China’s Funds Could Threaten Bank Business in 3 Years

Led by Alibaba Group Holding Ltd., China’s Internet companies are offering consumers access to high-return investments that look and smell a lot like bank deposits.

Despite quickly winning billions of dollars’ worth of deposits, the offerings of Alibaba and its rivals remain tiny compared with the trillions of dollars held by China’s banks.

So why are China’s banks rushing to match the Internet firms’ offerings, and pressuring Chinese regulators to clamp down? Some banking experts are crunching the numbers. The verdict: The Internet companies won’t hurt the banks right now, but the story could be different in a few short years.

A report issued Thursday by Chinese International Capital Corp. said that in three years the money market funds will manage funds comparable to 8% of bank deposits. So far they haven’t made much of a dent with Alibaba’s Yu’e Bao – the first fund to launch and by far the largest – having attracted about 400 billion yuan, or roughly 0.5% of the country’s 74.2 trillion yuan worth of deposits.

Money market funds are typically invested in assets that are supposed to be extremely safe. Yu’e Bao funds are primarily invested in interbank loans and deposits, and government and corporate bonds, according to Tianhong Asset Management, which manages the fund. They operate like demand deposits, with investors able to withdraw their funds at a moment’s notice. They also offer much higher rates than the banks – more than 6% compared with less than 1% for bank demand deposits.

CICC thinks that the migration of deposits will force up banks’ funding costs, meaning that their net interest margins could narrow by as much as 0.15 percentage points. Banks’ average net interest margin stood at 2.68% at the end of 2013.

The impact could grow even deeper over time. The report says that at their peak, money market funds in the U.S. were comparable in size to 60% of bank deposits as the country liberalized interest rates.

Barclay’s bank analyst May Yan says that the banks aren’t worried.

“The banks we spoke with do not consider money market-based Internet financial products such as Yu’e Bao…too much of a threat,” she said in a recent note following a tour of mainland banks. “They plan to overcome the deposit challenge by introducing their own Internet money market funds and enhancing their customer base.”

Still, on Wednesday the China Banking Association – a government-backed industry group – published an essay on the website of the Economic Daily, in which it suggested that money market funds should be subject to reserve requirements, much in the same way that banks are required to keep a portion of their deposits in reserve at the central bank. Such a move would result in the funds offering lower returns and could dent their popularity.

On Friday, the China Securities Regulatory Commission spokesman Zhang Xiaojun said that his agency is mulling rules governing the sector. The Wall Street Journal reported earlier this month that the People’s Bank of China was leading the other financial regulators in an effort to devise new regulations governing the sector.

“In order to further promote the health and stable development…online funds, we are currently looking into further strengthening the risk management of money market funds and the rules regulating the sale of online funds,” it said in a statement.

The regulator said that money market funds play an important role in moving China toward interest rate liberalization, but some funds don’t properly communicate to investors the risks involved.

Mike Werner, a Bernstein analyst says he doesn’t see internet finance as a threat to the banks, and that the funds themselves face real risks.

“If investors decide to withdraw their money in a short period of time, investors in these funds would face significant losses as assets would have to be sold at fire-sale prices in order to generate the liquidity  for the withdrawals,” he said. “This is something the regulators are now looking into further.”