Long-term plans for short-term trade finance in Ukraine
An innovative two-day seminar in Kiev brought together the regulator (National Bank of Ukraine), the world’s largest factoring association, FCI, and EBRD partner banks in Ukraine
In February 2018 the TFP team organised two days of training and panel discussions among key trade finance players and was the first training jointly funded by the NBU, FCI and EBRD. Many aspects of factoring were discussed, and we summarise them below.
Factoring is on the up
First, factoring continues to grow in both mature and emerging markets. Through their control methods and permanent monitoring of the receivables on their clients’ debtors, factoring companies or factoring divisions of banks are able to provide more financing than traditional lenders, and at the same time limit their credit risks to a strict minimum.
Factoring could become very useful for small and medium-sized enterprises (SMEs) and larger companies alike; it could be a good way to mitigate risks (risk protection) or to increase cash flows and “outsource” labour-intensive administration (including debt collection).
It may also be particularly attractive in financial systems with weak commercial laws and enforcement.
As with traditional forms of commercial lending, factoring provides SMEs with working capital financing.
But unlike traditional forms of such financing, factoring involves the outright purchase of the accounts receivable by the factor, rather than the collateralisation of a loan.
It is also quite distinct from traditional forms of commercial lending where credit is primarily underwritten based on the creditworthiness of the seller rather than the value of the seller’s underlying assets.
In a traditional lending relationship, the lender looks to collateral only as a secondary source of repayment. The primary source of repayment is the seller itself and its viability as an ongoing entity.
In the case of factoring, the seller’s viability and creditworthiness, though not irrelevant, are only of secondary underwriting importance. In factoring, the underlying assets are the seller’s accounts receivable, which are purchased by the factor.
What is factoring?
Factoring is a complete financial package that combines working capital financing, credit risk protection, and accounts receivable book-keeping and collection services. It is offered under an agreement between the “factor” and the seller.
Challenges must be overcome
Factoring only requires the legal environment to sell, or assign, accounts receivables and it doesn’t depend on good collateral laws or efficient judicial systems as much as traditional lending products do.
However, in Ukraine local legislation needs to be adjusted to align with international practices to allow factoring products to grow successfully.
Factoring may still be hampered by weak contract enforcement institutions and other tax, legal and regulatory impediments. Weaker governance structures may also create additional barriers to the collection of receivables in developing countries.
There are also a number of additional taxation, legal and regulatory challenges to factoring in many emerging markets. For instance, the tax treatment of factoring transactions often makes factoring prohibitively expensive.
Some countries that allow interest payments to banks to be tax deductible do not apply the same deduction to the interest on factoring arrangements.
What is more, VAT taxes may be charged on the entire transaction (not just the service fee), and stamp taxes may be applied to each factored receivables. Capital controls may also prevent non-banks from holding foreign currency accounts for cross-border assignments.
The legal and judicial environment may also play a critical role in determining the success of factoring.
A key legal issue is whether a financial system’s commercial law recognises factoring as a sale and purchase.
Another legal issue is whether a country has a Factoring Act or a reference in the law (or civil code) that legally recognises factoring as a financial service.
This recognition serves multiple purposes. First, it clarifies the nature of the transaction itself. For example, a Factoring Act explicitly dictates how judges must rule towards factors if sellers or customers default. And second, it legitimises the factoring industry; a supportive legal and regulatory environment encourages the factoring industry to grow.
A weak information infrastructure may also be problematic for factors. The general lack of data on payment performance, such as the kind of information that is collected by public or private credit bureaus or by factors themselves, can discourage factoring.
Factoring is, in risk terminology, a low loss given default (LGD) solution, providing the opportunity for safe, secure funding in an increasingly risk-aware regulatory environment. It offers a unique combination of meeting user, provider and regulator stakeholder needs simultaneously and so is a real win-win in business finance.
The EBRD-led factoring working group will collaborate with colleagues in Ukraine to update legislation, train local banks and work with the regulator, government bodies and SMEs to facilitate trade finance.
As a Bank we will continue working on new legislation in Ukraine that aims to distinguish factoring operations from collection activity and bad loan portfolio management.
Legal issues, restrictive regulation and low market awareness of the product are the reasons why “pure” factoring operations are stagnating in Ukraine (less than 0.1 per cent of GDP).
Therefore, with a target of 3.5 per cent of GDP (the average for emerging markets), factoring has huge potential to generate UAH 100 billion (€34.1 million) of additional short-term funding to local trade and production firms, particularly SMEs.
With the success of this workshop in Ukraine, more training is set to be offered in due course.
In Ukraine local legislation needs to be adjusted to align with international practices to allow factoring products to grow successfully.