Author: Joseph Giarraputo
SUPPLYING SOLUTIONS
SUPPLY CHAIN FINANCE


At a recent roundtable in London, Global Finance brought together some of the pioneers in the rapidly growing supply chain finance business to discuss the growth of their industry and the impact of the credit crunch.


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Betts: Essentially, we are financing payables and receivables for working capital purposes.

GLOBAL FINANCE: Let’s start by explaining supply chain finance and open account.

ANDREW BETTS, global head of trade finance and supply chain, RBS/ABN AMRO Bank: Supply chain finance is about working with both the buyers and suppliers on international transactions. On the supply side it involves classic supply of financing, moving into purchase order financing and pre-shipment financing. On the buyer side it’s about seller receivables—and it is moving into models of distributed financing.

JOHN AHEARN,
global head of supply chain management for treasury and trade solutions, Citi: Open account is how probably 90%-95% of all commerce takes place today. The classic products that we’ve sold for years—letters of credit [L/Cs], documentary collections, etc.—really handle about 5%-10% of global trade. The rest of it is done on open account, which is based on the trust between a buyer and the seller that the seller is going to provide the right goods and the buyer will make the payment.

MIKE MCDONOUGH, global trade product management, The Bank of New York Mellon: Supply chain finance is essentially trade finance outside of the traditional letter-of-credit role. The transactional mechanisms can be very similar but without the legal backing of the letter of credit. We could see a move back toward letters of credit away from open account, though, as parties become more risk-averse. To a degree, that will be determined by how deep this credit crisis goes.

BETTS:
We will probably see an up-spike in the use of guarantees or in stand-by letters of credit as a way of managing risk within the supply chain.

GF: If the credit crunch prompts greater use of L/Cs, will global trade slow down?

AHEARN: As liquidity leaves the system from the banking and financial institution side, it is going to affect our corporate clients at some point. Second, as the subprime mortgage crisis continues to unwind, consumers are finding it harder to get credit, which in turn could hit the big-box retailers. Over the past few years there really haven’t been any high-profile bankruptcies outside of the financial sector, so there has been this feeling that risk doesn’t exist. As we start seeing some of the larger retailers get into financial trouble, the feeling that we are in a “riskless” world will rapidly change. And that will drive a return to letters of credit.

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McDonough: Trade finance is merging with all the things that corporate finance bankers have done for years.

McDONOUGH: Maybe that will speed trade up. People know how to work with letters of credit; they’ve been doing it for 100 years. Few businesses have moved 100% to open account so switching back would be a relatively easy matter.
BETTS: The impact we are seeing is around capital markets, where corporates would raise financing through securitization or other forms of commercial paper. That market is dry at the moment so we’re seeing, in fact, an up-spike in the focus on supply chain finance and in receivables and payables financing as a way of achieving working capital.

GF: How does supply chain finance help companies cope with tight credit conditions?

AHEARN: Working capital is the real driver for most of our customers. When liquidity was plentiful and cheap, most of the major US and European companies became lazy. They had a large amount of working capital trapped on their balance sheet, and now that it is harder to raise capital, they are looking at their DSO [days sales outstanding] and asking themselves, How many receivables am I carrying on my books? Is there a way I can shorten those numbers? Can I extend my DPO [days payable outstanding]? How quickly am I providing or paying my suppliers? And for DIO [days inventory outstanding], how much inventory am I holding on my balance sheet? By working those numbers, you can free up massive amounts of working capital. Dell’s online model is a prime example. When you ordered a Dell computer online, Dell would get the cash from you, day one. Its DSO was one to two days, maybe, depending on how the credit card company worked. Dell had no inventory—its entire inventory was held by downstream suppliers—so, in turn, Dell’s DIO was zero. Dell would then have the suppliers take on 120- to 180-day terms so its working capital or cash conversion cycle was a negative 178 days. It was generating “free cash” by just managing the supply chain.

McDONOUGH: That is one end of the scale, but there are many smaller banks around the world that don’t have access to these kinds of facilities and sources of expertise and are facing a different set of challenges in terms of supply chain offerings. They are starting to hear about it from their clients, but they may be ill-equipped to provide the kinds of services those clients are demanding.

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Ahearn: The real value the banks bring is intellectual property-working with your client to deploy the supply chain.

AHEARN: The supply chain market is fragmenting into the “haves” and “have-nots.” The banks that have the ability to put together cross-border solutions and to run the end-to-end side of it are seeing a dramatic uptake from their customers because their customers can’t get the capital from other sources as cheaply as they can from their own trapped working capital.

BETTS: The international network banks are strong on the trade finance and supply chain side. And now banks that are strong in their domestic markets are working together to provide virtual networks of finance to both buyers and suppliers. We’re also seeing more cooperation between the big banks where, say, some of the facilities required by corporates are too large for one bank to take. There is an increase in syndication and participation around the network.

McDONOUGH: It is early in the product cycle, and banks have to be absolutely certain of who they are partnering with, especially if they are going to provide any kind of exclusivity.

GF: What is the range of bank offerings included in supply chain finance? Which do companies find most useful, and how might this be changing?

McDONOUGH: It is changing dramatically. Banks have been feeling their way through the process, trying to decide what products will give the most value-added service to the market. Many customers have moved away from banks for supply chain and open account transactions because they want to avoid what they see as high costs on letter-of-credit products from the bank. To reintegrate themselves in the process, banks have to be able to provide holistic products at a cost that is attractive to the corporate. They are realizing that the best products that they can offer are information and financing.

BETTS: The key element is financing the supply chain, not the services part that wraps around it or the information that supports the transaction. First and foremost it’s a matter of credit. For Royal Bank of Scotland supply chain finance is a credit product, and it surrounds financing and the payables and receivables or the extended supply chain of our international clients.

AHEARN: For Citi it is a combination of four or five different products, which are embedded in a new group called TTS—Treasury and Trade Solutions. If you are looking at supply chain financing, it spans a myriad of products. It is information: Where is your cash? What are your future payments? What do you need cash for? What working capital assets are on your balance sheet that you can liquefy to increase the amount of the investments you want to make? Our products help clients dramatically improve their DSO. We’re also effective on the DPO side of the equation.

BETTS: Essentially, we are financing payables and receivables for working capital purposes, and it extends into pre-shipment financing and into distributor financing. There is a services element in the surrounding information around data and cash management that knits together very well. When I was at DHL, we looked into inventory financing extensively and found it is difficult to achieve off-balance-sheet accounting treatment. That is the major barrier to a sustainable solution. There are one-off transactions being done, but whether that is something we will be able to grow and develop and be a contributor to financial performance of companies going forward is doubtful at this stage.

AHEARN:
The credit crunch is creating another interesting scenario. Banks’ weighted average cost of capital [WACC] was theoretically much lower than most of our customers’, which made us a cheap source of capital. Recent events have pushed up the banks’ WACC dramatically, so we may not be the cheapest form of capital anymore. That is going to drive us to do much more in the capital markets to ensure we continue to have the lowest WACC; otherwise the game does not work. So that raises another interesting point. We’re transitioning from a classic trade services business to a supply chain finance business, which is a business in which we are seeing rapid uptake because of the credit crunch and which is now starting to push the trade finance and supply chain business into the capital markets.

BETTS: The move from traditional trade services to supply chain finance is prompting the creation of a structured trade finance proposition that connects through to the capital markets through syndication or core distribution and other capital market instruments.

McDONOUGH:
There is another product niche here, which is helping small and middle-size banks around the world get supply chain finance and open account finance products into the hands of their customers. We’re finding there is a lot of interest in our white labeled or private labeled products, which these banks use to garner that business from their clients.

AHEARN:
We’re looking at the ramifications of Basel II on the trade business because it demands that more capital be applied against the trade business than under Basel I. We’re working out how to help them get these new assets off the balance sheet.

BETTS:
The Basel II capital implications sit alongside the credit crisis as major challenges for banks in terms of financing clients through supply chain financing structures.

McDONOUGH: The ability to securitize for your clients depends upon their having a critical mass of business to begin with. We really have to walk them—in some cases guide them—through the process and work with them as they develop it. They have issues to deal with that we dealt with a long time ago, but they are just facing them now.

AHEARN:
It’s an opportunity for a whole new business model for us—an asset servicing business. When you start securitizing these assets, you have to build an infrastructure to make sure you stay within the parameters of the programs.

BETTS: Certainly the focus around trade asset management is growing. We’ve set up a trade asset management division, and asset servicing is part of that. It takes us into a different dimension than where we were, say, three to five years ago. It’s being fueled by the credit crunch, the uptake in supply chain financing and the Basel II implications, and it requires a different way of thinking.

McDONOUGH: Trade banking was always a comfortable business. Now, suddenly, we are becoming credit experts; we’re becoming documentation experts; we’re becoming consultative sales people. Trade finance is merging with all the things that corporate finance bankers have done for years.

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Giarraputo: There is a problem getting off-balance-sheet treatment for most supply chain finance offerings.

GF: There is a problem getting off-balance-sheet treatment for most supply chain finance offerings. Will this be a real impediment to growth, and how is it being addressed?

BETTS: Balance sheet treatment depends on the corporate—where they sit in the world and where they are regulated. In the international solutions I see there is an arm’s-length relationship between the bank and the buyer. Lending is clearly to the supplier.

AHEARN: The technology side of supply chain has become commoditized. It is not that expensive to buy a lot of these supply chain systems, but the real value the banks bring is intellectual property—working with your client to deploy the supply chain so that you understand the tax rule requirements for them, understand the off-balance-sheet treatment and understand the regulatory requirements.

McDONOUGH: The cost is often perceived to be dramatically high. People are often staying away from open accounts because they believe it’s expensive to get into. Changing that perception is something that banks can play a role in—showing partner banks or client banks that this really isn’t that expensive.

GF: Some corporates are concerned that supply-chain-finance benefits may be offset by increased administrative costs. Are systems sophisticated enough to avoid this? Can much of the administrative requirements of supply chain finance be outsourced to providers?

McDONOUGH: They can, but they are not outsourced often enough. A lot of corporate clients have been doing open accounts for years, so many of them have already set up the administrative departments to handle the process. Convincing players with that established capability that banks can do it better or cheaper is not easy.

AHEARN: In a way, corporates that exist in the letter-of-credit world have already outsourced the accounts payable function to their bank. As they move from letters of credit to open account, they re-insource the process. The real risk in supply chain finance is not the administrative cost; the technology has made this a fairly seamless process. It is more on the cost of goods sold. As payment terms are continuing to be pushed out, vendors may come back with an increased price.

BETTS: Administration issues are not a barrier to doing transactions. It is a credit-related decision ultimately. We take a consultative approach that blends trade financing expertise with procurement, sourcing and international logistics knowledge as well through a multi-disciplinary approach with people from within these industries. We want these clients to size the prize and then actually work through how we would deliver that together efficiently and how best it can be done.

AHEARN: It is more than just credit related; it is also an alignment issue. It can be a problem when the decision to improve working capital is made by the treasurer, but people lower down in the organizations might say, “Fine, but I’m not taking my vendor who I’ve had for 50 years and pushing them out another 45 days or another 30 days.” It’s a mismatch.

BETTS: More and more corporates have joined-up thinking between treasury and procurement. The liquidity squeeze is really driving that alignment within corporates. We need to work with corporates on credit receivables to improve the cash conversion cycle. It’s about driving top-line growth and leads into variations on distributive financing. These facilities tend to be very large, and the largest trade finance banks are looking to syndicate those out to the marketplace. That takes us more into the capital market world.

AHEARN: Interestingly, that is starting to drive us to much purer pricing. There has always been this concept of relationship pricing where we provide a service because we have a great relationship. But because these facilities are much larger and have to go into a secondary market, you have to get much purer on your pricing.

BETTS: We’re observing new entrants into that secondary market—hedge funds or pension funds that are showing new interest in these credit receivables.

GF: What’s being done to reduce the cost throughout the supply chain?

McDONOUGH: It’s all about automation and getting the technology right. It’s like the Betamax-VHS conundrum. If you buy the wrong technology, you are going to have to go back to your board to get that money all over again and buy the right technology. Getting it automated correctly is the best way to get the costs out of the system.

AHEARN: You are really starting to see a movement of clients to do much more electronically, to get the purchase order into the client’s hand electronically and have them be able to turn it into an invoice, bring it in, have it auto-reconciled and make a decision as to whether that invoice is compliant. From there we drop it into a supply chain finance vehicle to be able to finance that particular receivable. There is dramatic movement in that space. In domestic markets such as the US, most of the paper has been digitized, but now there is a focus on cross-border trade, which is more difficult. Swift and the EU are both talking about setting up global standards, so the next evolution will be able to do the cross-border trade in a digitized, electronic form.

BETTS:
Distribution costs remain a significant part of the product pricing, and through large contract logistics providers around the world there is a strong commitment to reduce overall cost in the supply chain. The aim is for large corporates to have an open-book relationship with their carrier, which will be driven by cost reduction year on year. There is also a lot of activity on procurement involving direct sourcing and taking out some of the intermediary costs involved in sourcing as well as a focus on inventory and holding costs. Another area is tax optimization and supply chains. Looking at markets such as Switzerland and Hungary and Ireland, where there is less tax efficiency for finished goods, there are substantial ways to reduce costs in the supply chain. Within banking there is a focus on automating the trade flow, and there is a financing aspect, which is looking at the cost of capital of the supply chains and financing a buyer or supplier to create those advantages.

McDONOUGH:
There are manual processes, though. I don’t know how you automate document examination as fully as many expect. Perhaps it is doable, but there will still be an element of manual processing.

GF: We hear about the physical and financial supply chains converging or integrating. What is really happening?

AHEARN: I don’t see the convergence. While our clients may talk to us about their physical supply chains, and it provides us very useful information that we can use to develop financing tools for them, we are not about to try to replace any one of their logistics providers; we just don’t have the core competency to do that.

McDONOUGH: The market would like the physical and financial supply chains to converge, but it’s harder than it sounds. There is no one-size-fits-all. We have to build our business model around the clients and the business base that we have. It is easy to say that they should converge, but getting it to happen may be expensive.

BETTS:
It is an emerging area. There is some convergence, with the banks understanding what is meaningful in terms of data and working with a logistics provider and what that will deliver. The logistics providers are understanding more about what banks do and how capital and credit decisions are made. Bringing those two together does create value, but it is very specific, it needs to be worked through very carefully with clients, and it is specifically about trigger points for financing. Both have their place, but one should not replace the other.

GF:
High commodity prices and oil costs are altering global trade. How are they affecting supply chain finance?

AHEARN: They’ve put a lot of pressure on the banking sector—maybe not necessarily the supply chain finance side. When the value of a cargo of oil rises from $20 million to around $60 million or $70 million, it puts significant strain on the banks’ cross-border and balance sheet limits, but it doesn’t alter how trade finance gets done; it just makes the transaction size much larger.

McDONOUGH:
It has created a credit risk that has worsened during the credit crisis because it has affected people’s risk tolerance. Some corporates looking to lower their risk thresholds are lowering the amount of open account transactions they’re doing and perhaps moving back to letters of credit.

BETTS: It has had an impact. For example, if you’re making a purchase of $50 million and the price has gone to $150 million, it puts immediate pressure on working capital. It’s a very practical issue, which traders are having to deal with. And as the cost of goods rises, it puts pressure on the retail sector, squeezing its profits. It has made a real impact on a number of areas that will be with us for some time.

GF:
Do companies care where they get supply chain financing from?

BETTS: In my experience, they tend to focus very much on their prior relationship banks, so that is the first place a corporate treasurer will go for supply chain financing.

AHEARN: The non-banks or the potential players in this space are actually leaving the market quite quickly. They are also going through their own liquidity crisis. We’re also seeing a lot of the transactions of which we would be the sole winner now being broken up among a range of banks because companies are diversifying away from just one institution.

McDONOUGH: A lot of corporates are getting pretty attractive proposals and transactional offerings from non-bank providers and from logistics companies. In some cases, they found them attractive enough that they have gone outside of their banking group to get those services. Banks have to work out how to get back into that space. How do you regain that market share and that client relationship in a business that has traditionally belonged to the banks?

AHEARN: I disagree. You hear about companies winning huge mandates, but while they may win the technology mandate, there has to be a bank or someone behind them providing financing.

BETTS: In tight credit times corporates want to stay very close to their primary banks. There has been a move to consolidate a number of banking relationships. Clearly, that is not continuing. A company may need a particular supply chain program, but they will look to their primary bank to organize the deal.

AHEARN: Yes, companies are now coming to us and saying, “We want you to take the lead, but we want you to bring our four or five other relationship banks in.” That’s fine with us because it helps spread the pool. I really haven’t seen many logistics companies putting their balance sheet up to finance the supply chain.

BETTS: Finance in the supply chain is very much a role for the banks, either the large international network banks or a consortium of strong domestic players.

GF: What does the future hold for supply chain finance?

McDONOUGH: It’s going to be inconsistent in the short term until there is some standardization. Once that gets settled—even somewhat—there is going to be much more growth potential in this market.

AHEARN: The future is incredibly bright. There is an opportunity for us to really claim the space and to really create a new business for ourselves and to show our clients incredible economies of scale. The only thing that has the potential to derail it will be how bad the credit crunch actually becomes. If the cost of capital continues to rise for financial institutions at a faster pace than it is rising for the corporates, it is going to be a difficult model for banks to execute.

BETTS: The world of trade finance is somewhat anti-typical. In tough times corporates tend to look at trade financing and the risk mitigation it brings as a way of actually managing through these difficult times. There is a body of knowledge now about structures that can and do work; there is a build-out of capability for large corporates in developed markets and an understanding of how to finance the mid-market company in some of the emerging markets. As a way of working, this will become even more ingrained in the corporate treasurer’s agenda, and I see a bright future for all parties.


Joseph Giarraputo