Chinese banks have long operated under a protective environment in which deposit and lending rates have been managed in a rather tight band by the central bank. One advantage of these controls for the banks has been fixed net interest rate margins. But China’s traditional state-owned banks have been pressured recently to try to keep depositors from seeking the higher yield products now offered by online Chinese financing firms.

During my recent trip to China, I found many of my friends and family have been drawn increasingly to online investment products offered by several of China’s major Internet heavyweights. These products offer higher yields than bank deposits and are easy to access electronically. This phenomenon started last year when new money market funds were launched online. Leveraging a vast customer base in online payment systems, these products drew clients away from traditional bank deposits.

Granted, the amount of savings products held by online firms is still in its infancy as compared to the total deposits of Chinese banks, currently at US$12 trillion. However, the pace of growth may change the landscape within China’s highly regulated financial industry.

Traditional banks are feeling the heat. Several have started to fight back, launching new products that try to match the attractive yields offered by online money market funds. Ultimately, this should drive up funding costs for banks, and pressure those famously stable profit margins.

Banks have also responded by lobbying regulators to introduce measures that restrict the growth of online products. China’s central bank is no doubt evaluating potential risks from this new trend. But the central bank appears more concerned with identity theft issues to ensure adequate risk disclosure over the online investment products. The general sense is that central bank officials are focused on guiding the healthy development of such online firms, and ensuring they abide by the proper rules and regulations, than by restricting their ability to grow.

We believe that the rapid development of Internet finance will help speed up central government efforts to promote interest rate liberalization—a major reform goal of China’s banking sector. The idea is to give the banks the autonomy to set interest rates based on the market. In the past, banks have been very resistant to liberalized deposit rates for fear of funding cost increases. Under mounting competitive pressures, however, banks will need a more flexible rate regime to win business. We believe that only once China has a more liberalized system, will its banking system truly meet global operating standards.

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