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Supplying Finance to Supply Chains

Research at HKUST informs the debate about the benefits of uniform financial regulation across countries and looks into the effects of the financial intermediation in facilitating international trade.

By Associate Professor Alminas ZALDOKAS (left) and Assistant Professor Emilio BISETTI, Department of Finance at HKUST Business School

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International trade relationships often involve importing firms paying their suppliers with a delay. However suppliers, and especially small suppliers from emerging countries, require funding to invest in production. Their local financial markets and credit institutions might be cautious in providing such funding, especially in the presence of information asymmetries about the stability of the relationships with international importers and their overall willingness to pay.

Letters of credit, the traditional solutions to supply chain financing, are promises of payment between the importer’s bank and the supplier’s bank sent before the importer receives the goods, typically in exchange for shipping-related documents. Large international importers ask their banks to issue letters of credit to their foreign suppliers, which the suppliers can redeem with their local banks upon presentation of bills of lading. An alternative solution, factoring, would involve a third party (a factor, often a non-banking company) who would also buy the importer’s invoices at a discount.

While letters of credit and factoring allow suppliers to receive upfront cash, and to finance their operations before importers receive the goods, such solutions are expensive both in terms of financing and the related transaction costs of validating the letters of credit paperwork. Sellers end up being charged double-digit rates for passing their receivables to their banks or factors. 

Recently, new forms of supply chain financing such as reverse factoring have emerged as cheaper alternatives to traditional letters of credit and factoring in international trade finance. The key innovation of reverse factoring is that in reverse factoring transactions a large creditworthy importer (e.g., Walmart) initiates its own scheme with its international bank (e.g., Bank of America). The international bank then offers the importer’s suppliers from foreign countries to buy the importer’s trade credit from them. Effectively, the importer’s bank extends credit to the suppliers directly. In this way, small, credit-constrained suppliers can have access to cheap funding by taking advantage of the low cost of capital of their international customers: Instead of paying double-digit rates to advance accounts receivables, reverse factoring can cost international suppliers as little as a 1 to 2 percent margin over the benchmark rate.

Due diligence

While in theory reverse factoring provides significant advantages in relaxing small exporters’ credit constraints, regulators worry that such transactions might be used as a channel to move illegal funds across international borders. As a result, international banks are mandated to perform thorough due diligence of foreign suppliers to be allowed to provide reverse factoring. When the supplier’s country does not have strong Anti-Money Laundering (AML) and Know-Your-Client (KYC) regulations, even with the importer validating the supplier, international banks’ due diligence costs may be too high, and prevent banks from providing supply chain financing altogether. Put differently, Bank of America might agree to provide reverse factoring schemes only for Walmart’s suppliers coming from tightly-regulated countries, thus constraining the formation of supplier-customer links.

In an effort to relieve the burden of due diligence from international financial institutions and stimulate trade, international institutions such as the Asian Development Bank (ADB) and industry practitioners have been calling for the implementation of a uniform AML/KYC regulatory framework worldwide. This call for uniform regulation is particularly loud in Southeast Asia, a region with both high trade volumes and dispersed regulation. 

Strengthening regulations

Indeed, while typical AML provisions include, among others, the mandatory reporting and recordkeeping of suspicious transactions, the presence of a criminal offence for money laundering, and provisions limiting secrecy for financial institutions, these provisions display substantial heterogeneity across Southeast Asian countries, both in terms of their strength and in terms of their enforcement. For instance, looking at the compliance with around 40 AML/KYC requirements from the Financial Action Task Force (FATF) mutual evaluation reports (MERs) in 2019 and 2020, Malaysia was rated compliant or largely compliant on 38 out of 40 criteria, while Myanmar was rated compliant or largely compliant only on 20 out of 40 criteria.1 

In an ongoing research project, we ask whether strengthening AML/KYC regulations can stimulate the formation of supply-customer relationships between South-East Asian exporters and foreign importers. The answer to this question is not immediately clear. On the one hand, tight AML regulations may stimulate credit provision by foreign banks and relieve small suppliers’ financial constraints. On the other hand, the implementation of uniform regulations may be distortionary when countries differ in their institutional environment and economic conditions. Indeed, in the 2016 Trade Finance Gaps, Growth, and Jobs Survey conducted by the ADB,  banks claimed that AML/KYC regulations are the most restricting factor for them to provide trade financing services across borders (Di Caprio, Beck, Yao, and Khan, 2016)2. Moreover, competition by international banks may drive local banks out of business, with possible adverse consequences for local economies. 

To study the impact of AML/KYC regulations on international supply chain relationships, we have collected and organized data on the implementation of these regulations in Southeast Asia over the past ten years. While the strengthening of these laws has been gradual, for each country in the region we have identified one year in which the AML/KYC regulations were particularly strengthened. Our overall sample consists of 40 countries in the Asia-Pacific region, and we found that eight South-East Asian countries and regions – Bangladesh, India, Indonesia, Myanmar, Malaysia, Thailand, Cambodia, and Hong Kong – radically strengthened their AML/KYC regulations between 2010 and 2015.

Positive effects 

Exploiting granular international supplier-customer transactions between 2007 and 2018, we study whether an increase in the strictness of AML/KYC laws in a country is followed by changes in the structure of supply chain networks for that country, i.e., whether new supply chain relationships are formed or broken. To make a concrete example, we ask whether Thailand’s Anti-Money Laundering Act of 2015 increased or decreased the number of supply chain relationships between Thailand and the foreign countries.

Our preliminary evidence suggests that tight AML/KYC regulations have a positive effect on supply chain formation. In Figure 1, we show that, in the years surrounding an AML/KYC law change in South-East Asia, on average every second international firm added one extra supplier from countries that tightened their AML/KYC regulations, relative to other South-East Asian countries that did not change their AML/KYC laws around the same time. 

Datasource: Factset Revere, period 2007-2018, Southeast Asian countries

Our results shed light on a relatively unexplored issue in academic finance – the role played by international banks in the intermediation of international supply chains. With this, this project aims to inform the current debate on the costs and benefits of uniform financial regulation across countries. Our findings suggest that ensuring smooth intermediation with strengthening financial regulation might improve, rather than hinder, real international trade flows. Thus policymakers should take into account the effects beyond the direct effects on local banking markets when considering strengthening AML/KYC regulations.

Supply chain financing has attracted media and policymaker attention recently with the collapse of Greensill Capital, a specialized lender. This controversial event further highlights the need for robust financial intermediation to soften other frictions that restrict international trade, such as possible post-pandemic restructuring of supply chains and crumbling trade liberalization.

1. The Asia/Pacific Group on Money Laundering (APG), Malaysia’s MER 3rd Enhanced Follow-Up Report from 2019 and Myanmar’s 2nd Follow-Up Report from 2020
2. Alisa Di Caprio, Steven Beck, Ying Yao, and Fahad Kahn, 2016 Trade Finance Gaps, Growth, and Jobs Survey, ADB Briefs