Internet finance anytime soon, Shen says.

“It will be very difficult. No country has been successfully doing that,” she says. “It will take a long time for the regulator to find the right approach.”