Chain reaction

Trade finance, Working Capital Management

Chain reaction

September 2019

In an environment where global supply chains connect large and small enterprises, where real-time payments are becoming the norm, and where there is increasing scrutiny of corporate social responsibility, supply chain finance – empowered by intuitive data analysis – comes into its own, explains Enrico Camerinelli

Sustainable supply chains see the participation of public authorities or private corporations seeking to achieve the appropriate balance between financial, environmental and social considerations in the execution of procuring goods and delivering services or works at all stages of the value-transformation cycle. Such considerations pertain, for instance, to the respect for core labour and safety standards in the production process, and the energy efficiency performance and innovative characteristics of the purchased products

 

SMEs and trade facilitation

Trade facilitation programmes and practices have concentrated on a variety of mission-critical elements in both the public and private sectors, from education to logistics, and from infrastructure to regulatory considerations. Focusing primarily on the physical movement of goods and developing solutions around it are the commonly understood scopes of trade facilitation. However, the exclusion of financing as an element of these efforts, and as a key component of trade facilitation, misses a critical commercial reality that underpins global trade flows, trade relationships and international supply chains. New banking regulations have, in many cases, made access to trade finance more difficult for small and medium-sized enterprises (SMEs) than before, particularly when SMEs are based in developing and emerging markets, as is the case today for many SME suppliers linked to global supply chains.

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SMEs play a significant role in global trade flows and economic value creation, as long as they can access timely and affordable financing − especially financing for their import–export trade operations. Since the 2008 global economic crisis, the financing of international trade has gained an unprecedented visibility among political and business leaders, with trade now being acknowledged as one of the major mechanisms that support economic recovery. Lack of adequate financing (including risk mitigation) is consistently identified as a major obstacle to the pursuit of additional opportunities in international markets. The credit crunch of the 2008 crisis was a wake-up call for corporate executives, who had to quickly find alternative sources of funding. Pockets of free cash were found by improving receivables collection and rescheduling payments with trading partners. Trade then became an engine of recovery and a subject of focus.

 

Beyond the bilateral

While traditional trade finance mechanisms involve trade on a bilateral basis (i.e. one buyer and one supplier), supply chain finance (SCF) schemes look at trade more holistically, in terms of the ecosystem of commercial relationships that make up an international (or global) supply chain. This foundation can then lead to consideration of the potential for better linking SCF schemes to trade facilitation practices. Financing can be provided at numerous points in the transaction life cycle, including against a legally recognised payment obligation (such as an invoice approved for payment), or against a receipt evidencing that the goods are held in a trusted/secure warehouse facility and can remain accessible to the lender until repayment is made. Suppliers may prefer to obtain payment immediately by having a bank discount the draft and remit monies through a loan, with repayment of the loan to take place when the obligation becomes due. Similarly, a buyer can delay the point at which it remits payment by arranging for a bank to pay the supplier but only seek reimbursement from the buyer at an agreed future date.

"SCF schemes look at trade more holistically"

At many points in the life cycle of a trade transaction, a financing option or solution can be offered to one or more parties. Some options are linked to specific steps – or phases – of a trade transaction, such as the issuance of a commercial invoice or the transfer of ownership between supplier and buyer. Such event-triggered (i.e. event-based) financing might be offered at one or more points in a typical trade transaction (see Figure 1).

Finance practitioners may present solutions in connection with transaction-related events that can serve as a basis for financing. These events include the:

  • Creation of a purchase order;
  • Issuance and acceptance of an invoice; and
  • Acceptance of a bill of exchange under a letter of credit.

Supply chain practitioners also link SCF discussions to working capital management and optimisation, and the management of days sales outstanding or days payable outstanding.

 

Legal frameworks

legal framework

Legal norms and prescriptions can certainly facilitate the execution of SCF schemes by creating a sense of confidence. Furthermore, they may represent a compelling reason to implement rules that would otherwise be ignored. It is widely acknowledged, however, that legal acts per se do not solve an issue. As an example, if the provisions of the EU Late Payment Directive1 are strictly enforced, two unintended consequences may happen:

  • SME suppliers risk winning in court but losing the contract. A supplier that can prove in court that it has been subjected to grossly unfair payment conditions by a client (likely a large multinational corporation) will probably claim the repayment of the recovery costs for payments delays plus the interest on the delayed payments. The likelihood is high, however, that the large multinational client will cancel the contract in retaliation.
  • The second unintended consequence is even more subtle and disruptive. The circumstance may occur in which the supplier is a large multinational and the buyer is an SME. This is not infrequent in industry sectors such as automotive, electronics and consumer goods. If the supplier (i.e. the large multinational) claims that payment terms received from the client (i.e. the SME) are higher than the ones established by the directive, it can go to court and, pursuant to the terms of the EU Late Payment Directive, receive more favourable conditions (i.e. get paid earlier). And the risk for the large supplier of losing the contract with the smaller client has very little impact on the supplier’s overall business performance. The conclusion is that the application of the directive has only negative consequences for the SME buyer, which now has to pay the supplier earlier and takes a hit on its working capital profile.

Of course, none of the above scenarios are the intended outcomes of the EU Late Payment Directive. SMEs can be comforted that government-based trade facilitation initiatives communicate public sector concern towards easing the burden of a long-lasting crisis off the shoulders of financially proven SMEs.

US$3bn

dispersed by IFC’s GTSF to nearly 1,000 suppliers across 14 countries since 2012

Source: IFC

With these initiatives, public bodies intend to avoid criticism of lacking clout with the larger buyers and want, instead, to set a binding contract between anchor buyers and political bodies that uses their weight to improve the financial conditions for SMEs.

Corporate social responsibility (CSR), for instance, represents one of the most significant initiatives that strongly connect public regulatory intercession between large multinational anchor buyers and their SME supply base. Public authorities are leveraging the reality that buying goods from – or trading business with – socially responsible companies is becoming a strong business-selection criterion in public opinion. It is also a reason why those companies that do not fulfil the criteria of CSR are being heavily hit with negative brand reputation.

CSR is a serious matter, defined by the European Commission as the responsibility of enterprises for their impacts on society. To further the integration of CSR into business practice across the EU, the Commission published a new policy on CSR in October 2011.2

CSR applications of SCF

Financial institutions should benefit from − and take advantage of − this new CSR sentiment. They service clients that want to kick off payment-related codes of conduct on behalf of their trade partners (i.e. suppliers and distributors) but not to the detriment of worsening their own working-capital values. Banks can leverage their SCF proposition and offer appropriate solutions to corporate clients who are eager to be financially responsible with their SME suppliers.

Just as the impact of social responsibility is setting the pace of the EU political agenda, CSR’s impact on business results is so high on banks’ lists of priorities that the chief executives of some of the world’s largest banks3 created the Banking Environment Initiative (BEI) in 2010.4 Its mission is to lead the banking industry in collectively directing capital towards environmentally and socially sustainable economic development. The BEI achieves its mission by focusing on topics where industry-wide action is needed. The most important of these is to identify how banks can better support their corporate clients’ needs on key sustainability topics. In 2010, the Board of Directors of the Consumer Goods Forum (CGF) committed its 400 members, representing a combined procurement power of over US$3trn, to achieving zero net deforestation in their supply chains by 2020. The BEI answered this call for action by issuing the Soft Commodities Compact,5 the result of two years of extensive collaboration with the CGF, to establish how to align the banking industry with this goal.

The Soft Commodities Compact includes two commitments:

  • Banks will work with consumer goods companies and their supply chains to develop appropriate financing solutions that support the growth of markets producing palm oil, timber products, soy or beef without contributing to deforestation.
  • Banks, where needed, will raise the standards they expect of certain clients in high-risk geographies so that they are encouraged to improve their sustainability performance in line with CGF expectations through 2020.
"Supporting SMEs via SCF requires more than simply offering a selection of financial instruments"

The first tangible result of the Soft Commodities Compact is the Sustainable Shipment Letter of Credit (LC),6 a financing solution that can be used by banks to incentivise the international trade of sustainably produced commodities. By allowing trade finance banks to differentiate between sustainable shipments and conventional ones, the Sustainable Shipment LC opens up the opportunity for banks to encourage and financially support growth in the trade of sustainably produced goods. The International Finance Corporation (IFC) − a member of the World Bank Group − has confirmed it will offer preferential terms for this type of shipment to its partner banks, offering potential reductions in the cost of capital.7

In line with such SCF-supported CSR strategies, the IFC launched the Global Trade Supplier Finance (GTSF) Program8 to provide short-term, post-shipment capital to suppliers in emerging markets immediately after the buyer agrees to pay. GTSF determines the supplier’s interest rates based on a combination of the buyer’s cost of credit and the supplier’s performance against the buyer’s environmental and social (E&S) standards. It offers suppliers monetary incentives to make E&S improvements, and helps them pay their workers fully and on time. In Vietnam, under the GTSF Program, the IFC has joined forces with Nike, Puma and other brands to form the Vietnam Improvement Program, and has cumulatively disbursed more than US$270m to their suppliers.9

 

End-to-end analysis

Supporting SMEs via SCF requires more than simply offering a selection of financial instruments. It demands a more thorough (i.e. smarter) approach that consists of understanding and mapping a company’s information flows, business and operational processes, and data insights. By leveraging CSR criteria, far-sighted banks will start assessing corporate credit risk using statistical data related to a company’s end-to-end supply chain performance − which could encompass on-time deliveries, compliance with sustainability protocols, correct shipping documentation and on-time payments − in order to obtain a more accurate risk profile. This will allow banks to decide what degree of risk they want to take and enable them to price it accordingly.

Enrico Camerinelli is a senior analyst at Aite Group specialising in wholesale banking, cash, trade finance and payments. He is based in Milan

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Sources

1 See https://bit.ly/2QgCv93 at ec.europa.eu
2 See
https://bit.ly/2qEJcoM at europa.eu
3 Barclays, BNY Mellon, China Construction Bank, Deutsche Bank, Lloyds Banking Group, Nomura, Northern Trust, Santander, Sumitomo Mitsui and Westpac
4 See
https://bit.ly/1l01Gsb at cisl.cam.ac.uk
5 See
https://bit.ly/2YxvW1F at cisl.cam.ac.uk
6 See
https://bit.ly/2xEGuAB at cisl.cam.ac.uk
7 See
https://bit.ly/2J9Yj0B at ifc.org
8 See
https://bit.ly/2XqJYWn at ifc.org
9 See endnote 8

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