Online lending: Chinese investors get second chance

By Santosh Pai and Vinu Peter Immanuel, Link Legal India Law Services
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India has growing internet penetration and a large unbanked population, but Chinese investors need to be wary of much tighter regulations when entering this market

The rapid boom and bust in China’s online lending market has caused many players to explore overseas markets. India shares some characteristics that make it an attractive market in this industry, such as growing internet penetration and a large unbanked population.

However, one major difference between China and India is the regulatory approach. China initially adopted a hands-off approach that allowed thousands of lending platforms to innovate, and started regulating the industry only when it reached
a critical mass.

Chinese investors
Santosh Pai
Partner
Link Legal India Law Services

In contrast, India made registration compulsory, issued conservative regulations at the outset, and tightly controlled the number of licences. After two years of nurturing this industry, India is now slowly liberalising it, thus giving Chinese investors a second chance to conquer a large market.

Non-banking finance companies (NBFCs) have a long history in India, and are regulated by the Reserve Bank of India (RBI). Historically they have been restricted to capital-intensive sectors such as real estate and infrastructure, or consumer loans for homes and automobiles.

Fintech companies that harness unconventional datasets differentiate themselves by serving new categories of customers, making better-quality credit decisions and improving user experience.

Online lending platforms especially in the peer to peer (P2P) segment empower individuals to take credit decisions which otherwise only a bank or financial institution could have taken, thus allowing them to scale up faster. This ability to scale up fast without building a physical network of branches makes such companies attractive to venture capital investors.

Chinese investors
Vinu Peter Immanuel
Associate Partner
Link Legal India Law Services

India currently has only 20 P2P lending platforms, and another 30 technology companies that act as intermediaries between various categories of lenders and borrowers. The RBI, which regulates NBFCs, recently acknowledged that, “although nascent in India, and not significant in value yet, the potential benefits that P2P lending promises to various stakeholders (the borrowers, lenders, agencies and others) and its associated risks to the financial system are too important to be ignored”.

This message has three key takeaways: (1) the Indian government has recognised the importance of online lending; (2) it will support the industry; and (3) this industry will always be tightly regulated.

The RBI issues more than a dozen types of NBFC licences, but the two most relevant types for online lending are Investment and Credit Company (ICC) licences and P2P lending licences. The ICC is defined as “a financial institution carrying on as its principal business – asset finance, the providing of finance, whether by making loans or advances, or otherwise for any activity other than its own, and acquisition of securities”.

The NBFC Peer to Peer Lending Platform (Reserve Bank) Directions (2017) provide for registration and regulation of P2P licence holders. Both categories of licences are subject to a minimum capital requirement of ₹20 million (US$271,000).

While an ICC licence permits issuance of loans from owned funds to several categories of borrowers such as small businesses, consumers and students, a P2P licence only permits operation of a platform to bridge retail borrowers with lenders.

Foreign direct investment (FDI) is permitted up to 100% in non-deposit accepting NBFCs including ICC and P2P categories. Foreign investments in excess of 25% are subject to RBI approval. Applications for such RBI approval need to demonstrate the technological improvement and benefits to the Indian public arising out of the FDI.

Similarly, a foreign investor looking to register a 100% owned NBFC also requires RBI approval, with the need to demonstrate prior experience and a capable management team. Hence, the following market entry strategies can be employed:

  1. Minority acquisition. Chinese investors with any background can acquire a less than 25% stake in an existing NBFC. This does not require RBI approval and hence is the quickest to implement;
  2. Majority acquisition. Chinese investors with relevant track records can attempt a majority acquisition of up to 100% in an existing NBFC, subject to RBI approval. This can take three to six months;
  3. Greenfield. Chinese investors with relevant track records and an experienced management team can apply to register a new NBFC. This process also takes three to six months, but that can get extended if queries are raised;
  4. Multi-step strategy. To overcome disadvantages of both acquisition and greenfield strategies, a first tranche minority acquisition without RBI approval can be followed by a second tranche majority acquisition with RBI approval, after clocking some track record in India. Management teams of the target NBFCs can also be leveraged to apply for a fresh NBFC licence.

It is true that the RBI has absorbed a lot of lessons from China’s regulatory experience. This confers a natural advantage for reputed Chinese companies that have survived the market collapse in their domestic market. It also allows them to leverage their competitive advantage in terms of access to low-cost capital and technological capabilities.

Chinese investors can also profit from India’s conservative regulatory approach, which is already bearing fruit. The average default rate in India is only around 3%, compared to 15% in China.

The biggest source of risk for Chinese investors is the pattern of behaviour among their compatriots. In their haste to conquer the Indian market, if some ill-reputed Chinese investors employ methods that are vogue in China, such as “borrowing” an NBFC licence, or using a VIE structure to circumvent Indian laws, then such incidents will ring alarm bells in the RBI and make it harder for law-abiding Chinese investors to enter the market.

Santosh Pai is a partner at Link Legal India Law Services. He can be contacted on +91 90 04265235 or by email at santosh.pai@linklegal.in

Vinu Peter Immanuel is an associate partner at Link Legal India Law Services. He can be contacted on +91 95 82551669 or by email at vinu.peter@linklegal.in

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