How the Credit Crisis Tested Supply Chain Finance

June 2007 – The Federal Open Market Committee votes to maintain its target federal funds rate at 5.25%

The summer of 2007 was the height of the credit boom for the US supply chain finance (SCF) market. The uncommitted structure of these programmes, their short terms, self-liquidating nature and pricing premium over traditional bank financing made these facilities extremely attractive to financial institutions. The SCF market had ample liquidity, characterised by intense competition. Most major banks had SCF programmes, were participating in third-party offerings or were invested in IT-based systems.

Companies interested in improving working capital saw a true value proposition in creating a SCF programme for their suppliers. By giving suppliers a tool to quickly convert their receivables to cash, buyers could negotiate longer payment terms and increase their days payable outstanding (DPO). More effectively matching payment terms to the number of days in inventory freed up cash for other purposes. Best in class companies had a growing realisation that the opportunities to extract operating efficiencies from the physical supply chain had peaked and that innovating the financial supply chain promised further improvements.

SCF programmes benefited suppliers by enabling them to quickly convert their receivables to cash at an attractive rate, thereby improving days sales outstanding (DSO), a key performance ratio. Notwithstanding their size or borrowing profile, suppliers sold their receivables to a third party at a discount rate based on the credit profile of the buyer, typically an investment grade company. There were strong incentives to join an SCF programme. Lenders made 100% financing available to suppliers on a non-recourse basis.

The combination of (a) excess liquidity in the banking system, (b) a trend among buyers to give suppliers a choice in SCF providers and (c) a rise in the number of global SCF players resulted in downward pressure on rates. The 2007 boom period is remembered for offering all-time low discount rates for SCF assets.

October 2008 – The Federal Open Market Committee votes to decrease its target federal funds rate by 50 basis points to 1%

By the autumn of 2008 the severe dislocation in credit markets led either to the collapse, forced merger or sidelining of numerous global institutions. As overall market liquidity contracted, banks reallocated the capital in many SCF programmes to support committed bank lines. The sheer size of SCF programmes (many over a billion dollars in aggregate) put a severe strain on the ability of SCF programmes to remain a reliable funding source for suppliers. Many companies suspended signing up new vendors and expanding programmes and instead focused on ensuring programmes had enough capacity to fund existing enrolled suppliers.

Small to medium-size suppliers, the bulk of the users of SCF programmes, relied on shrinking or increasingly expensive secured and unsecured bank credit lines to maintain viability. A number of conventional non-bank sources of receivables financing ceased to exist, entered receivership or significantly curtailed their activities. For some suppliers, higher borrowing costs resulted in higher prices to buyers. Many suppliers experienced disruptions in cash flow when the routine SCF payments they had come to rely on were suspended.

Banks with liquidity, operating well-managed SCF programmes provided real, material value to clients by continuing to fund the programmes. A number of traditional relationship banks with longtime, multiple client touch points and a diversified funding pool, successfully maintained the viability of their clients’ SCF programmes.

In a perfect intersection of the forces of supply and demand, the increased risk in the credit markets, along with reduced liquidity and greater supplier need resulted in pricing for SCF programmes steadily rising throughout the crisis period to dramatically higher rates.

August 2010 – The Federal Open Market Committee will maintain the target range for the federal funds rate at 0.0% to 0.25%

Today’s business climate continues to challenge small to medium-sized businesses. Capital remains scarce for certain industry sectors. We are seeing companies implementing short term tactics along with long term strategies to mitigate the risks to their supply chains.

Tactically, many buyers are expanding their use of purchasing cards and taking advantage of early payment discounts. Given the low interest rate environment, these options may generate a higher return on deployed cash for these companies.

Strategically, many companies are focusing attention on building collaborative relationships with key suppliers. There has been increased interest in providing reliable, buyer-centric and attractively priced SCF programmes. It is widely accepted that SCF programmes increase supplier loyalty, enhance goodwill and make buyers more valued customers. In turn, more suppliers advocate for an SCF choice from their customers to secure an alternate source of much needed working capital.

Post-crisis industry research provides evidence that a large number of companies are actively exploring SCF options. New trade finance instruments such as SWIFT’s bank payment obligation (BPO) are in trial. Online market places for the sale of receivables offer an alternative to buyer structured programmes. Increasingly prevalent social media and industry forums promote the benefits of SCF programmes. Technological improvements continue to create better, faster, less expensive products. Banks and IT groups that provide processing platforms constantly improve the interconnectivity between trading parties and expand the services they provide.

With increased due diligence and more stringent underwriting standards in place, investment grade companies are the primary beneficiaries for the liquidity returning to the market. In addition to the mainstay sources of capital, private equity firms and individual investors have begun to participate in the SCF market, an indication of the reduced risk perception of these assets. With the return of liquidity to the market and financial institutions eager for funded assets, discount rates over the past year have trended downward, considerably off their crisis highs.

Lessons and Opportunities

What are the lessons to be learned from the credit crisis? Prudent SCF providers should consider the uncommitted nature of these programmes and build in a cushion of availability above the actual programme spend. Additionally, providers need to diversify the sources of funding for SCF programmes giving thought to the size, geography and types of institutions (banks, insurance companies, hedge funds) that participate.

For buyers, there is a growing appreciation that supply chains need to be protected from the damage caused by strategic suppliers losing access to financing. As a result of the inability of some SCF programmes to purchase receivables for a period during the crisis, buyers were compelled to reduce payables terms. Buyers now appreciate the need for back-up liquidity to support their SCF programmes. While still seeking extended trade terms when considering implementing an SCF programme, many buyers are now equally motivated by providing reliable financing for suppliers.

Likewise, suppliers understand the importance of having multiple funding sources to provide protection in an economic downturn. Take up of SCF programmes is higher than before.

Financial institutions can thrive in the SCF market. Without question, SCF programmes have proven their value as a financing tool for buyers and suppliers looking to improve working capital and build collaborative relationships. SCF providers that continue to invest in their services with increased spend on technology, improved operating efficiencies, and streamlined supplier on-boarding can put their capital to work in a market that is poised for expansion as the overall market improves.

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