Will Reverse Factoring cause the next bubble?

Alejandro Serrano, a professor of Supply Chain Management in the MIT-Zaragoza International Logistics Program and Spyros Lekkakos is a doctoral candidate in the same program recently penned a post on reverse factoring causing a bubble.

Recall Reverse Factoring is a financial arrangement where banks or non banks use a favorable credit rating of large, solid buyers to secure Libor or Euribor priced money for suppliers.

Their argument had several flaws.

Flaw 1: These programs are for cash-starved suppliers

Reverse Factoring programs are typically targeted at large spend suppliers (eg. greater than $25 million) for several reasons. One the cost of onboarding, see Supplier Onboarding – Don’t shortshift Execution  Two, in order to generate any returns, banks or funders need scale. They are not interested in financing SMEs with this model.

Flaw 2: If a buyer failed to meet its obligations, weak suppliers could go under.

First, since Reverse Factoring programs have been initiated, anecdotally talking to bankers there has never been a loss. There certainly have been issues with supplier insolvency and offsets that can occur, and contractually buyers are still on the hook. But given the fact that these programs are targeted at the Investment grade or near investment grade, the probability of default is extremely low.

Second, based on flaw #1, these programs are typically offered to much larger companies, not SMEs.

Third, SMEs fail all the time. That is the nature of “creative destruction” popularized by economist Joseph Schumpeter.

Flaw 3: As Reverse Factoring vehicles become more established they could be extended to sub-investment-grade buyers, compounding the risk of defaults.

Many funding providers are interested in bringing reverse factoring programs downstream. But I have written that this is both not easy and will not scale in a big way. You just dont have the credit arbitrage opportunities for one. See Will Trade Payable Finance programs move downstream?

Flaw 4: Reverse factoring can raise the risk profile of supply chains to dangerous levels, and could even cause a systematic financial failure.

This is really throwing the baby out with the bathwater. This is not a new credit product that is just growing during good times, only to crash in the next recession because of high credit losses. And we are not talking subprime or even Marketplace lending, where there are huge incentives to grow a book by Independent Sales Agents with no skin in the game other than commissions.

These programs have been running successfully for well over 15 years, and while focused on a specific segment of credit, are not going to bring the markets tumbling down as these authors suggest.

You could also argue that ordinary factoring has in general not been profitable in emerging markets. First, it is hard to find good historical credit information on SMEs. Second, fraud is a big problem in this industry – bogus receivables, non-existing customers, etc. – and a weak legal environment and non-electronic business registries and credit bureaus make it more difficult to identify these problems.   While factors can buy receivables “with recourse”, which means that the seller is accountable in the case that a buyer does not pay its invoice, however if the supplier defaults, you may not recover.

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