22 McKinsey on Payments October 2010

Supply chain finance: From myth to reality

Trade finance is a cost-intensive and highly specialized business dominated by a small number of global . Given the scale and size traditionally required to compete in this highly specialized market, most banks have ignored in favor of more profitable businesses such as cash management and lending. But globalization and the new credit environment have changed the rules of the game. Long regarded by corporates as more myth than reality, (SCF) today offers banks a practical way to meet buyers’ and suppliers’ liquidity needs within a tighter regulatory framework. This article examines the evolution of sup- ply chain finance and discusses the strategic options available to banks seeking to play a role in this new model of trade and cash management services.

Nicolas Hurtrez Challenges facing traditional trade more than 85 percent of cross-border trade Massimo Gesua’ sive finance services transaction volume. Furthermore, Basel II Salvadori Trade finance revenues amount to barely guidelines do not recognize the short-term four to five percent of corporate banking self-liquidating nature of traditional trade fi- revenues. As small and medium size enter- nance instruments, resulting in dispropor- prises (SMEs) have become increasingly ac- tionately high capital costs. tive in international trade, the average value of transactions has decreased, but the docu- Trade finance is vital to economic mentary burden has stayed the same. Put- prosperity ting additional pressure on margins, more While banks struggle to protect trade fi- profitable large corporate customers have nance margins, trade services play a vital been shifting from letters of credit (L/Cs) role in economic growth. The inability to fi- and letters of guarantee (L/Gs) to open ac- nance trade contributed significantly to the counts, assuming the counterparty risk of unprecedented 25 percent drop in interna- their strategic trading partners. Despite a tional trade in 2009, as demonstrated by the surge in L/Cs following the crisis, the trend $250 billion G20 support package of April toward open account trade continues, par- 2009. Today, access to liquidity is still re- ticularly among OECD countries. According stricted. As a global head of trade finance to SWIFT, open accounts now make up observed recently, “Despite some corporates Supply chain finance: From myth to reality 23

now having full access to liquidity, others ward open source networks makes it possi- are still in a difficult situation because of ble to procure almost any good or service, banks’ continuing credit policy restrictions.” including , from anywhere Going forward, the implementation of Basel in the world, and banks need to set a clear III and post-crisis regulatory reforms will strategy to secure and optimize the value of raise the capital costs of asset-based strate- their trade and treasury services on the gies for banks, and consequently, the cost of basis of a more complex and integrated de- trade finance will remain a top strategic livery platform. concern for businesses of all sizes. Several SME owners have told us they now person- The evolution of supply chain finance ally look at trade finance issues and care- Corporates may be excused for once dis- fully consider the quality of trade services missing SCF as little more than myth, and when choosing a partner. Large corpo- bankers freely admit that each institution rates, meanwhile, have come to view the fi- has its own definition of SCF. However, the nancial health of their strategic partners as a various SCF programs available today re- primary operational risk but at the same flect one of three models, which have devel- time want to improve liquidity by delaying oped since the concept of SCF first appeared payment to these same suppliers as long as in supply chain literature in the early 1990s reasonably possible. (Exhibit 1). In light of these new economic realities, Introduced in the 1990s, the first model of supply chain finance may enable banks SCF combined domestic trade finance with both to increase the value of their trade supply chain management through an inno- (and treasury) services and improve corpo- vative invoice financing arrangement known rate liquidity. SCF, however, poses signifi- as “reverse ,” a three-way agree- cant competitive threats as well as ment by which the bank (or “factor”) pur- potentially huge opportunities for banks, chases the receivables of the supplier with large and small. The ongoing transition to- legal recourse to the buyer. In this earliest

Exhibit 1 Supply chain finance business models Supply chain finance has Geographic scope Domestic Cross-border expanded over Transition of time into a SCF over time broader set of 12Reverse factoring International reverse Buyer-led initiatives factoring integrated services enabling favorable Typically included with trade Financing receivables financing for finance services the suppliers Typically included with cash management services

Activity scope

3 Integrated platform Purchase order tracking Integrated services Invoice matching services/E-invoicing Open accounts payments End-to-end financing solutions including reverse factoring Source: McKinsey analysis 24 McKinsey on Payments October 2010

model, reverse factoring was purely a do- The third and most promising model is still mestic service offered within select indus- emerging and represents the holy grail of tries, especially the automotive sector. A SCF. Ultimately, the third model will inte- large, investment-grade company could ex- grate the pieces of the financial supply chain tend its days payables outstanding while al- from end to end, fully automating the buy- lowing its suppliers (typically smaller, less ers’ procure-to-pay and suppliers’ order-to- creditworthy companies) to reduce their cash cycles. This new level of integration days sales outstanding at a favorable rate. will support event-triggered financial serv- Thus, reverse factoring is a form of credit ices along the physical supply chain (e.g., arbitrage: by relying on the stronger credit purchase order tracking, invoice matching rating of the buyer, SME suppliers get liq- services, e-invoicing, open account pay- uidity at better terms. ments, import/export financing, reverse fac- The second model of SCF emerged as many toring) and afford full transparency into large companies began sourcing their raw each transaction. This transparency will materials from SMEs around the world. The allow liquidity providers (whether banks or key enabler here was the development of non-bank finance companies) to apply dy- technology platforms with two innovative namic pricing in purchasing outstanding in- features. First, these platforms connected all voices (e.g., the closer the goods to counterparties around the world, and sec- destination, the lower the pricing). The inte- ond, they made it possible for multiple gration of procurement, invoicing and fi- credit providers to connect and compete on nancing within a single platform represents financing, with the expectation that lower the full convergence of cash management cost receivables financing would attract and trade finance. more suppliers. A buyer (e.g., a large super- Win-Win-Win: Better liquidity, more market chain, acting as a hub) would re- efficient capital allocation quire its top 200 to 400 suppliers to connect SCF is a rare example of a tripartite value to a platform (typically supported by the proposition for banks, buyers and suppliers buyer’s bank) in order to receive faster pay- (Exhibit 2). First, it helps banks optimize ment at a favorable discount. use of capital by reducing the consumption Despite these innovations, participation in of risk-weighted assets, as counterparty risk SCF has never fulfilled expectations, due to a shifts to larger buyers with a better risk pro- number of inhibiting factors. First, legal and file (important in light of Basel III). Second, accounting standards in many countries do the credit differential among investment not recognize e-invoices and other electronic grade buyers and their SME suppliers is documents as legally binding. Second, the wide enough in the current funding market low cost of capital in the mid-2000s virtually to make the credit arbitrage of reverse fac- eliminated the marginal advantage of credit toring an attractive way to improve liquidity arbitrage between large corporate buyers for both buyers and suppliers. For example, and SME suppliers. Third, linking suppliers SCF programs allow buyers to extend pay- with banks’ proprietary platforms proved to ment terms from 60 to 120 days while pro- be cumbersome and expensive. While the viding suppliers access to better financing second model of SCF reached a modest level rates (e.g., 120 days at 100 bps instead of of success in previous years, the failure to 60 days at 500 bps). According to industry achieve critical mass has prompted many sources, SCF could unlock $100 billion to companies to abandon SCF programs. More $500 billion of liquidity by accelerating the recently, however, technological improve- for suppliers and ex- ments and the economic environment have tending days payables outstanding for buy- rekindled interest among suppliers, suggest- ers. Third, the more efficient, automated ing that the second model has the potential credit mechanism of SCF strengthens each to gain traction going forward. link of the supply chain, thus decreasing Supply chain finance: From myth to reality 25

Exhibit 2 SCF programs Benefits to buyer Benefits to supplier Benefits to bank provide significant Provides basis to negotiate Provides accelerated payment Increases profitability thanks improved commercial terms with option to lower capital requirement benefits to all suppliers (i.e., lengthening (especially in light of Basel III) parties involved payment terms) Provides alternate source of liquidity (e.g., off- Increases top line by supporting Improves vendor relationships financing such as securitization) clients’ entire supply chain from by providing access to new and end-to-end cheaper sources of funding Provides potentially better financing cost (depending on credit Builds stronger, more collaborative Reduces payment processing quality and industry) relationships with clients costs Provides visibility and facilitates Increases reach and profile of Enables better cash flow reconciliation of payments with trade and treasury organization management invoices (faster dispute manage- ment) Efficiency gains among clients create growth potential, leading Offers more predictable cash flows to expanded need for banking services

Source: McKinsey analysis

buyers’ operations risk. Finally, elimination finance and receivables management serv- of paper processing can reduce processing ices in conjunction with its cargo service. times of 30 to 60 days to approximately 10 These services have already contributed to days, enabling suppliers to offer better dis- the increasing globalization of supply counts for early payment. chains. Seeking to reduce costs and improve operating efficiency, many companies have From myth to reality outsourced management of their supply As of today, no bank has achieved such a chains to logistics experts. Similarly, SCF fully integrated supply chain solution. Most will allow corporates to unlock trapped liq- are still busy migrating their traditional do- uidities through automated financing at mestic platforms to cross-border standards. lower rates. Some of the established leaders in trade fi- Any bank that chooses to ignore the ongo- nance offer fragmented solutions but not ing evolution of SCF runs a risk of disinter- globally. In addition, a high hurdle separates mediation. By allowing bank and non-bank mythic vision from today’s reality: There is competitors to take their pick of preferred no common standard to enable the ex- services, from procurement to financing, change of data among different technology SCF could actually weaken the relationship platforms. SWIFT’s Trade Services Utility between banks and their corporate clients. initiative and its Bank Payment Obligations Indeed, in the best-case scenario, we expect aim to generate this link between purchase that as this market grows, big global banks orders and financial instruments but has yet will likely experience a loss of market share to win full buy-in from the industry.1 even as their trade services revenues grow. Meanwhile, non-bank players are leveraging recent technology innovations to position Launching a successful SCF program themselves as key participants in integrated In choosing a delivery platform for SCF, financial supply chain services, including the banks need to think carefully about where

1 For more on the remaining obstacles credit link. Ariba, for example, connects they want to play in the trade and treasury to financial supply chain integration, see buyers with suppliers; Prime Revenue, Or- services value chain. Some banks may seek “Who will drive B2B electronification, banks or technology providers?,” bian and Demica offer online access to fi- to consolidate a leadership position with a McKinsey on Payments, June 2010. nance providers; and UPS Capital offers comprehensive proprietary platform. Most 26 McKinsey on Payments October 2010

Trade finance glossary Trade finance incorporates highly specialized instruments to Forfaiting mitigate risk between trading partners. Traditional trade instru- The supplier sells a large, medium-term receivable at a discount ments such as letters of credit are document-heavy and require to the forfaiter “without recourse.” The supplier ships goods to the extensive manual processing, and cost-to-income ratios of 50 buyer and delivers documents to the forfaiter, who assumes the percent are typical in the trade finance business. Consequently, a risk of non-payment and handles collection. In distinction from small number of large banks (varying in scope from local to factoring, forfaiting contracts are made on a transaction basis global) dominate trade services, leveraging scale to establish cen- with suppliers (usually exporters) that sell capital goods, com- tralized processing operations. The following glossary of trade fi- modities or large projects with medium-term credit needs ranging nance terms provides an overview of traditional transactional and from 180 days up to 7 years. newer working capital solutions. Export financing Documentary collections (D/C) In pre-shipment export finance the bank provides a loan to the sup- The supplier entrusts collection of payment to the remitting (sup- plier (exporter) to finance the processing of goods to be delivered to plier’s) bank, which sends documents and instructions for pay- the buyer (importer) on the basis of a confirmed purchase order ment to the collecting (buyer’s) bank. The buyer pays the face and/or L/C. In post-shipment export finance the bank provides a amount either upon acceptance of documentation or at a speci- loan to the supplier against their export receivables for the period fied future date to the collecting bank, which transfers funds to between shipment of goods and receipt of payment from the buyer. the remitting bank. Credit insurance (CI) (L/C) CI protects an exporter of products or services against the risk of The buyer’s (issuing) bank makes payment to the supplier's bank, non-payment. CI generally covers commercial risks such as buyer with the supplier presenting documents confirming the shipment insolvency, bankruptcy or protracted defaults, and certain political of goods within a given time frame. L/Cs reduce the risk of non- risks, as well as currency inconvertibility, expropriation, and delivery for the buyer and guarantee payment to the supplier changes in import or export regulations. upon shipment. Supply chain finance (SCF) Letter of guarantee (L/G) SCF programs generally refer to bank-sponsored buyer-centric ini- Promise by the bank on behalf of a buyer to compensate a sup- tiatives using open accounts and providing liquidity to suppliers plier for any detriment suffered on the basis of the non-fulfillment through reverse factoring. of obligations. L/Gs protect the buyer against the commercial risks of non-fulfillment of the supplier’s obligations and reduce Trade-receivables-backed financing non-payment risk for the supplier. The supplier transfers accounts receivable assets, usually on a re- volving basis, to a special purpose vehicle, which issues notes Open account sold to investors through secondary distribution. This form of A standard arrangement with no third-party or guarantees in- can be beneficial to non-investment-grade volved. The seller presents an invoice to the buyer for goods deliv- medium-size suppliers, as the securitized assets are rated accord- ered. Suppliers are increasingly obtaining credit insurance to ing to the creditworthiness of the buyers, providing the supplier mitigate the non-payment risk. with liquidity at a lower cost of funds. Factoring Commodity inventory financing The supplier sells its short-term accounts receivables to the factor A form of structured finance in which the pledge of a commodity (a bank or specialized trade finance company) for cash at a dis- is used to improve credit terms. Funding techniques include pre- count on the face value. Factoring allows the supplier to offer export finance and inventory finance, and the lender is reim- open account terms and reduce days sale outstanding. bursed through the sale of the assets. Supply chain finance: From myth to reality 27

banks, however, will either partner with an- Key factors for successful other bank or third-party or pursue a combi- development of SCF business models nation of in-house development and external As a new delivery model for trade and partnership in order to focus on the pieces treasury services, SCF requires banks to best suited to their clients’ needs. The choice bring large corporates and SMEs on board depends in part on the financial institution’s through the development of new infra- size, footprint, IT capabilities and appetite structure, new value propositions and new for investment but also on its growth strat- sales and marketing strategies. To success- egy (e.g., targeting new outlets for lending or fully enter the space of cross-border reverse enhancing existing cash management offer- factoring services (Model 2), banks will ings with trade services) (Exhibit 3). need to: Any bank, regardless of size and ambition, 1. Ensure their footprint covers key trade must recognize current market expectations corridors: The trend of increased south- for openness. An open network (in which south, south-north trade is likely to inten- various credit and technology providers sify in the coming years. Banks will need serve the network of buyers and suppliers) to meet their clients’ growing needs in has the highest likelihood of attracting criti- more diverse and exotic locations, whether cal mass. Participating companies want to through partnerships with local institu- access trade finance from various providers, tions or increased physical footprint. not only the bank that serves as their pri- 2. Target relevant industries: Build participa- mary treasury services gateway. Conse- tion in segments where the bank has quently, we expect hybrid solutions to strong relationships, particularly those become the most popular. where demand for innovative solutions is

Exhibit 3 Option 1 Option 2 Option 3 Option 4 Banks should DEVELOP OUTSOURCE BUY HYBRID PLATFORM choose an SCF proprietary system to another bank from external vendor platform according Description Internal development or Bank-branded solution Open network platform Combine proprietary software licensing through private label (e.g., Prime Revenue, system with open to capabilities and agreement agreement Orbian, Demica) system(s) footprint Integrate cash management and trade finance functionalities (e.g., E-invoicing, Procure-to-Pay)

Prerequisites Large volume/scale Knowledgeable sales team Knowledgeable sales team Same as options 1 & 3 Global footprint Insourcing bank must meet Skilled technology workers clients' footprint Large, knowledgeable sales team Robust technology resources Ability to distribute risk to create adequate capacity on single risk

Bank Increase client stickiness Flexibility/scalability Increase speed-to-market Capture volume from clients already advantages Fully leverage own brand Access to suppliers Attract suppliers with participating in existing equity through global bank access to multiple banks open systems Full control of legal Focus resources on core Technical support and help Build volume with new framework strengths deploying solutions at participants on own suppliers Can insource/white label to No need to host platform platform other banks Focus technology Ability to structure hybrid resources on core programs strengths Source: McKinsey analysis 28 McKinsey on Payments October 2010

highest (e.g., industries where payment tions at various levels of the client organi- terms vary widely across the supply chain). zation. Benefits will be most readily per- 3. Secure participation of buyers first and ceived by the CFO and treasurer, but then help them onboard suppliers: SCF is issues of operational risk and supply a buyer-led concept. Banks should start chain management will engage the CEO by bringing the largest clients on board, and COO as well. Procurement officers who in turn attract suppliers. Multina- may mistakenly pay more attention to tional buyers have already been targeted price discounts obtained at the expense of by the leading trade finance banks, but in worse payment terms. Banks should pre- aggregate, mid-size corporations repre- pare sales staff, ideally specialists in fi- sent the largest potential for growth. nancial supply chain management, to Banks should invest significant time in educate people throughout the client or- facilitating the roll-out of programs, en- ganization about how SCF impacts their gaging cross-functional teams and ensur- duties and performance. ing CFO/CEO sponsorship on the * * * supplier side. The recent financial crisis brought the end To move to the next level of integrated SCF of cheap credit and diminished trust among services (Model 3), banks will also need to trading partners. On the upside, it has also ensure the following: created new opportunities and accelerated 1. Merge existing domestic cash manage- trends that could redraw the industry land- ment platforms with cross-border trade scape. Going forward, new regulations will systems: This will enable banks to track likely require banks to hold more capital the full supply chain across a single infra- against risk-weighted assets and companies structure and offer transactional and fi- expect to use credit arbitrage to manage liq- nancing services triggered automatically uidity costs. The new model for supply at key moments in the supply chain. chain finance opens the growing trade fi- nance market to a wide array of banks (and 2. Become 100 percent paperless: The elec- non-banks) eager to eat into the market tronification of all documents is the only share of the big global players. Banks of way to deliver a truly distinctive value various types and sizes can profit from sup- proposition to clients. Corporates should ply chain finance, provided they can craft be able to upload electronic invoices, the right strategy in an increasingly global L/Cs and L/Gs directly from their enter- and electronic market for cash management prise resource planning systems. and liquidity services. 3. Adopt the right coverage model: Banks should revamp their marketing and sales Nicolas Hurtrez is a consultant, model for transaction banking. SCF is a and Massimo Gesua’ sive Salvadori is an associate broad proposition with strategic implica- principal, both in the London office.