LEVERAGING THE SUPPLY CHAIN TO SUPPORT THE FUTURE OF GLOBAL TRADE, by Anurag Chaudhary - Global Head of Trade Risk Distribution, Trade &Treasury Services, Citi

Trade is becoming more complex for both banks and corporates. Supplier finance provides an ideal solution but will require innovation on the part of banks if capacity is to keep pace with demand, writes Anurag Chaudhary, Global Head of Trade Risk Distribution, Trade & Treasury Services at Citi.

The fundamental shift that is taking place in the way that buyers and sellers interact – essentially a movement away from letters of credit to open account trading – is leading banks to re-think their trade strategies in order to continue to grow their trade business, both in terms of volumes and revenues. Many trade banks around the world have come to a similar conclusion following such reassessments: finance focused on the supply chain will play a major role in the future of trade.

Supplier finance has a number of benefits for trade banks. From a credit perspective, it generates short-term self-liquidating assets that are critical to the vendor management process and have demonstrated a low historical probability of default. Given the limited opportunities for banks to sell short-term products to investment grade multinational companies, supplier finance is a highly attractive trade asset class, and internal credit approvals tend to be straightforward. Supplier finance also aids banks by enhancing their trade product portfolio, enabling them to meet clients’ increasingly complex needs.

From a corporate’s perspective, global economic turbulence and geopolitical instability create pressure to improve their vendor management process and enhance manufacturing process efficiency. An important part of this strategy is strengthening the supply chain by ensuring that vendors have access to an ample supply of credit and liquidity. Supplier finance provides a solution by making cost-effective finance available to vendors from the corporate’s banks. Moreover, as a banking solution, supplier finance can enable clients to grow sales and procurement while ensuring robust internal risk management and controls.

Most companies are seeking to optimise their procurement and exploit low-cost geographies while simultaneously selling their products in global markets to enhance sales and expand their customer base. This strategy has created an outsourcing industry that has expanded immeasurably over the past decade. Outsourced and offshore operations have in turn resulted in ever-longer supply chains, which increase complexity and risks. As globalisation accelerates, supplier finance can help corporates to manage vendors and supply chains more effectively, increasing their resilience to shocks and enabling them to become a critical source of competitive advantage.

Meeting the needs of different types of clients

Supply Chain business can primarily be classified into two product offerings:

   1. Account Receivables (also called a supplier-centric solution): The bank purchases Account Receivables from the supplier and takes the buyer risk. The supplier gains liquidity, risk mitigation and balance sheet optimisation, while the bank retains control over the cashflow pertaining to these receivables and right of recourse to the seller for any dilution risks. At maturity the buyer pays directly into a bank-controlled account. Given their short-term nature (usually up to 180-days) and self-liquidating nature, these assets are attractive to both banks and investors.

2. Account Payables (also called a buyer-centric solution, reverse factoring or supply chain finance (SCF)): This solution has a longer gestation period and requires both buyers and sellers to be onboarded to an electronic SCF platform. However, once this process is complete the solution is automated and efficient. Moreover, SCF is easily scalable: as additional vendors join a programme, the platform easily accommodates increased invoice volumes. The buyer irrevocably accepts invoices before uploading them to the platform, consequently removing the risk of commercial disputes in the underlying transaction. 

In any trade transaction, there is a tension between the needs of buyers, which want to pay as late as possible, and suppliers, which want to collect their money at the earliest opportunity. Both Account Receivables and Account Payables programmes aim to ease this discord between buyers and suppliers. The programmes allow a supplier to sell its invoices to a bank at a discount once they are accepted by the buyer. That allows the buyer to pay later and the supplier to secure its money earlier, permitting both parties to improve their working capital cycle while lowering associated costs and enhancing their balance sheets.

Challenges to supplier finance

Both Account Receivables and Account Payables programmes have a proven track record and have created considerable benefits for buyers and suppliers over many years. When supplier programmes begin they are typically of a size that can be easily booked and held on a bank’s balance sheet. They are simply one of a range of trade financing solutions, including credit, cross-border funding and short-term liquidity, made available to clients to meet their requirements. However, the success of supplier finance creates its own challenges.

Often the success of an initial programme at headquarters level prompts an expansion to include overseas subsidiaries. Increasingly, the size of supplier finance programmes has grown to a level – as much as $1 billion for large multinational companies - that is difficult for a single bank to accommodate alone. To facilitate such enormous programmes, it is necessary for banks to partner with other banks or investors so that a comprehensive global trade financing solution can be provided.

Partnering with other institutions raises a number of critical issues for banks to address, including:

(i)    The need to restructure the bilateral agreement between client and bank to make it available for sale

(ii)    the creation of true sale structures for selling assets to investors

(iii)    invoices denominated in multiple currencies

(iv)  sourcing of legal opinions regarding account receivables across each country

(v)   the requirement for operational capabilities to implement defeasance solutions

(vi)   automated systems to bill the client for all invoices irrespective whether they are sold or not.

Possible solutions for asset sell-downs:

1.     100% of each invoice:

This is usually applicable for Account Payables programmes. Under this asset sale solution, the bank assigns 100% of each individual invoice to the investor via an assignment structure while at the same time continuing to act as a collection agent on behalf of the investor with reference to the client. After acceptance of the invoice by the buyer, the bank discounts the invoice in favour of the supplier and then assigns the specific invoice in favour of investors prior to their funding. Since each investor will hold and own a specific set of ‘whole’ receivables, investors have the right to serve notice and take legal action directly against the buyer in case of payment default. The bank can get off-balance sheet treatment from this structure as it sell/assigns 100% of each invoice on getting funds from investors.

The disadvantages of an assignment structure are that each invoice must be notified to buyers to ensure legal assignment, making the process onerous for the buyer. Generally, the buyer does not want to change its payment process and prefers the bank to act as a collection agent on behalf of the investors. Therefore there is a need for the bank to upgrade its electronic platform to manage these asset sales for supplier finance. Given the large size of supplier finance programmes, an assignment structure also entails a high volume of invoices that need to be managed by the electronic platform.

2.     Pro rata share in the overall programme:

This is usually used for Account Receivables solutions. It uses an assignment structure where each investor participates in the entire supplier-centric programme. It works in a similar way to a syndicated loan facility where the bank has a bilateral account purchase agreement with the client/seller and a bespoke risk participation agreement with investors as a group. The bespoke risk participation agreement usually needs to address the following key components:

(i)    the need for all parties to have pro rata participation and rank pari passu at all times

(ii)    the roles and responsibilities of the collection agent

(iii)   procedures in case of remedial management or default scenarios

(iv)   voting rights for each investor

(v)    the ability to transfer from one investor to another investor

(vi)  as investors' participation is funded, it is imperative that there is no settlement risk for the bank.

For Account Receivables programmes, additional potential issues that need to be considered include:

(i)   the risk of invoices being presented for factoring/financing before goods have been shipped

(ii)  the risk of the bank being unaware of invoices being issued together with credit notes that effectively cancel the invoice.

(iii)  the risk that invoices are paid into another bank account without the bank being informed.

(iv)  the possibility of a commercial dispute between parties that the bank is unaware of.

These risks highlight the importance of alignment between the bank and investors for the smooth and efficient running of a programme.

Meeting the challenges of the future

Individual banks managing supplier finance programmes face numerous challenges. They must meet the needs of buyers, suppliers and investors simultaneously. In addition, banks need to structure off-balance sheet solutions for supplier finance assets sales, have the capability to sell down assets at regular intervals, manage their credit and liquidity exposure under each programme, and service clients’ ongoing needs.

At the same time, the trade business also faces challenges as supplier finance continues to grow. The inclusion of non-bank investors in supplier financing will facilitate the continued expansion of programmes as they become too large for any one bank to manage on an overall basis.

However, to enable broader investor participation, banks must collaborate to help standardise product definitions for both Accounts Receivables and Account Payables programmes. Underlying Master Participation Agreements also need to be standardised, via independent bodies, to make it easier for banks and non-bank investors to negotiate documentation.

As the market continues to evolve, banks must ensure they change with it. They need to invest in order to build electronic platforms and operational infrastructure that deliver economies of scale, not only to manage the client interface to purchase account receivables but also to process the periodical sale of large number of invoices to investors. Banks may also need to reorganise: trade distribution and syndication teams in bank are likely to play a critical role – as they did in the loan syndication market – as the supplier finance business grows.