Will Reverse Factoring be the cause of the next Financial Bubble?

Alejandro Serrano and Spyros Lekkakos, Contributors

January 23, 2015, CFO.com, US

Companies in Europe that are still struggling with the high cost of short-term capital and limited access to bank credit are turning to an unlikely financial ally: their customers.

A financial arrangement called reverse factoring (RF) uses the favorable credit rating of large, solid buyers to secure relatively cheap capital for cash-starved suppliers. The method is seen as a win-win for all the parties involved and is being encouraged by national governments. The Obama administration, for instance, recently launched SupplierPay initiative that encourages companies to use instruments like RF to free up capital for suppliers.

But RF can raise the risk profile of supply chains to dangerous levels, and could even cause a systematic financial failure, research carried out by the MIT-Zaragoza International Logistics Program, in Zaragoza, Spain, suggests.

The suppliers involved in Europe are often small to medium-sized companies (SMEs) that continue to suffer from the credit squeeze caused by the 2008 financial crisis. Large corporations with double-A or triple-A credit ratings generally have no problem borrowing money. But SMEs in Europe with, say, a triple-B rating that need to finance their operations and build working capital still find it difficult to borrow at competitive rates.

The common form of RF, initiated by the buyer, involves a return-oriented approach for a large pool of suppliers. The seller or supplier in need of liquidity sells some of its buyer’s receivables to a financial institution, such as a bank, proposed by the buyer. Since the buyer has an excellent credit rating, the bank offers the supplier competitive priced loans based on the sale of the receivables. In return, the supplier agrees to extend the buyer’s payment terms.

Suppliers win because they have access to affordable capital, and buyers win because they secure extended payment terms (although supplies are paid later, the savings on their borrowings more than compensate the supplier for that). The bank wins because the transaction brings new business; banks often on-sell other products to participating suppliers.

In 2013 Proctor & Gamble reportedly extended its payment terms for all suppliers by 30 days as part of an RF program to ease suppliers’ liquidity problems. Unilever used a similar approach and was able to reduce its working capital by some $2 billion in three years. In another example of the strategy, Philips used RF to obtain preferred-buyer status with its suppliers and reduce the risk of supply chain disruptions.

A number of RF programs have been initiated in response to market disruptions. WalMart’s supply alliance program was created for thousands of its apparel suppliers – including many SMEs – in the aftermath of the 2009 Chapter 11 bankruptcy of the CIT Group Inc., an established commercial lender.

Some European governments see RF as a way to overcome the liquidity problems that have plagued their economies, and actively encourage the growth of these programs. President Obama’s SupplierPay aims to give buyers the option to pay suppliers earlier or use some sort of financial mechanism to ease vendors’ financial issues.

As RF matures it is evolving away from traditional buyer-owned or bank-owned platforms and towards an internet-based service model in the cloud. This new iteration is easily accessible and reduces the need for software development and lengthy implementations that add cost and time to the process. The introduction of industry standards, and challenging economic conditions, are also driving the growth of RF. Mature programs attract a wider pool of lenders, making them even more attractive.

But the strategy also brings some serious risks that are easily overlooked as a growing number of companies embrace RF. First, the mechanism works well as long as buyers pay on time. It is assumed that large firms with impressive credit ratings are highly unlikely to delay payment or default. However, as the Lehman Brothers debacle in September 2008 underlined, even enterprises that are rated highly by credit agencies can collapse.

If a buyer did fail to meet its payment obligations, the financial institution involved would be forced to opt out, and the relatively weak supplier could go under. If RF programs were sufficiently widespread, such a default could trigger a market crisis. As RF vehicles become more established they could be extended to sub-investment-grade buyers, compounding the risk of defaults.

The chances of such things happening are increased when banks’ due diligence is not rigorous enough. There is always a temptation to cut corners when a large portfolio of suppliers – each one representing new opportunities for selling financial services – is part of the deal. Moreover, assessing supply-chain risk is not a core competency in the banking industry.

Another threat to consider is the level of indebtedness that RF encourages, and the degree of risk this represents for individual companies and economies.

Although RF does provide a cheap source of capital for SMEs, these schemes incur other costs. Suppliers entering into RF agreements may signal that they are weak. Committing to a buyer in this way can compromise a company’s negotiating position, and limit its options when the time is right to pursue other investment opportunities.

Some of these risks are mitigated by the emergence of networked supply-chain financing solutions that connect a wider range of trading partners, increase the efficiency of programs, and improve visibility into transactions. Further, RF fosters more collaboration between suppliers and buyers, which, in turn, bolsters competitiveness.

However, as the RF bandwagon continues to gain momentum, companies and governments need to be aware of the downside risks that could ultimately cause another financial meltdown.

Alejandro Serrano is professor of Supply Chain Management in the MIT-Zaragoza International Logistics Program (aserrano@zlc.edu.es). Spyros Lekkakos is a doctoral candidate in the same program.