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Fix the financing of supply chains

Alex Yang and others explore how market-led technology-enabled innovations could strengthen supply chain delivery

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Supply chains have been heavily featured in the news recently with respect to their disruption. However, getting products onto shelves requires not only the efficient operation of the physical supply chain, but also the underlying financing of supply chains, which are often unseen.

Recent research highlights the pivotal role of these financial arrangements, such as trade credit (supplier-extended credit to buyer), in a well-functioning supply chain. We find that government regulations that restrict the usage of trade credit, although well-intended, could reduce supply chain efficiency. Instead, market-led technology-enabled innovations may prove a better way to strengthen the supply chain.

For decades, supply chains were seen as a routine and unglamorous piece of economic plumbing. While supply chains are becoming more global, for the man and woman in the street, the complication and risk behind them were out of sight and out of mind. No longer. 

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As we enter an era of more supply volatility and rising financing costs, we need to work harder to better understand and manage the global supply chain.

Supply chain issues have become an umbrella term for a series of interruptions to the delivery of everything from energy and agricultural produce to items including indigestion tablets, computer chips and coffee. These “issues” are blamed variously on Brexit, Covid-19, and the Russian invasion of Ukraine.

Regardless of the reason, pointing fingers at current events does not solve the problem. As we enter an era of more supply volatility and rising financing costs, we need to work harder to better understand and manage the global supply chain.

A healthy supply chain requires not only the physical infrastructure and human capital that deliver physical products at the right time and place, but also the smooth financial flow that aligns incentives and facilitates procurement and sales.

The financing of supply chains is new. Trade credit, or delayed payments, have existed long before the invention of specialised financial institutions. Today, it is the most important source, financing more than 40% of global trade.

The near-universal prevalence of trade credit has been rationalised by a number of theories ranging from lowering transaction costs to sharing inventory risk. Despite these potential benefits, the practice of trade credit is far from perfect.

One main issue is that many companies are relating trade credit to market power and are demanding such credit amounts that are beyond reasonable use and delaying payments. This practice places a heavy financial burden on small and medium enterprises (SME) that endangers their survival and hinders their ability to create jobs.

 

Governments intervene to restrict the usage of trade credit, with mixed results

To ease the financial burden of extending trade credit on SMEs, in the last decade or so, political and regulatory reforms around the world have targeted trade credit and business payment behaviour. In 2008, the UK passed the Prompt Payment Code, encouraging firms to adopt a prompt payment culture. In 2011, the US Federal Government required all federal agencies to accelerate payments to small contractors, with a target of 15 days.

In the EU, France was the first to adopt regulation that directly restricted trade credit. In 2008, the French parliament instituted the Law on the Modernisation of the Economy (LME), which imposed a 60-day limit on trade credit terms for all French businesses, with limited exceptions. In 2012, the European Union, as a whole, followed France and set a 60-day limit.

These reforms are well-intended. However, whether they have achieved their intended purposes, and whether there are any unintended consequences, have been the focal questions of a stream of recent academic research.

On the positive side, one study focusing on the French trucking industry found that restricting trade credit usage indeed reduced liquidity risk and subsequent distress for smaller suppliers, and it lowered barriers to entry.

America’s QuickPay scheme produced more mixed results. Accelerated payment from the government to companies covered by the scheme encouraged employment in those firms, but it also “crowded out” firms that were not covered. The overall economic impact of the scheme was small.

A healthy level of inventory at each tier of the supply chain is essential to managing the various risks in the chain

More worrying evidence was seen in Chile, where the government restricted the length of payment terms that one large retailer could impose on smaller suppliers. In response, the retailer significantly reduced its trade volume with these small suppliers and chose to source more goods from within their own subsidiaries rather than from external suppliers.

 

Reducing inventory and harming financials: evidence from France retailers

Examining trade credit regulations through a supply chain lens, our recent research focused on a major investment in the supply chain – inventory. A healthy level of inventory at each tier of the supply chain is essential to managing the various risks in the chain that range from changes in customers’ taste to supplier disruptions. As such, inventory represents a substantial amount of investment for businesses. For example, among public retailers, inventory accounts for more than one third of their total assets.

The linkage between trade credit and inventory is intuitive: by providing trade credit, the seller shares the buyer’s inventory cost and risk, which would otherwise be borne solely by the buyer. Such sharing incentivizes the buyer to hold a higher level of inventory, which, in turn, would better serve customer demand and eventually not only increase the seller’s own sales, but also benefit the entire supply chain. Therefore, restricting trade credit usage below the equilibrium level may undermine this link and lead to under-investment in inventory and subsequently impaired supply-chain performance. Could such a phenomenon be observed because of the recent restrictions on trade credit?

 

To quantify this impact, we focused on France’s LME, which restricted the trade credit duration to 60 days for most French firms. In order to isolate the impact of the legislation, it is necessary to identify a set of control firms that were comparable in all respects except for their exposure to the LME. Given that most French firms were subject to the new legislation, we combined companies from other EU countries to create comparable synthetic “twins” of each French firm.

Furthermore, we sought to eliminate the potential impact of other confounding factors (such as the 2008 Global Financial Crisis) that might have affected French businesses differently from their non-French counterparts. Specifically, we use a subset of French companies and their respective European “twins” that were unaffected by the LME (their trade credit usage was already below the 60-day threshold) as a baseline for calculating a relative effect that is free of confounding factors.

We found that the LME had a significant impact on retailers’ inventory investment. Taking hardware retailers as an example, the LME caused a 16 percent decline in trade credit, which subsequently led to an 11 percent reduction in inventory.

A drop in inventory is not only going to lead to emptier shelves and more unsatisfied customers, but also hurt retailers’ financial performance. Indeed, we observed a 15 percent drop in revenue and a 3 percent decline in gross profit for retailers due to trade credit restrictions.


Supply Chain FinTech: Potential and Challenges

As our research shows, government regulations that directly limit the use of trade credit are not the panacea. In fact, one advantage of trade credit is that it is deeply integrated in supply chain transactions and allows for more flexible allocation of working capital among different stakeholders. Rigid government regulation kills such flexibility.

Instead, we argue for a market-based approach that incorporates “supply-chain fintech”, which uses digital technologies to facilitate the financial flows in the supply chain. By enabling better visibility and pricing flexibility, supply chain fintech could not only better incentivize large companies to pay their suppliers when the latter need capital, but also tackle other challenges in trade finance.

For example, one headache faced by credit-starved SMEs is that banks or their large suppliers do not lend to them. The Asian Development Bank estimated the global “trade finance gap” sits at $1.7 trillion, with small and medium-sized enterprises accounting for half of the total.

Reasons for this finance gap vary: lack of collateral; information asymmetry regarding the condition of the would-be borrower; regulatory requirements that are hard for lenders to fulfil, such as know-you-customer; and low profitability.

Digital technologies could help overcome these difficulties. Internet-of-things could help monitor inventory, allowing companies to unlock their collateral value. Blockchain-based consortiums are working on breaking information silos and providing end-to-end supply chain visibility. Finally, big data and analytics offer the potential to better identify supply chain stakeholders in need of credit and assess their risk.

Offering such suggestions inevitably brings to mind the 2021 collapse of Greensill, the supply-chain-finance business that engaged, among others, former British Prime Minister David Cameron. The collapse of Greensill, however, was a failure of neither trade finance in general nor technology in particular, but of risk management and corporate ethics.

Healthy financial flows in supply chains have become more important than ever for local and global economies

In fact, some innovations that Greensill participated in, such as the Pharmacy Early Payment System (PEPS), have their own merits. Leveraging predictive algorithms, the PEPS enabled UK pharmacies to receive payment before their expenses are reimbursed by the NHS. The error stemmed from Greensill extrapolating this idea to allowing aggressive businesses to receive financing based on “future receivables”. However, it was premature for the UK government to abruptly end the practice of PEPS without a comprehensive review of its operational and social implications.

As with most financial innovation, supply chain fintech requires more sophisticated risk management. Even more, it requires a deeper understanding of how supply chains operate. Without understanding how such solutions affect business operations, we could fall into the same trap as government regulators in disrupting the invisible flows that serve as the backbone of supply chains.

We have come a long way since the introduction of trade credit. Healthy financial flows in supply chains have become more important than ever for local and global economies. The future of the financial supply chain should be empowered by technology, not confined by stricter regulation.

 

Alex Yang is an Associate Professor of Management Science and Operations at London Business School.

Nitish Jain is an Assistant Professor of Management Science and Operations at London Business School.

Christopher Chen is an assistant professor of Kelley Business School, Indiana University Bloomington, and received his PhD from LBS in 2019.