Determinants of Global Factoring

Growth of Factoring

Leora Klapper Financial Economist World Bank

Factoring services can be traced historically to Roman times. Closer to our own era, factors arose in England as early as the thirteenth century, as commissioned merchants for manufacturers in distant, unfamiliar markets. These factors relieved manufacturers of selling and credit collection responsibilities and specialised in assessing the market’s risk and collecting monies due. While demand for these services continues to contribute to the growth of factoring, the effective delivery of these services by individual firms is no longer the sole reason for the expansion of the industry. Examination for factoring as a world-wide phenomenon leads to the conclusion that a conducive and responsive legal environment may be of even greater importance to the growth of factoring at the beginning of the twenty-first century.

Globalisation

Today, total worldwide factoring volume is over US$500bn, an increase over the past five years of over 90%. One reason for the growth in factoring is that as global competition grows, businesses are less apt to demand payment at the date of or within a short time of delivery. Rather, firms are offering their customers increasingly attractive trade credit conditions, such as interest-free account payables at longer maturities. As a result, firms have a greater volume of account receivables to use for financing. Many factoring companies provide businesses with complete financial packages that combine: financing, administration (collection), risk bearing (credit protection), and cash management expertise. Demand for these services has increased as a greater number of good, "credit-worthy" customers turn to factoring to avoid the expense and burdensome paperwork associated with letters of credit and for the ability to purchase goods on open account terms.

For many businesses one of the most appealing benefits of factoring is the ability to enter overseas markets which would otherwise pose too great a credit risk. Businesses may employ a factor’s international expertise to offset the large geographic costs associated with international sales, such as their familiarities with foreign markets. When the dispersion of buyers is international, factors may provide additional services (though at a higher cost to the seller) like overseas collection and performing a credit analysis across legal requirements and languages. In addition, a factoring company may pay for trade account receivables in local currency and will burden (and discount) both the credit and the currency risk of the account receivables purchased.

Credit Risk Assessment

The use of factoring is beneficial when there are information asymmetries between a firm and its customers. As found in previous literature, such as Mian and Smith (1992) and Smith and Shnucker (1994), firms also factor account receivables in order to better manage their exposure to credit risk. In particular, a factor that specialises in an industry with many buyers and sellers may be able to pool information among sellers in order to offer firms a better credit portfolio of their customers. This suggests that firms incurring larger costs collecting information on the creditworthiness of its customers should be more likely to factor their account receivables. If that is true, this hypothesis suggests that factoring volume (as a percentage of total sales) should be higher in countries with greater information asymmetries. We should find that firms in countries with informationally opaque business environments give greater value to those financial intermediaries that perform credit analyses.

Factoring is particularly appealing in middle-income countries, where it is typically more difficult for firms to raise working capital. In middle-income countries, large information asymmetries between borrowers and lenders make it difficult and costly for firms to receive financing. In addition, many developing countries have weak bankruptcy and secured transaction laws which prohibits the use of collateral. Consequently, in general, firms receive financing contingent on their future expected cash flows. However, accounts receivable can be defined as expected cash flows to the firms independent of the firms’ business risks. This suggests that an additional incentive exists for firms in high-risk countries to sell their accounts receivable from high-quality customers, both domestically and internationally, as a source of short-term financing.

Economic Contributors to Factoring Volume

Because the growth of factoring has not been consistent across countries, regions , or zones of economic development, Ordinary Least Squares (OLS) statistical tests have been used to estimate the determinants of factoring volumes. The dependent variable is factoring volume as a percentage of GDP. The independent variables consist of samples of national macroeconomic and financial measures, such as per-capita GDP, exports, bank capital and legal characteristics (for example, the efficacy of secured transaction law and contract enforcement).

National economic indicators are found to be very significant in determining factoring volumes. Factoring levels are significantly higher in countries with a higher level of merchandise exports relative to GDP. This reflects the greater success of export-producing manufactures and the subsequent higher demand for international factoring. Factoring levels are also significantly higher in countries with greater total bank credit (as a percentage of GDP), even though real interest rates are insignificant. This suggests that factoring is not a substitute for bank lending but is determined instead by the demands of businesses for a service that banks cannot provide. In addition, factoring levels are significantly higher in countries with higher country sovereign debt ratings. A higher rating suggests overall confidence in the central bank and a sound and safe financial system, which implies an environment conducive to all types of lending. This highlights the fact that in certain environments factoring exists not as commonly understood as a substitute for ordinary lending, but as a supplementary source within a sound business environment. And finally, factoring levels as might be expected are significantly higher in lower income countries, where factoring is a relatively more important source of financing.

Legal Differences

Another important set of determinants of factoring turnover is differences across countries in laws and the effectiveness of their enforcement. These differences are not commonly thought of as an economic indicator and may, in fact, belong to the political realm. A second set of determinants of cross-country differences in factoring volume should be levels of judicial efficiency. These measures identify the ability of the courts to enforce contracts at a low cost, resolve disputes, and be free of political pressures, patronage lending, and corruption as typified by "cronyism". Judicial efficacy includes not only the written laws and regulations, but also the credibility and effectiveness of their enforcement. La Porta, et al. (1999) examine across-country differences in the quality of laws, regulations, and enforcement. They find that stronger judicial systems and investor protection encourage the development of financial markets and instruments and that countries which better protect creditors have larger credit markets.

Consistent with the findings of La Porta, et al. (1999), the ability of a factor to be able to assign receivables and have priority to the receivables in the case of the seller’s default is highly significant. In a survey that I conducted, I found greater factoring volumes in countries which permit the assignment of receivables. In addition, factoring volume is higher in countries that have secured transaction laws giving secured creditors priority in the case of default. In general, an increase in overall creditor rights and a legal system conducive to financial transactions are conducive to greater factoring levels.

The ability and credibility of a court system to enforce contracts also significantly increase the amount of factoring. In addition, factoring is highest in the OECD countries, reflecting their overall higher level of financial sector development. And factoring is lowest in transition economies where there is a lower development of legal systems and judicial efficiency. An infrastructure of a working judicial system is essential for the development of financial products. Finally, factoring is lower in countries with legal systems of Germanic origin (such as Germany, Austria, Japan, etc.) due to the restrictions on assignment. It may also reflect the dominance of the bank-oriented system in these countries. Since banks provide full-service credit options firms may be less likely to use traditional factoring services.

Conclusion

Factoring is an important financial instrument that has been gaining importance for some time and is likely to continue to be of great importance to developing economies for the foreseeable future. My research suggests that many elements contribute to the growth of factoring within individual economies, such as a large manufacturing sector and high percentage of exports. Ultimately, however, the presence of an efficient legal system may prove to be the single most important element fostering the growth of factoring. Factoring, as it is becoming clear, can only thrive in conjunction with a conducive legal framework and judicial support.

Bibliography

La Porta S., et al., 1999, Investor protection: Origins, consequences, reform, Financial Sector Discussion

Paper No. 1, The World Bank.

Mian S. and C. Smith, 1994, Accounts receivable management policy: Theory and evidence, The Journal of

Finance, 47(1), 169-200.
Smith J. and Schnucker, C., 1994, An empirical examination of the organisational structure: The economics of the factoring decision, The Journal of Corporate Finance: Contracting, "Governance and Organisation, 1(1), 119-138.

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