As the use of letters of credit declines worldwide, banks are devising other ways to help companies manage their financial supply chains
With global trade ballooning and companies looking for ever more efficient ways to fund and manage that trade, the world’s biggest banks are falling over themselves to find ways to help. Early last year, for example, Bank of America announced that it had integrated its supply chain financing technology with its “supplier outreach” services to enhance its trade payables discounting program, which helps customers finance payables throughout their supply chain and reduce demands on their working capital.
Citigroup has pinpointed “end-to-end treasury financial supply chain management” as an area where it can help companies develop a more “holistic picture” around the information, such as purchase orders and invoices, pertaining to movement and receipt of goods across borders. At Deutsche Bank, Marilyn Spearing, the newly appointed global head of trade finance and cash management, announced that as part of her new role she would focus on financial supply chain management and facilitating the flow of credit between importers and exporters, as well as enhanced risk management.
By entering the trading cycle earlier, Shaw says JPMorgan can provide companies with greater visibility into their trading processes, which leads to substantial cost savings. The bank claims to have achieved $2 billion in savings for its top 10 clients by streamlining their operations. It cites the example of a major US manufacturer that outsourced its global trade management operations to JPMorgan in order to better take advantage of duty minimization programs under preferential trade agreements such as NAFTA. According to JPMorgan, by outsourcing to the bank, the company achieved direct cost savings of more than $20 million.
Plugging Lost Revenues
Traditionally, banks’ involvement in companies’ supply chains was two or three steps removed from the purchasing decision and issuing of trade documents. It was only when it came to paying for the goods that the banks got involved by providing a letter of credit (LC). The LC was designed to protect both the exporter and the importer against the risk of non-payment by the buyer by transferring that risk to the issuing bank.
It’s a far from perfect system. Not only is it paper-intensive, but according to some estimates more than 50% of LCs are rejected on first presentation, resulting in costly delays. This, coupled with the fact that trade flows and company supply chains have become more sophisticated with the opening up of new markets and the sourcing of new suppliers via e-procurement, meant that trading partners started seeking alternatives to LCs.
Today an increasing amount of trade is conducted on an open account basis. Under this arrangement, the exporter simply relies on the good faith of the buyer. Although riskier, open account trading is less expensive and time-consuming than LCs and is eating away at banks’ traditional LC business. With that change came a new opportunity for banks to add value. “The LC was easier, as the bank just had to check the documents and release the money,” says Fritz Philipps, director of global transaction banking at Deutsche Bank. “With open account trading, corporates share the risk, which offers new opportunities for banks.” While banks like Deutsche have captured a sizeable chunk of the cross-border open account business, Philipps says it is not enough to replace revenues lost through the decline in LC business.
In the meantime, other opportunities for banks to add value to corporates’ financial supply chains emerged. Rising commodity prices meant that suppliers found it more costly to source raw materials. “Somebody has to finance the production and inventory,” says Philipps. At the same time, in some industries such as the retail sector, smaller suppliers are being squeezed by larger buyers wanting to push DPO (days payable outstanding) out to 90 days or more, which means suppliers are forced to obtain financing to cover their receivables.
“By delaying payment to a small or medium-size supplier, especially one based in an emerging market, the large corporate is forcing its supplier to finance those longer payment terms at a cost of funds that is usually much higher than the cost of funds available to the large corporate,” says Sarah Jones, CEO of SCF Capital, a supply-chain financing company. Jones says a measure such as DPO disregards the impact on a large corporate’s finances if a supplier has to raise prices in order to cover the cost of finance.
One way of overcoming this is to leverage the balance sheet and credit standing of the buyer to extend financing to the supplier. Philipps is not convinced all importers would want to use their balance sheet in this way. “It depends very much on the industry and whether the comfort level is high enough at an early stage in the supply chain to provide that level of commitment,” he says.
Shaw of JPMorgan believes there is an opportunity for the banks to add value by helping companies realize working capital gains earlier, which directly affects their cash balances. “If buyers are pushing out DPO, how can banks respond to that? Can we develop solutions that will allow customers to push out DPO but allow suppliers to get paid on time if not earlier?” he asks.
Philipps believes a number of supplier financing scenarios could emerge. One scenario is funding suppliers on the back of purchase orders. So, for example, if an Asian sneaker manufacturer gets a commitment from a top sporting goods manufacturer for an order in 2007, and that sporting goods provider is a customer of Deutsche Bank, the bank may be comfortable extending financing to the sneaker manufacturer to cover their receivables. “The risk for us to fund such a company is much lower knowing that they have this order,” Philipps explains.
Entering the Digital Age
Before banks or other financial services providers can determine whether a supplier requires financing to cover DPO, or a distributor needs working capital in order to buy more product, information pertaining to a particular trade needs to be “digitized” and “standardized,” says Jones. As a former treasury director for EMEA at Hewlett-Packard, Jones knows only too well the problems companies encounter when they are presented with incomplete information in their financial supply chain. While at HP she often received phone calls from regional shared service centers demanding more information from the banks so they could reconcile their bank statements. Jones believes digitizing and standardizing trade documentation, such as invoices, would lead to not only greater cost savings and efficiencies but also enhanced visibility into the complex web of relationships companies maintain with their suppliers.
Some progress is being made in this area, albeit at an individual bank and industry level. In conjunction with the Brussels-based banking co-operative SWIFT, major trade services banks have established the Trade Services Utility (TSU), which provides a central matching engine for standardizing the electronic exchange of information pertaining to purchase orders and invoices between banks. With the exception of the chemical and automotive industries, more than 75% of purchase orders in most industries are still paper-based. Shaw believes the TSU has a better chance of success than previous bank-led efforts at automating trade documentation, as it is focused just on the purchase order and the invoice, not a host of underlying trade documents.
Philipps says the TSU is a good way of facilitating the financing component in companies’ supply chains as well as the provision of information corporates need to better manage their receivables. Given that some supply chains are more complex than others, though, he says the TSU’s benefits may not extend to all industry sectors. Shaw acknowledges that the relationship between buyers and suppliers is complex and says that is why JPMorgan Chase has linked more products, including the Vastera acquisition, into its overall trade services solution so that it can help companies achieve greater visibility.
The banks may be convinced they are adding value, but some corporates are not so sure. “I think the banks understand the financing piece very well,” states Jones. “However, traditional banks have tried to sell financing products without understanding the real corporate drivers and objectives.”
In order to succeed in the corporate supply chain, Shaw says banks need to move out of their historical trade finance and cash management operational silos. “LCs are still going to be around, but there is a whole new market we are targeting,” he explains. “Some banks are looking at that market from a payment and settlement perspective, but there is a lot more than the payment here.”