Supply Chain Finance: A Tool for Managing Suppliers’ Counterparty Risk

There has been a recent paradigm shift across supply chain managers around the world. Having spent the past 20 years building their supply chains according to the ‘just-in-time’ principle, many corporations are now considering how they can move instead towards a ‘just-in-case’ approach.

Risks and Dangers

It took a streak of unfortunate events to change the attitude of executives and consultants and it is now almost universally accepted that a completely stripped down supply chain, without any sort of redundancy and buffer, can be very efficient but also terribly dangerous. The one example that everybody now has in mind is the tragic tsunami in Japan, which caused the interruption of many automotive production lines. Even without disasters of this proportion, modern supply chains remain surprisingly fragile and exposed to the risk that key suppliers could stop their deliveries abruptly. When a few years ago in Mexico, a fire set out in a plant producing chips for mobile phones, nobody thought that two giants such as Ericsson and Nokia could experience a massive disruption in their value chains, but that is exactly what happened. This inevitably leads to the question: how can a supplier’s counterparty risk be properly addressed?

Supply chain risk management, which is now a popular discipline, is receiving more and more attention and it is becoming increasingly easier to justify initiatives and investments in the corporate world. Recent market observations have proven that a company stock price can suddenly lose up to 25% of its value following the interruption of its supply chain. This is fuelling a stream of projects, aimed at protecting corporates from such an occurrence, mainly by better assessing and diversifying the supplier base.

Bankruptcy and Financial Strength

Out of all the negative events that can affect the ability of a supplier to keep delivering, bankruptcy is probably the most manageable one to deal with. Over the years the financial service industry has developed a set of models and instruments that can be used to evaluate the financial health of a company. It is now an established best practice to review the financial stability of strategic vendors. Though accurate assessment alone, is not enough. During the economic crisis in 2009 nearly a third of large corporations in the western world were confronted with bankruptcy problems from their suppliers, regardless of how good or bad their previous appraisals had been. What corporations are really looking for is a way to proactively ensure that their suppliers can keep operating in healthy financial conditions, even when unpredictable incidents in their micro- or macro-economic world occur.

Thanks to the most advanced supply chain finance (SCF) techniques, corporates have found, and are now applying, an effective tool to manage an important component of their supply chain risk – when their suppliers run out of cash. Normally, an SCF programme comes as the first item at the top of the agenda, when a strong corporation decides to improve the financial resilience of its supplier base. This mechanism allows a bank to provide immediate liquidity to a supplier by purchasing the receivables confirmed by the buyer and allocating the entire risk to a solid buying entity and is proving to be a successful risk alleviator. In the midst of a sudden credit crunch, immediately after the Lehman bankruptcy, SCF succeeded in keeping many small companies alive, although most of their traditional credit lines vanished almost overnight. This saved entire industry sectors from an unfair collapse, since they had to face a sudden liquidity crisis that had nothing to do with the sound fundamentals of their business. SCF helped keep things in balance by following a very basic principle: as long as a supplier keeps delivering goods, regularly and in good quality, the buyer will confirm its invoices and feed the bank with this information, enabling an immediate financing payment to the supplier from the financial institution. A well-functioning SCF programme offers healthy industrial relationships a shelter against the storm of the financial markets, making sure that every party continues operating according to the expectations of the others.

SCF is now considered an integral part of the sourcing strategy of all forward-looking companies. The costs for shifting the sourcing of key components from one strategic vendor to a new one is simply too high, particularly when the partner has been involved in the design and development phases. Much smarter is the creation of a mutually reinforcing partnership, which gives both parties the confidence that their collaboration is solid enough to survive through the highs and lows of real-life business. One of the most authoritative and objective groups of experts in the matter, the international Supply Chain Council (SCC), summarised recently their view on the subject with a clear statement: “Financial collaboration between customers and suppliers never seems to lose.”

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