ALTHOUGH SUPPLY-CHAIN finance is not broken out in transaction banks’ results – and there are no independent data sources – growth is thought to be running at hundreds of percent a year. No one doubts that supply-chain finance is becoming a core product for banks but inevitably some are questioning whether or not the current pace of growth can be sustained as the global economy recovers and financial markets normalize.
In the supply-chain finance gold rush, most of the spoils are going to the world’s largest transaction banks – for international mandates only they have the necessary coverage for implementation. Given the relatively recent success of supply-chain finance it is perhaps unsurprising that banks have yet to effectively differentiate their products. Other than network reach and local market knowledge there is little to separate most of the big bank’s offerings.
The runaway success of supply-chain finance poses questions about the sustainability of its business model. By definition it requires banks to lend more, to a wider range of entities – many of which are relatively small and are often in emerging markets. New models for distributing and sharing risk might be necessary if global transaction banks are not to find themselves restricting supply-chain finance through lack of available balance sheet.
Pushing suppliers
In the years before the financial crisis, the rationale for supply-chain finance, which uses the buying companies’ (usually) superior credit rating to extend credit to suppliers at lower costs than they would normally pay, was straightforward. It was another way for buying companies to improve their working capital by extending the terms on which they paid their already hard-pushed suppliers.
The problem for banks was that over the preceding decade many global companies had spent large sums re-engineering their processes and structures to improve working capital. The potential benefits of supply-chain finance did not look proportionate to the additional complexity it entailed. Moreover, the world was awash with cheap and easy credit – for buying companies and even their suppliers in developing countries: supply-chain finance didn’t seem worth it.
Then the world changed. “The recession resulted in increased interest in reducing costs,” explains Adnan Ghani, head of global trade finance, global transaction services, at RBS, who says that surveys undertaken by the bank show that 63% of CFOs see working capital finance as core. “The first thing that springs to mind to better manage working capital is renegotiating terms with suppliers,” he adds.
By extending terms, a buyer necessarily makes things more difficult for the supplier (which is likely to have to pay cash for raw materials). “Extended payment terms also increase the suppliers’ exchange risks as they often buy those raw materials in local currency and sell their goods in dollars,” says Lawrence Webb, global head of trade and supply chain at HSBC. Given the fluctuations in exchange rates in the past year it is very easy to wipe out low-double-digit margins over a 120-day payment cycle.
During the financial crisis, senior management began to realize how critical supply chains were to their survival and how easily they could be disrupted in an environment where working capital was difficult to secure, notes Jeremy Shaw, head of trade services in EMEA at JPMorgan. “Whereas previously the pitch was frequently about pushing out terms, it switched to using surplus cash and capital – of which many large companies have plenty – to make their business more resilient.”
The enlightenment
As interest in safeguarding supply chains increased, the focus of supply-chain finance began to change from naked self-interest – in extending their days payable outstanding – to enlightened self-interest. “In a recent project for Rolls-Royce, the company didn’t extend payment terms at all,” says Lex Greensill, head of supply-chain finance, EMEA, at Citi. Instead, its objective was to provide liquidity for its supply chain. It judged that the shock of the failure of one of its key suppliers could be much larger than a few basis points in cost savings.
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“Regular supply-chain-finance solutions are somewhat commoditized”
Lex Greensill, Citi |
There are limits to this enlightenment. “The motivation for supply-chain finance differs between industries,” notes Daniel Schmand, head of trade finance EMEA, global transaction banking, at Deutsche Bank. “The more strategic and technical the industry, the more strategic support for suppliers features as a key driver. And the more commoditized the industry, the more the focus there is on pushing out payment terms and optimizing working capital.” Nevertheless, as the economic recovery accelerates, all buyers recognize that risk for suppliers is increasing. Going into a downturn, lower orders unlock cash. “However, as sales increase there is a significant gap in working capital – a whipsaw effect,” says Greensill. In January, Caterpillar announced that it intended to double its orders from suppliers this year but was worried about this whipsaw effect. “They chose to implement a supply-chain finance programme specifically to mitigate this risk,” Greensill adds.
Meanwhile, although it is easy to assume that demand by suppliers for supply-chain finance will decrease as the financial markets normalize, that overlooks the different experiences of different types of companies in sourcing credit. “There are still many markets where companies not in the top tier will find their access to credit is restricted,” says Schmand.
This problem is often most acute in those markets affected by a reshuffling of the banking sector or where there are no savings and cooperative banks. “In the Netherlands, for example, the disappearance of ABN Amro and the restructuring of the market mean that, for many mid-sized companies, it is still a real challenge to access funding,” says Schmand.
What do banks need to get supply-chain finance right?
Unlike other areas of trade finance, supply-chain finance has no branded solutions. None of the main banks – normally eager to come up with snappy acronym-laden titles – currently offers anything other than simple supply-chain finance: the absence which is revealing. “Regular 101 supply-chain-finance solutions are somewhat commoditized,” concedes Greensill at Citi.
To be sure, there are emerging features that have yet to permeate the market, such as the ability for companies to share the rewards of secured lending to their suppliers with their banks as an alternative to investing surplus funds, says Greensill. However, such ideas are still in development and banks are instead differentiating themselves by highlighting characteristics that have been mainstays of bank marketing for centuries – scale and knowledge.
This is less simplistic than it seems. “The challenge in building a supply-chain-finance solution is to be able to on-board suppliers rapidly and to understand local laws for assigning receivables,” says RBS’s Ghani. Consequently, emphasizing the size of branch networks and experience of local markets makes sense.
“The ability to on-board suppliers and gain a high acceptance rate is the critical differentiator,” agrees Shaw at JPMorgan. “If suppliers don’t take advantage of the programme then it will be suboptimal. To achieve high uptake and smooth on-boarding it is usually beneficial to have dedicated teams on the ground but inevitably it is impossible to have teams in every country.”
Nevertheless, the requirement to have local staff for on-boarding rules out many regionally focused banks from competition for international mandates. “Partnering with local banks to deliver supply-chain finance is possible but it can have serious legal implications,” says Deutsche Bank’s Schmand. “On-boarding is out of your control yet you bear responsibility for it. It’s hard to see how it could work in practice.”
On the matter of knowledge, local-language skills and an in-country understanding of how documentation works is crucial, according to Schmand. Moreover, as this is still a relatively new market those banks that can demonstrate a track record of implementation continue to have a first-mover advantage, says Ghani.
Of course, the other factor that helps to determine which banks win business is inertia. While many supply-chain-finance mandates are won in competition following an RFP a surprisingly large number are gifted to the buying company’s core transaction bank.
The danger of cannibalization
At first glance, supply-chain finance looks like a classic win-win-win outcome for banks, buyers and suppliers. Banks gain additional business, which often leads to new banking relationships with suppliers, according to Schmand at Deutsche Bank. Buyers usually get to extend payment terms – sometimes by 60 days or more – making their working capital work harder. Suppliers get access to funding at much lower costs than those available from local banks: a buyer currently paying 600 basis points in an emerging market might pay just 100bp under a supply-chain-finance programme.
However, some observers believe there is a danger that supply-chain finance could undermine other lending activities by banks. “From the banks’ perspective it can be self-defeating,” says JPMorgan’s Shaw. “If you are already financing suppliers at 400bp and a supply-chain-finance programme offers them credit at 100bp you’re cutting off your own knees.”
This argument raises a bigger question about transaction banks’ business models for supply-chain finance. Those banks with extensive branch networks in the countries where suppliers are located – most notably HSBC – are adamant that to achieve effectiveness in supply-chain finance and bring benefits to all parties, a bank needs to be able to see both sides of the transaction.
“If we receive a purchase order from a buyer directly we can track how long it takes before a shipment occurs via a bill of lading,” explains HSBC’s Webb. “We can then see when the buyer accepts the goods and when they make payment. Following that chain of events allows us advance funding based on recorded events. Unless a bank has a relationship with both the buyer and the supplier it is impossible to get that level of visibility.”
Webb believes that this visibility will become more crucial as supply-chain finance develops. “Currently supply-chain-finance solutions are at the approved invoice stage when the need for financing really begins at the purchase order stage when raw materials are purchased (currently that finance comes from local banks),” he says. “For supply-chain finance to be possible at that stage of a transaction, the bank has to know that supplier – and not just through a tie-up with a local bank.”
Sharing and distributing risk
Although much discussed, letters of credit have not enjoyed the renaissance predicted last year. Of the $15.8 trillion of world merchandise trade in 2008, just 20% was conducted using documentary credit such as letters of credit, according to the World Bank, and few believe the proportion changed significantly in 2009. That means that the potential market for supply-chain finance – effectively the entire open-account market – could be worth more than $10 trillion, even accounting for the decline in world trade. The question of how to share and distribute that vast risk is therefore critical to supply-chain finance.
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“It is crucial to be able to share risk. Even the largest banks necessarily have risk limits for individual companies”
Adnan Ghani, RBS |
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Retaining the risk originated from supply-chain finance will clearly prove unsustainable as the market grows. “Given the size of the open-account market, banks simply don’t have enough balance sheet to satisfy the full market demand,” says Webb at HSBC. “It is crucial to be able to share risk,” agrees RBS’s Adnan. “Even the largest banks necessarily have risk limits for individual companies.” Current options for risk distribution are limited. It can be syndicated to other banks or investors anonymously or shared in a more open way. “Increasingly risk is being shared through partnering arrangements, which differ from syndication because risk is disclosed,” says Adnan. “Consequently, banks take part because they have an existing relationship with the buying company or would like to build one.”
In the short term, these club-style deals to share risk are expected to grow. However, most observers recognize that non-bank investors will be required at some point in order to cope with expected volumes. Shaw at JPMorgan says that insurance companies or alternative investors are potential buyers given the short-term, low-risk nature of the supply-chain finance. “As the risk always has effective recourse to the buyer – though not for accounting purposes – there should be few issues about acceptability of risk: these are usually blue-chip companies,” he says.
However, to create a product that is saleable to external investors supply-chain finance will have to change. “Traditional trade has standardized products and methodology and in order to expand it to a wider market, supply-chain finance will have to do the same,” says Webb at HSBC. One potential forum for establishing standards for open account is the Swift Trade Services Utility, which is essentially a pipeline that enables banks to communicate and transact with each other. “While it has potential for facilitating easier supply-chain finance, it is still at the early adoption phase and could take some years to come to evolve fully,” says Webb.
In a similar initiative, last autumn a working group of supply-chain-finance market participants (borrowers, lenders and banks) chaired by Stuart Siddall, chief executive of the Association of Corporate Treasurers, was established by the Bank of England to develop standards and try to build a sustainable market. Although the group is due to issue a report shortly, few people are holding their breath.
“Moves by Swift and others to standardize elements of open account are positive but won’t necessarily lead to a saleable instrument,” says Deutsche Bank’s Schmand. “And while such a product could develop locally, there is still some way to go before a truly global one becomes available.”
Nevertheless, some observers are happy to ponder the future of risk distribution in supply-chain finance. Shaw believes a likely outcome of the quest for a saleable instrument is a variation of the asset-backed commercial paper (ABCP) securitization format. However, he acknowledges that there are a number of hurdles to be overcome first. “ABCP typically comes with supporting bank liquidity, which doesn’t necessarily work in a supply-chain format,” he explains. “Also supply-chain finance is typically skewed towards large individual obligors whereas ABCP references multiple underlying receivables offering [investors] the benefits of diversification.”
Despite the huge scale of the task to standardize elements of supply-chain finance and package it into instruments that external investors would buy, the clever money is on an eventual solution. It is indisputable that the potential scale of supply-chain finance is huge. It is also an unalterable fact that banks’ balance sheets are finite.
Most importantly, it is unarguable that the rewards on offer are attractive: the financial crisis has resulted in a repricing of the business – whereas suppliers of a buyer that can borrow at 30bp used to be financed at 40bp they are more likely to pay 100bp now. The collision of those three forces makes a successful outcome almost certain.
