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 banks. Given the scale and size traditionally required to compete in this highly specialized market, most banks have ignored trade finance 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, supply chain finance (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 financial services, 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 bank 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 factoring,” 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 working capital 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- cash conversion cycle 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.