01 December 2006 Features

 

A spoonful of sugar

Bob Blower

Banks are eying supplier finance to sweeten the supply chain pot for small and medium-sized businesses, but there are plenty of pitfalls on the way

A new trend in corporate banking is about to hit the UK. Major banks are gearing up to offer supplier finance to small and medium-sized businesses around the country, and Europe. There is also a range of non-bank suppliers already in the market to provide this innovative new source of cash for hard-pressed small and medium-sized enterprises that want to avoid the pitfalls and costs associated with overdrafts, factoring and forfeiting, but which still need to access working capital at different phases of the supplier cycle.

Supplier finance, simply explained, offers early payment of invoices to a supplier who has a credit-worthy buyer based on an undertaking by the buyer to pay on the due date. This buyer-centric practice differs from traditional seller-centric factoring because the buyer undertaking and associated contractual arrangements with the bank effectively eliminates the performance risk on the supplier. The bank will therefore generally finance against the full value of the promised payment rather than just a percentage of the invoice (as is the case in factoring).

Additionally, since the bank is looking to the buyer as its sole source of repayment, it can generally make cash available more cheaply to the supplier than other forms of working capital such as overdraft or factoring. Given that the suppliers may be existing customers of the bank in addition to the buyers, some are asking whether this is the banking equivalent of turkeys organising Christmas, as well as voting for it and inviting their friends? However, as Tony Pinn, director of business solutions at Barclays Bank, says “The banks have generally reconciled this potential dilemma with the fact that none of them has more than a minority market share of the small and medium business market and, consequently, this can be viewed not only as a defensive measure but also an opportunity to extend penetration in this important market segment.”

So, while on the face of it the answer to this question is yes, undoubtedly this idea is the beginning of a campaign by local banks to open an additional route of client acquisition and to drive business into SMEs. In addition, the product is particularly attractive to banks that do not have a major franchise supplying the mass market with existing forms of working capital finance where making cash available at near the face value of the underlying obligation would undermine existing margins from less credit efficient products such as overdrafts (where the risk is purely to the borrower, unless a guarantee is given).

From the point of view of larger international banks, such as Citibank, JP Morgan and Standard Chartered, that have limited penetration into this marketplace, they can use their relationships with large volume buyers, which are usually also mainly international clients, to acquire access to these SMEs through large buyers’ supply chains.

Information in the form of documents is exchanged and agreed through each part of the supply chain, providing opportunities to offer finance at several points in the chain. These documents are presently mainly paper-based, but it is expected that in future such documents will increasingly become electronic with the impetus offered by EU and SEPA-based legislation to increase the role of electronic commerce and to provide security around electronic contracts and e-invoicing. If that happens then banks will see increasing opportunity to advance cash against the supply chain of any large corporate, whether that corporate is a client of the bank for other services or not.

To be able to provide this service, banks will need to be able to process, or at least access, large quantities of electronic data efficiently from both the large buyer, and from numerous diverse suppliers. This is a challenge for a number of legal, tax and market-related reasons, but it is already possible through web-based technologies and EAI technology to link to finance and accounting packages to ERP systems to extract relevant data. Furthermore, identity management technology such as Identrus is available to provide a level of protection against fraud.

But the real drive towards innovation is likely to occur because the ERP vendors are themselves moving away from proprietary formats such as idocs and towards the more open XML. This enables the extraction of data without costly and complex integration to each ERP system. Banks will be able to access data electronically rather than having to audit bundles of paper, but this approach also raises a number of challenges:

• Ensuring the uniqueness of each document. Banks will be accessing copies of documents rather than documents they hold so trust will be a major issue to ensure the same document is not used several times over to raise cash.

• Persuading corporate clients to make data available. This is likely to be a data protection issue, and where legislation prevents data being held outside the country.

• The law and practice in many jurisdictions still does not reflect modern web-based practice and recognise the enforceability of contracts in hyperspace.

• Only a small proportion of trade is currently electronically driven, most transactions still require paper documents or take place through dedicated point-to-point links such as EDIFACT. Banks and their partners will need to find incentives and technologies to ease the path to electronic documents.

• It is still not clear in Europe what is needed to ratify a contract electronically — German law still requires two signatures on a physical document for instance.

• Tax. Varying rules on VAT across EU members means that invoices, for example, vary from country to country and create complexity in managing cross border transactions.

To date, banks have sought to work around some of these problems. As Pinn again says “the focus up to this point has been around basic supply chain financing solutions which are based on buyers delivering what is essentially payment instructions electronically to the bank. In this way, issues around invoice, VAT and other areas are outside the scope of the services and the interaction with the buyers is not largely different than that which already exists where the bank is making supplier payments.

The challenge that some banks are now seeking to take on is to look more to the upstream supply chain processes and to therefore be able to offer more-end-to end solutions with the benefits that affords to both the commercial parties and the bank.”

Early ventures in financing the supply chain such as the Orbian system in the US, found it difficult to persuade a large enough group of suppliers to take up the offer of early cash to make it worthwhile. However, more modern non-bank entities such as Prime Revenue have experienced reasonable success and can be expected to push forward with more deals such as one reportedly completed for a middle-sized UK retailer recently. This has driven banks to counter with their own offerings.

Banks are faced with other challenges though. Many invoices are raised for relatively small amounts of money and the effort to collect sufficient numbers of small amounts is likely to require some smart marketing and low cost scaleable technology. Moreover, the SME will be sensitive to the risk that such a facility will be linked to the credit standing of another company, and while corporate liquidity and credit standings are currently good, should economic circumstances worsen, banks may then be more reluctant to make funds available and SMEs may be forced back onto more traditional sources of funding without a relevant credit history. Secondly, the cost of capital for a bank is substantially higher than for non-banks with access to the wholesale money markets. In consequence banks’ returns are likely to be lower on a capital adjusted basis unless securitisation techniques are used.

The real challenge, though, is likely to be the accounting treatment required for large companies that use financing techniques to lengthen payment terms. In the US, faced with large companies effectively borrowing from suppliers by lengthening payment terms, there are examples where the Federal Accounting Standards Board has required companies to treat the cash effect as a loan to the buyer. This then negatively impacts on corporate gearing of the large buyer, and could trigger a downgrade in credit assessments. Given the UK’s perennial problem with late payment — an average of 88 days according to Experian — any move to explicitly link supplier finance to even later payment where terms become uncommercial can be expected to attract the same level of political and press scrutiny as supermarket supplier relationships have done. In these circumstances the UK Accounting Standards Board could well be forced to adopt a similar approach to the US and constrain the buyers in the way they use such programs.