Farooq Siddiqi
Director, Transaction Banking, Global Supply Chain Finance Sales, at Standard Chartered Bank, explains how the pre-shipment elements of supply chain financing work and how they can benefit all those concerned.
Supply chain financing (SCF) has become a popular theme in global treasury, but most banks still only offer the service in the context of post-shipment finance to suppliers. By contrast, pre-shipment finance to suppliers and customer financing are far more challenging concepts from a banking perspective and also have much more to offer to corporations.
Trade finance has seen appreciable investment in the open account financing space in recent years. However, much of this investment has been focused on technology. While this is undoubtedly important in terms of reducing costs and streamlining processes, it is merely the first step in addressing issues of a more strategic nature from a corporate perspective.
From a strategic viewpoint, the focus is on managing growth, increasing market share, building supply chains (both upstream and downstream) as a source of competitive advantage, and finally unlocking the implicit value of a corporation’s supply chain.
For example, major corporations with public commitments to specific working capital targets cannot simply extend additional credit to their distributors/resellers.
At the same time, those distributors/resellers may have the potential for enormous sales growth but cannot take advantage of this due to cashflow limitations.
In this type of environment the traditional bank approach of offering post-shipment trade finance and a slick user interface is of limited use (though it is an important first step).
Instead, the focus is gradually shifting towards solutions that enable corporations to achieve broader business benefits. For example, some form of mechanism that allows distributors a longer credit period and higher credit limits, without prejudicing the working capital targets of the ‘lead’ corporation that is supplying them, is clearly necessary. Business knowledge
However, providing such a mechanism requires most banks to step beyond their traditional area of expertise. This is because this is not simply a case of offering conventional funding to suppliers/buyers.
Instead, a collaborative tripartite effort is required among bank, lead corporate and its supply chain partners if meaningful benefits are to be derived from the ‘halo effect’ of a corporation on its supply chain.
The ‘halo effect” being how much value suppliers/buyers attach to the importance of being a member of the lead corporation’s supply chain.
The key, therefore, is in understanding the lead corporation’s business model and its components such as sourcing, manufacturing, sales and treasury.
This business model needs to be understood in context of the markets in which the corporation operates in terms of both industry dynamics or trends and (most importantly) its business strategy and priorities.
The participating bank will therefore have to see itself as a business partner with the corporate in its supply chain, which means having a granular understanding of the ‘nuts and bolts’s of the corporation’s business. The supply chain’s traditional working practices, typical credit terms, incentives, margins etc must be fully grasped before the bank will be able to add significant value.
In addition, the bank has to have a clear appreciation of the relative competitive position of the lead corporation, both globally and within particular markets, as this is a major factor in determining the ‘stickiness’s or ‘halo effect’s of a supply chain.
This ‘stickiness’s or ‘halo effect’s determines the strength of the lead corporation’s (anchor) supply chain. While some major international companies may be financially robust, if their supply chain is not perceived highly by their suppliers and buyers, it will probably be difficult to extract additional value from it.
On the other hand, if the supply chain is perceived highly, implicit value can be extracted from it in various ways, such as financing solutions for the buyers/suppliers, changes in terms of trade, changes in cash discounts, incentives schemes and so on.
New credit model
Offering pre-shipment supply chain financing to suppliers and buyer financing (in most cases with no recourse to the anchor corporation) that goes beyond conventional bank funding means that the bank requires an innovative credit model. Such a model has to be capable of accurately measuring the end-to-end strength of an anchor corporation’s supply chain.
If a bank is trying to offer solutions or financing structures around a lead corporation’s supply chain, its credit model must be in a position to evaluate the entire supply chain, rather than just the individual counterparties within it. Simply using traditional methods of risk assessment based upon balance sheet and financials is insufficient.
In order to offer the maximum value to clients, such a proprietary credit model requires the following attributes:
Supply chain credit evaluation model:
The credit model should look at all parameters that influence the strength of the supply chain and, in a simplistic sense, score or grade it to assess whether or not the anchor corporation’s supply chain is bankable from a risk perspective.
Industry specific knowledge:
Sector inputs are critical when comparing the anchor’s supply chain strength with best in class. It is pointless to compare a technology supply chain with a retailing supply chain, as the business dynamics are completely different.
Peer evaluation is critical in understanding business, market and other risks associated with the supply chain.
Appropriateness of solutions or structures:
Once a credit model has been used to evaluate supply chain strength, the next step is the selection of an appropriate solution set.
Even within the same supply chain, different solutions can be offered to the buyers/suppliers based upon internal segmentation, or business and country strategy.
A one-size-fits-all approach is inappropriate as it will reduce the value proposition from the anchor corporation’s perspective.
Global reach:
Given the globalisation of markets, the credit model must be able to operate across borders anywhere in the world. This is particularly challenging for many banks in the case of emerging markets where the need for such supply chain financing is often the greatest.
Supporting the business:
Rather than using the generic credit approval structure within the bank, a dedicated global structure is required. This means that (irrespective of the location involved) the same credit team will be looking after a particular lead corporation’s supply chain(s).
This hugely expedites decision-making, as well as offering consistency from the corporate perspective – as only one decision is required by one credit team, irrespective of which (or how many) markets a buyer/supplier operates in. Particularly in the case of multi-country cross-border supply chains, this is hugely advantageous in comparison with the conventional approach, as multiple sign-offs from credit personnel in multiple locations are not required.
Robust and scalable back-end technology:
Supporting a business of this nature requires much more than just a nice graphical user interface. Significant dedicated effort and investment is required here to ensure seamless processing of both deal setup and day-to-day supply chain financing.
If these attributes are in place, then a scalable business model becomes possible. As such, it is also able to respond rapidly even to challenging requests, such as a lead corporation looking for financial support for a single distributor that operates in multiple jurisdictions.
This can also be supported by globally standardised documentation.
Information, information, information
One the most critical inputs to such a proprietary credit model will be information provided by the lead corporation. This information ranges across multiple areas including the company’s business model and intentions, as well as data relating to supplier/buyer performance. The quality of this information and the relationship with the lead corporation has a huge influence on what can or cannot be provided in terms of funding.
Take a simple example where a distributor needs 60 days’s credit, but the lead corporation will only allow 30 days. The bank might agree to provide credit for the 30 to 60 day window.
If the distributor indicates that it will not be able to pay on day 60 as a major sale had not quite completed in time, the bank is able to receive independent corroboration of this from the lead corporation.
In a conventional funding scenario this corroboration would not be available.
Other more general information is also of value when assessing a particular distributor for credit. The lead corporation may indicate that the distributor is performing strongly and is nearing the point where it might be about to receive additional performance discounts or similar status uplift.
Or it might inform the bank that the distributor was about to have its franchise extended to an additional country or region.
This type of information allows the bank to take a far more innovative approach to providing financing. At the same time, if the information provided by the lead corporation is negative (eg, a distributor is about to be disenfranchised) this obviously gives the bank an early red flag that will allow it to adjust its credit exposure appropriately.
It is this information that allows the ‘halo effect’s of the anchor corporation to be translated into tangible and extractable value. The frequency and extent of information sharing is in turn driven by the company’s motives.
In practice, companies that have a more strategic attitude to their supply chain (eg, use it to drive market share or as a source of competitive advantage) are typically extremely open about sharing information, which in turn enhances the ‘halo effect’.
Leverage and support
As mentioned above, the perceived value or ‘stickiness’s of a supply chain has a strong influence on distributors’s payment behaviour. If a distributor is representing a lead corporation with a strong brand and market position that allows good margins, then it obviously has an equally strong incentive to retain that franchise.
Therefore, in a tripartite supply chain financing situation, such a distributor also has a strong motive to honour its commitments to the bank.
In some circumstances, the lead corporation may even have a more direct role in putting pressure on a wayward distributor to do this, such as by withholding further shipments.
The ‘stickiness’s element is equally applicable to the upstream supply chain as suppliers to strong buyers are significantly dependent on the latter, which in turn reduces some of the performance risk issues.
Whether or not support from the lead corporation involves a direct financial element depends upon individual circumstances. In some cases, some risk sharing may be involved, with the lead corporation agreeing to make good a certain percentage of any default.
In others, especially where the supply chain is very ‘sticky’s and the information flow is of high quality, this may not be necessary. In exceptional cases, to uphold their reputations, lead corporations have offered restitution even though not contractually obliged to do so.Credit uplift
Supply chain ‘stickiness’s doesn’t guarantee default-free business – inevitably there will be the occasional company that is determined to commit fraud and does not care about its supply chain relationship with the lead corporation.
However, experience to date certainly suggests that buyers and suppliers in a valued supply chain will exhibit appreciably lower default rates than would normally be expected from their formal credit rating or other financial data.
This notional credit uplift in turn improves the risk return profile and this, in turn, reduces the pricing for risk.
Even where a distributor runs into difficulties, a tripartite discussion usually takes place to determine the nature and extent of the problem. In many cases – especially among fast growth companies in emerging markets – working capital is often stressed and a cash flow mismatch results.
In such circumstances, if the basic business is still sound, some form of risk repackaging and support is often possible – thereby avoiding outright default.
New thinking, new clients
Providing working capital solutions focused on supply chain dynamics requires a shift in thinking that many banks will struggle to achieve – a conventional credit mindset has no place in this space.
Instead, a far more holistic approach is required that also involves aligning bank processes and mentality with the way the lead corporation and its supply chain function. A deep understanding of how the particular supply chain’s industry operates is also essential.
Adopting a supply chain approach also opens up the prospect of new or broader relationships between the bank and smaller companies in the supply chain. While the bank may have strong ties with the lead corporation, on a conventional bipartite basis it might only have minimal contact with its downstream or upstream buyers/suppliers.
Supply chain finance has the potential to change this – the bank encounters new potential customers and those customers encounter a range of services that might not have been available from their traditional banking partners.
Bridging both sides
Supply chains are becoming increasingly collaborative in nature, leading to much closer ties between buyers and suppliers. As companies focus on making their supply chains more competitive and aligned towards achieving both tactical (mostly operational) and strategic (working capital efficiencies, business support) objectives, they are increasingly also looking at bringing in other partners (such as banks) to extract value from their supply chains.
While supply chain financing has hitherto been largely seen in terms of post-shipment financing to suppliers, it is now rapidly evolving into deeper and broader solutions on both sides of the supply chain. Technology is a key enabler in this but not a goal in itself.
Traditional thinking around trade finance (especially post-shipment finance) is therefore increasingly being challenged by companies’s growing expectations of the banking community. Responding to those expectations will be a demanding task for many banks, but not necessarily an insurmountable barrier.
Already there are early signs that those banks that have corporate supply chain financing expertise may be looking to repackage this as ‘white label’s services for other financial institutions.
