Everyone in China's banking community from the central People's Bank of China has seemingly reached a consensus to aggressively develop the nation's consumer finance markets, with the central bank's 1999 directive "Guidelines for Conducting Personal Consumer Credit" being the definitive policy document.

The motivation behind this is strong and clear: The central bank will be able to provide an extra stimulus to China's economic growth by growing the consumer finance market, while the banks, which have mountains of non-performing loans, will effectively diversify their asset bases and achieve higher levels of profitability and competitiveness.

Despite the strong commitment, the monetary authorities' clear vested interests and the appealing growth opportunities for the banks, there has not been a consumer finance market explosion in China over the past few years. In 2002 an alarming trend occurred, with a slight year-on-year fall in consumer finance transactions. Although concrete and even impressive progress has taken place in some parts of the country, such as Shanghai, and certain sectors, such as auto finance, but there is a general seeming lack of momentum in the development of China's consumer finance market.

One suspects that the stagnant growth has two causes. First, on the supply side, the banks are rightfully concerned about the primitive stage of China's consumer credit reporting and evaluative system, and by extension, the potential undesirable mix of a highly risky portfolio, coupled with the banks' inability to exert proper and effective risk management. In their limited track records in offering consumer finance products, the banks have undeniably had their hands burnt by scheming fraudsters who never had any intentions to repay the banks overly exuberant stock market investors who borrow from the banks to engage in highly speculative trading activities, and finally those who have simply taken on more liabilities than they can manage. These factors combined have greatly hampered banks' enthusiasm in aggressively developing consumer finance products, especially when they are already facing the great challenge of so many non-performing loans on their books. Put simply, the banks cannot afford to make another mistake in acquiring a large amount of consumer credit receivables with weak credit quality.

On the demand side, consumers are possibly concerned by the thought of financing consumption by borrowing, a concept seemingly at odds with the Chinese tradition of financial prudence. In practice, the banks' inexperience and reluctance to handle legitimate requests for consumer finance can also discourage potential clients. But the supply side's reluctance is the more fundamental and dominant cause, while the demand side's hesitation is more derivative in nature.

Given the factors holding back the growth of China's consumer finance market, what feasible solutions can we rely on for rejuvenation? The obvious option is to proceed with caution while the consumer credit market infrastructure takes shape, especially in key areas such as the establishment of a reliable credit rating system and the drafting and passing of necessary laws and regulations, along with public education in this area. All these developments are indeed crucial and deserve unwavering commitment from both the industry and the regulators.

But there is a need to evaluate the merit of securitization as a financing tool for commercial banks. If employed judiciously, the banks can leverage securitization to pursue the profitable growth of their consumer finance receivables portfolios, while still maintaining a manageable level of credit risk.

Briefly, securitization refers to corporations' and banks' practice of transforming a portion of their assets into underlying collateral for financial securities and selling securities to interested buyers. In practice, an intermediary called the "trust" is often involved and the trust is responsible for maintaining custody of the assets and issuance of the securities. The buyers will receive future cash flows generated by the underlying assets. As for the sellers, they will continue to manage the servicing of the assets for a fee, but will no longer claim ownership.

Securitization is a widely used financing tool in numerous US industries. For example, General Motors' financing arm, the General Motors Acceptance Corporation (GMAC), provides auto financing to customers who purchase GM vehicles. Once the auto loans are underwritten, GMAC routinely packages and sells a significant portion of this massive portfolio via securitization 45 percent in 2002. In the mortgage industry, the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") buy mortgage portfolios from lenders and convert them into securities that they eventually sell to investors. In the credit card industry, credit issuers especially the "monolines," i.e. corporations whose only business is credit card operations, as opposed to commercial banks who are also in the credit card business rely heavily on securitization for financing. The securitization ratio of its total receivables is usually about 80 percent for one MBNA.

Securitization offers several benefits to the sellers. First and foremost is that securitization enables sellers to manage risks more effectively. Through this method, sellers are able to shift some risks embedded in its assets to investors, thus shielding themselves from uncertainties. Secondly, it allows sellers to leverage their own funds more effectively. If a bank retains the ownership of all its receivable assets, then it has to set aside a certain amount of reserve capitals in anticipation of negative credit events like default and write-off, according to government regulations. This ties up a portion of the bank's capital which otherwise can be invested elsewhere more lucratively. However, if the bank successfully moves some receivables off its own balance sheet, then it can free up the capital reserve funds for other uses. Both scenarios afforded by securitization appeal to the sellers greatly, as the increasing popularity of securitization demonstrates.

With regard to securitization in China, one can argue that this has already taken place. Last March, the China Huarong Asset Management Corporation successfully sold US$1.5 billion of non-performing loans to Goldman Sachs and Morgan Stanley, a transaction with certain securitization characteristics, and Huarong is preparing for the sale of US$3 billion more NPLs. But Huarong and other AMCs' holdings do not include consumer finance receivables. How relevant is securitization for China's consumer finance market?

Given the current market status and securitization characteristics, the answer should be a guarded but optimistic "yes."

First, let's examine the issue from the banks' perspective. If there are buyers who will pick up the securitized receivables portfolios, the banks will have a very strong incentive to become much more aggressive than before in developing the consumer finance market, as the upside potential of such a move will far outweigh the underlying risks. As discussed above, securitization will enable banks to expand this lucrative line of business without committing too much capital and shouldering too many risks. As China's economy grows, economic structure will also undoubtedly change, most likely starting to resemble the US pattern where consumer spending is the national economy's biggest component. The more Chinese banks can learn to serve this market, and profit from it, the better prepared they will be for future challenges.

But where will the buyers come from? Foreign investors are the obvious candidates, as they have already demonstrated a strong desire to tap into this market, just look at Citigroup's strategic alliance deal with Pudong Development Bank earlier this year, the purpose of which is to explore China's credit card market. Consider a scenario where, due to government regulations, foreign banks cannot operate totally freely in China's consumer finance market, then the second-best thing for them will be the securitized version of the consumer finance receivables portfolios. Therefore, one can always count on international investors for strong demand.

Yet, the most suitable buyers are probably ordinary Chinese citizens. It is widely known that private savings in China total 10 trillion yuan (US$1.20 trillion), or the equivalent of China's annual GDP. It is also clear that most of these savings are sitting on the sidelines someone has even coined the vivid albeit slightly frightening term "caged tiger" facing a dearth of exciting investment choices. Under the right circumstances, if executed cautiously, it is conceivable that Chinese consumers could play an important role in financing the growth of Chinese consumer finance market.

One immediate concern for this scenario is that domestic small investors may get badly burnt by securitized consumer finance investment products, just as they have been "hooked" or "trapped" before by other types of investments. However, consumer finance "bonds" will not necessarily be riskier than, say, the equity shares of a large Chinese industrial conglomerate, and the reasons are two-fold.

First, the short- and medium-term outlooks for the consumer finance sector seem to be much brighter than those of a typical large-cap Chinese company. The former will grow vigorously in tandem with the entire economy, while the latter will have to face the increasingly difficult competitive pressure that WTO membership brings.

Second, the performance of a consumer finance investment product is very closely linked to the credit performance of the underlying portfolio, and there is little room for insider manipulation. In contrast, corporate governance in large public companies, or rather the lack of it, is a serious problem facing Chinese investors that is unlikely to be resolved in the near future. Therefore, qualitatively speaking, if a Chinese small investor feels comfortable investing in the domestic stock market, then they should have the risk-tolerance level for investing in China's consumer finance market naturally, this does not mean that investors do not have to show due diligence if they choose to invest in this type of product, or that China does not need to continue the development of its nascent credit rating system.

In summary, the growth of China's consumer finance market has slowed somewhat in recent years, likely caused by the banks' reluctance and the public's lack of enthusiasm. However, securitization with its functions of risk transfer and capital reallocation may be able to play an instrumental role in accelerating the process. Rigorous analysis will be needed, yet this financing tool and its possible contribution to the Chinese economy certainly deserve serious consideration.

(China Daily March 15, 2004)