Incorporating a successful supply chain finance platform may shield banks from disintermediation of their SME business in emerging markets, writes eBiashara director Maarten Susan, who highlights what banks stand to gain.
Small and mid-sized businesses (SMEs) form the bread and butter of emerging economies, but funding them is not a simple matter: credit origination costs are high (because of non-standardised loan processing) and monitoring costs are even higher. Imperfect or disappearing collateral and opportunistic entrepreneurial decision-making are just some of the issues that a relationship manager faces on a daily basis. In times of recession, or rising interest rates, losses in the SME portfolio may easily surpass 10%. Needless to say, many financial institutions are very conservative when it comes to SME financing in these markets.
Across emerging markets, many banks struggle to define a long-term SME financing model that meets the individual needs of small businesses, but at the same time offers adequate returns, and meets internal efficiency and loan loss criteria.
Banks offer a wide range of products to SMEs, but when it comes to financing, the requirements of any entrepreneur are essentially twofold. What every company needs is (a) access to working capital to manage daily operations, and (b) medium-term funding to finance capital expenditure. Historical evidence suggests that asset-backed financing (capex) offers a much better performance record than financing working capital – which is traditionally done on the basis of pledging inventories and receivables. But if most of the problems occur in the area of working capital, would it not make sense to take a closer look at how banks could create financing solutions that are both cost-efficient, and offer a much better risk/return perspective?
SCF as a solution
Business owners will invariably cite liquidity management as their single biggest problem. Product or services are delivered, but contractual payment terms are largely ignored by buyers, and even fast-moving or perishable goods may face collection periods of 45 to 60 days – which could easily become 90 to 120 days for the larger retailers. As such, SMEs face a dual problem: on the one hand, highly conservative lending attitudes from banks and, on the other hand, unsustainably high days sales outstanding (DSO) ratios. In combination this implies a liquidity squeeze, leading to sharply reduced commercial resilience, and causing commercial stagnation throughout value chains. A 2014 paper by theEuropean Commission estimates that the adverse effects of “late payment” is so large that is can be measured as a percentage of GDP.
Supply chain finance offers solutions. The concept knows many definitions, but the one we use at eBiashara is “a series of solutions that turn unpaid invoices into cash”. Invoice discounting is by no means a new model, but it is our strong belief that most banks insufficiently understand how to develop and deploy a professional SCF strategy to overcome the problems of traditional SME banking, and start offering real value to their clients who need cashflow availability, if not predictability.
Indeed, most banks offer a form of invoice discounting to established clients, but few have turned this into a mainstream financial product. Traditionally, invoice discounting is a supplier-driven proposition, where an SME client asks its bank to provide liquidity by advancing funds against one or more invoices – drawn on one or more buyers. As a first step the bank will always want to verify the authenticity of the invoices, which is a costly and laborious process. To run efficient and highly scalable operations, banks must have access to a totally automated SCF platform.
Reverse factoring turns the supplier-driven process on its head, and instead takes the buyer as a starting point. Committed buyers work with the bank on an early payment programme, selecting a group of priority suppliers that are eligible to participate. Conceptually the workflow is very simple: Suppliers deliver as usual, the buyer checks received quantities and qualities, and will forward a confirmed (final) invoice to its administration department for settlement on due date.
So far, nothing new. But under an early payment programme, a small data extract is sent to the bank’s SCF platform on a daily basis.
Suppliers with access to this cloud-based SCF system will see their approved invoice appear once it has been uploaded, and may then elect to have the invoice paid early by simply clicking a check-box. The system will tell them exactly what the (discounted) interest charge is going to be. Once selected, a payment instruction is sent to the bank that will be executed without manual intervention. On due date, the bank collects from the buyer to close the transaction. A very simple process indeed, but to create an IT solution that is versatile enough to cater for much more complex trade transactions, and that will pass the most stringent bank security requirements, explains why there are only a handful of solution providers that are able to work with banks around the world.
A reverse factoring programme involves three parties: the supplier(s), the buyer and the bank. The advantages for suppliers and the bank are obvious. Suppliers get access to quick, easy and unsecured funding, and banks can boost their SME loan-book without incurring associated SME risk. After all, reverse factoring relies on the buyer, often a stronger corporate banking client, for repayment on due date. Through the SCF platform, banks automate the processing of hundreds of invoices per day – which provides immediate cost efficiency benefits. But the question remains: why would a buyer participate in such a programme?
Interestingly, a 2014 study by ACCA found that the biggest gains from reverse factoring occur on the buyer’s side. Supporting an early payment programme that benefits their suppliers does not cost buyers anything – after all, discounted interest is not paid by them but by the beneficiary of early payment (the suppliers). With primary recourse on the buyer, banks may require them to allocate part of their established risk limit to the SCF programme, and they may want to enforce this limit with hard collateral. Trade insurance offers a very viable alternative where collateral is not available.
In return, buyers create a hugely loyal and committed supplier base: they may be able to stretch contractual payment terms (with the knowledge that suppliers have access to an early payment option), or they may demand better pricing in return for inclusion of the supplier into the early payment programme. Finally, many banks will offer buyers a financial incentive in the form of margin sharing.
On the other side of value chains, distributor finance works in much the same way, although the objective there is to extend payment terms, and not to shorten them. Extended payment terms allow distributors to sell first and use the proceeds to pay the seller. As such, we call this a late payment programme. The seller has the option to discount the (extended payment) invoices by means of a factoring programme – with the corresponding financing cost shifted back to distributors in the form of higher pricing.
Lessons learned in Kenya
What we have learned with eBiashara is that rolling out an SCF platform for banks is just not a matter of selling software. The smaller SME banks in particular require a holistic solution that includes product development, risk management (with trade insurance as a key component), the training of bank staff, a help desk support to maintain a 24/7 platform, the onboarding of buyers and suppliers and hands-on assistance in sales and marketing. Banks that commit to an SCF strategy typically break even within three months and quickly start to appreciate that the dynamics of (reverse) factoring are very different from mainstream banking.
What the future holds
Statistics from the International Factoring Group (IFG) show that the global market for factoring is enormous and was estimated at over US$2.3tn in 2013. Africa, as an example, holds a market share of just over 1%. This is bound to grow exponentially in the next few years. SMEs are in dire need of financing, and GDP growth rates consistently surpass 5% in the larger Eastern and Western African markets.
Banks that are slow to recognise the opportunity will see their SME business model disintermediated by specialised SCF companies that have access to the same platform technology as banks, and can tap into offshore credit lines from dedicated investment funds in search of non-traditional and better yielding asset classes. Sensible factoring legislation still has some way to go with African regulators, but already we’re seeing that first movers are finding ways to build profitable loan portfolios, and provide access to finance in market segments
at the lower end of value chains.
8 reasons to roll out an SCF platform
Drive revenue growth
Buyer gives access to tens/hundreds of suppliersCompete against banks who do not deploy a system
Reverse factoring = SME pricing at corporate risk
Large volume/small ticket transactions can only be executed on a dedicated and automated platform
Enormous expansion of potential market
Straight Through Processing (STP) reduces human intervention (especially with volumes going up)
System is priced on SAAS basis: no write-offs
Turnaround time (TAT)
TAT reduced to “guaranteed next day payment”
If anything, this positively contributes to client retention (loyalty factor)
A structured programme approach offers excellent opportunities to mitigate risk through credit portfolio insurance (on both sides of the chain)
Buyer uploading approved invoices eliminates a very laborious (and costly) verification process
Maker/checker methodology applied throughout
Capturing transactions on both ends of the supply chain gives a true and holistic picture of client performance
Bringing all product limits and sub-limits together for buyers and associated sellers gives an unparalleled sense of control
What is needed for successful SCF roll-out?
- A world-class scalable technology platform
- An effective business model
- A sensible product/risk strategy
- A targeted marketing/sales strategy
- First line help-desk support (for buyers and suppliers)
- Second and third line business and technical support (for the bank)
- An onboarding methodology (for suppliers and buyers)
- Training… and more training