Arvind Rangarajan is an IIMC Alumnus (1989-91) and a retired banker. Roles include Head of Trade for Standard Chartered, India, and Head of Structuring for Deutsche Bank India and short-term consultant for World Bank. Other interests are distance running and translating old Tamil poetry.
Financial Ratios form the core of the commandments guiding the Loans and Bond markets of our day. Companies have to tread the balance between Debt and equity carefully. Borrow too much and the risk to the lenders forces up interest rates. Borrow too little and equity holders would punish the stock for poor yields. It is no secret then that financial controllers are always seeking the holy grail – money that is neither equity nor debt. Is this real? Welcome to the world of Factoring.
What is Factoring?
In the ancient world, Jesus had decreed Usury or the charging of interest as one of the seven deadly sins. In his divine comedy, Dante placed Scrovegni, the Paduan Money Lender, in the seventh hell. As the Catholic church searched for avenues to deploy the vast sums gained from the sale of indulgences, a new financial instrument evolved. Factoring or the purchase of Bills at a discount. Since no interest was paid, and the compensation could be attributed to exchange rate, the question of usury was side stepped. So, there is a hoary tradition in the west that facilitating the purchase of goods by buying bills or invoices (and charging costs) is a Trade Credit and not a loan. While accounting standards have been upgraded, there has been a tradition of not counting Trade credits as debt for purposes of the financial ratios. The ratio of Net Working Capital (or the sum of current assets less trade credits) to Sales has become a norm in evaluating a firms leverage and sales efficiency.
Factoring and the test of “True Sale”
When a company sells goods, it is usual to offer the buyer a few days to pay. In accounting terms, the sale has happened, and in place of the finished goods on the balance sheet, cash should appear. Instead, until the buyer pays, we have his “obligation to pay” or “receivable”. It is this right to receive cash from the buyer that financiers would purchase.
Consider the following income statement and balance sheet extracts of a company in Figure 1:
The best way to reduce the receivables is, of course, to collect them from the obligors and convert them to cash. But what if that is not feasible? This is where companies look to “sell” their receivables. The buyer of the receivables or “factor” is usually a bank or a financial institution. Modern accounting standards hold that where such receivable purchase is done on a “with recourse” basis, it is no different from a loan or other debt. If the purchase is “without recourse” and the seller of the receivable is not obliged to make good even if the obligor (Buyer of goods) defaults, it is not a debt on the book of the seller.
For the amount raised to be classified as not debt, the factor should have no right to return the receivable and seek repayment if the obligor does not pay. Additional signs of a true sale would be that the factor does not claim any overdue interest if the payment is delayed. IFRS 9 provides the accounting standards for asset derecognition from the balance sheet. It also provides small practical flexibilities. For instance, if the factor pays only 98 on a bill of 100 and charges a penalty for poor quality or late delivery, such setoffs are allowed to be made good by the seller to the factor without affecting the true sale test.
TReDS and the new era of Factoring in India
India too has had its waxing and waning enthusiasm for factoring. Indians invented Hundi, which could allow pilgrims to travel safely without carrying hard currencies. In India, the discounting of notes of hand was common practice over the last several centuries. The modern era has however seen Hundis fall into strong disfavor. Regulators view the flexible and fungible end-use as anathema and licensed institutions – banks and non-bank financial institutions are expressly forbidden from financing such instruments.
Evolving technology adoption has now allowed the GST network in India to track sales and verify invoices. A monthly GST collection of 1 lakh crores would imply a gross sales of about INR 10 lakh crores per month assuming a GST rate of 10% on average. This implies a need to fund receivables of between INR 30 and 40 lakh crores assuming a 90 to 120 day credit cycle on average for the organized sector. Current exposure to bills in the Banking sector is around INR 2 lakh crores (RBI 2021). Most of the gap in financing would fall on micro, small, and medium enterprises (MSME).
As a way to help MSME, the Reserve Bank of India (RBI) created Trade Receivables Discounting System (TReDS), an electronic platform to buy the receivables on a “without recourse” basis. Using TReDS, banks can buy receivables from MSME sellers after their buyers (obligors) have accepted the obligation to pay. This has the advantage of predicating the credit risk on buyers and helping MSME with liquidity without increasing their borrowings. To help lower costs, RBI mandated that all transactions on TReDS would qualify towards a bank’s priority sector obligations. This has effectively brought financing rates down to around 4%, even below the prime rate of the State Bank of India. TreDS hit a milestone of INR 2,000 crores a month of bills discounting in March 2021. This is minuscule when we compare it with INR 1,112 lakh crores of total bank financing in India (RBI 2021).
With defaults at historic highs, banks have had to become cautious when they assume the risk of obligors paying their dues on time. In Figure 2, the Viability Kite ABCD shows the limited market to which TreDS appeals. Area 1 (in red) has the receivables due from the best obligors. But the obligors find that they can usually raise money cheaper from capital markets and so there are usually only a few of these obligors although Banks would like to take this risk. Areas 2 and 3 represent a higher return for banks with an acceptable level of risk, and this is the area that contributes the bulk of the volumes currently seen in TreDS. The BBB and lower-rated obligors and their vendors are thus largely left out of factoring on TReDS. The low-risk appetite of the banks has left out the vast majority of BB- and BBB-rated obligors from the market.
It is with a view to changing this demand for higher risk obligors that the Indian Parliament passed the Factoring Act 2021, in August. It has since been notified in the official gazette.
Why pass a new Factoring Act?
There are today, only seven factoring companies in India. Unlike in other countries, India’s poor experience with verifying the genuineness of receivables and endemic problems around double financing of the same invoice has pushed RBI to have a separate category of Non-Bank Finance Company (NBFC) Factoring. These companies were hitherto required to focus on Factoring and ensure that at least 50% of their turnover and assets came from the purchase of Receivables (RBI 2016). Further, all trades had to be registered with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI, central registry) within 30 days (Standing Committee on Finance 2021). Thus, an institution that first registered the receivable in CERSAI is entitled to the cash flows when the obligor pays. The registration addresses the risk of who gets paid in the event of a double financing.
Still, NBFC sponsors found lending easier to manage than factoring. The requirement to focus on factoring to the exclusion of other lending opportunities led to the neglect of the sector. The new act seeks to amend this stipulation that factoring should constitute 50% of the business. If the threshold of 50% were lowered, a large number of the estimated 9,500 NBFC may register on TReDS and discount the receivables of higher risk obligors familiar to the NBFC. After all, NBFC and microfinance institutions have successfully evolved a model to lend to small borrowers in villages and towns who are usually not bankable.
Insurance
A further feature of the new Act is that it takes a policy decision allowing banks and financial institution to mitigate risk through credit insurance (Standing Committee on Finance 2021). Until 2010, banks and NBFC could take an insurance policy under which up to 85% of their exposure to the risk of default by obligors was insured. Like any insurance policy, there are complex terms and conditions, with the mandatory requirements of doing a basic due diligence and adhereing to internal credit guidelines. A series of defaults in 2010 and resultant large claims convinced the Insurance Regulator that insurers themselves poorly understood what they were insuring. Some insurers issued policies that were effectively a guarantee, with no strings attached. A ban on the use of credit insurance by banks and financial institutions followed in situations where they had no recourse to the Sellers (i.e., where True Sale applied).
The new Act seeks to now revisit this decision. The IRDAI has now issued final guidelines (IRDAI 2021). Banks and Factoring companies may now directly take trade credit insurance on their factored receivables. However, there are restrictions on insuring a single obligor except if the sellers are MSME. This will allow the insurance to be applied to TReDS and relatively poorly rated companies, with a good track record of payments, will now find their payables easily funded. (Many small companies with good financials can never get rated better than BBB simply because of size).
IRDAI had earlier permitted a trial transaction with insurance protection on TReDS. The idea once again is to enlarge the universe of viable obligors and pass on more credit into the hands of the MSME sector.
What the future holds
The Act mandates the linkage of the GST network to the TReDS so that invoices may be verified and any financing registered with a central registry. This would help cut down the risk of fake invoices and dual financing. But the way to make this happen is as yet unspecified. A Central registry that did not identify each transaction and each obligor and seller with a unique reference and thus track deals would be valueless. It seems difficult to enforce a national mandate of identifying and marking each and every invoice financed. Blockchain technology has a feature of being immutable – ( cant be changed) and this has prompted the TReDS platforms to adopt a blockchain based solution where an invoice presented in one exchange is notified to the others. The technology helps mask client details but the unique identification system helps ensure that the same invoice is not discounted on other exchanges. A similar approach may come into play with lenders and the central registry. A government sponsored blockchain protocol may however be necessary to convince people of the authenticity and reliability of the technology.
The financial treatment of a discounted receivable (on the books of the obligor) is also likely to remain confusing. If a bank has purchased a receivable, it is not seen as a debt of the obligor. By contrast, if a bank provides a loan to fund the obligor’s payables, it is a debt of the obligor. The effect on the cash position of the obligor is identical, but in the former situation, the obligor is held to a lower standard on debt-equity and other leverage ratios. Where auditors have insisted on treating the receivables confirmed on TReDS as “Acceptances” and included them under debt, some obligors stopped participating on TReDS even at the risk of paying a higher price to discount the payables in other, non-government-mandated platforms or using bilateral arrangements.
Bank refinance
Typically, true sale considerations prevent the factor from having any security. There is only a title to the receivables. The current RBI master circulars prescribe that banks may not refinance invoices discounted (which are unsecured) to NBFC except if the invoices are for the automobile sector (RBI 2013). This meant that any NBFC undertaking factoring would have to fund it through equity or capital markets and not rely on bank borrowings. Such restrictions are a major disincentive to factoring. The new Act recommends that factors should be granted a “specialized MSME funding entity” status (Standing Committee on Finance 2021).
Credit enhancement agreements
Today TReDS provides a highly subsidized source of funds because the receivables qualify as a priority sector lending for the bank participants. But an NBFC has no such requirement. The expected influx of NBFCs on TReDS would work best if there were a method for institutions to “accept” or underwrite the risk of buyer default without necessarily having to provide funding as well. Funding would come from people who need the priority sector benefit and pay a suitable price for it. Like in the stock exchanges, a system of margins and .guarantees from Banks can help mitigate the risk of NBFC who “accept” and find they cannot honor their commitment in case of default.
Conclusion
The new Factoring Act once again brings an ancient and oft-forgotten financing tool into the spotlight. This time around, the developments in data science, payment systems, and online KYC make for a much better prospect of expanding the product into the unbanked and under-banked segments of the Indian economy. In the nineties, commercial vehicles and their securitization were the hot favorite areas of growth. In the noughties, microfinance flowered. Will the twenties belong to factoring? Time will tell
References
IRDAI. 2021. IRDAI (Trade Credit Insurance) Guidelines Sep 2021. Available at https://www.irdai.gov.in/ADMINCMS/cms/whatsNew_Layout.aspx?page=PageNo4561&flag=1
RBI 2013. Master Circular – Bank Finance to Non-Banking Financial Companies (NBFCs).
RBI/2013-14/57 DBOD.BP.BC.No.6/21.04.172/2013-14 dated July 1, 2013. Available at https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=8115#5
RBI 2016. Master Circular – The Non-Banking Financial Company – Factors (Reserve Bank) Directions, 2012. RBI/2015-16/27 DNBR (PD) CC. No. 049/03.10.119 / 2015-16 July 01, 2015 (Updated as on April 11, 2016). Available at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/27MS4BD1673FA1DF4E7B93FEBBD02DFD5C92.PDF
RBI. 2021. Scheduled Banks’ Statement of Position in India as on Friday, August 13, 2021. Report dated August 27, 2021. Available at https://rbi.org.in/Scripts/BS_StatisticsDisplay.aspx?Id=427
Standing Committee on Finance. 2021. Twenty-Fourth Report of the Standing Committee on Finance on The Factoring Regulation (Amendment) Bill, 2020, Ministry of Finance (Department of Financial Services). Available at https://164.100.47.193/lsscommittee/Finance/17_Finance_24.pdf
Source
https://www.iimcal.ac.in/sites/all/files/pdfs/9_th_anniversary_issue_september_2021_.pdf