How Can Basel Framework Better Be Adjusted for SME?

The Basel Framework is based on the idea that arm's-length banking and automated risk management (using more or less sophisticated algorithms) are superior to tacit knowledge from bankers, relationship banking and social collateral. It comes from the belief that detailed social engineering works and that society can be micro managed by super bureaucrats creating rules and procedures for everyone to follow. But it has been tried for decades and failed over and over. It just does not work. 

One must instead dare to trust each woman and man's own judgment and delegate responsibilities. I have read papers claiming relationship banking creates less credit losses, but so far found none claiming arm's-length banking does the same. Changing the perspectives of the Basel Framework is paramount for making the financial system the enabler of growth. Relationship bankers having close and long term relations to the SME creates a much more sound financial system based on capital requirements, social collateral, local bankers' judgment and debt levels in relation to the production of products and services. The Basel Framework's arm's-length mentality has instead provided a mindset of trading and growing debt by financial institutions far away from the real economy. Add absurd bonuses and you create a scenario for a public wanting revolution of the financial system and the scalps of some bankers.

Support of SME is In the Role of Central Banks

I have on several occasions highlighted many of the problems with the present regulatory platform for the financial industry, in particular the Basel Framework soon on its third version. In general I have no problem with capital requirements and risk management and that we need regulation for it. However it has to come from the correct perspective. The Basel Framework was created in the 80-ties during deregulation of the financial markets, mainly the credit markets, which came as a natural consequence of president Nixon abolishing Bretton Woods in 1971.  

The perspective of the Basel Framework:

1. Banks shall be protected at all costs. No banks shall be able to default. There shall be no run on banks.

2. Corporate lending is dangerous and therefore shall be restricted in the banks' balance sheets. 

3. Sovereign risk and real estate mortgage is very low risk and should therefore be incentivized for the banks to invest in.

What have we seen:

1. Banks do go bust. There are still run on banks and financial institutions, e.g. Lehmann Brothers. It is not possible to regulate away bad management. We also saw big flaws in the Basel risk management procedures which did not consider liquidity risk for instance.

2. Corporates have been pressed out to the credit markets outside of the banking system. SME (Small and Medium Sized Enterprises) can only borrow very small parts of the needs from banks. Most lending requires owner's guarantee and/or mortgage of their houses.

3. Banks balance sheets explode on sovereign debt and real estate mortgages. Pretty good bubbles no doubt.

The problem is that the SME market provides most money and employment in the society but they are discriminated by the Basel Framework. This should be a major concern for the central banks and governments. Instead they push for Basel version III. 

Many scream for regulation. But the regulation has to have the correct perspectives otherwise they become counter productive. I would say that the bubbles we have seen during the past 20 years many times have been fuelled by the Basel Framework.

Dynamic Discounting and Reverse Factoring - pros and cons

Here I have listed the pros and cons for Dynamic Discounting (DD) and Reverse Factoring (RF). There are related blog posts available from the list of  "Labels in Blog" far down in the right column of this page.

This list is developed from a practible corporate treasury perspective. The aim has been to cut through any  sales pitches from the vendors. It is not necessarily the case that you implement either DD or RF. There are situations when both can be applicable in parallel or different solutions applicable in different geographical areas and jurisdictions. Hope this grid is helpful.

Factors to consider	How the factors affects each solution
	Reverse Factoring (RF)	Dynamic Discounting (DD)
Decrease DSO (days sales  outstanding) for Suppliers	Yes	Yes
Attractive financing terms for the Suppliers	Yes. This is the main argument for RF, the less creditworthy Supplier can use the higher rated Buyer’s credit terms, benefiting from lower interest rates and, with approved invoice, higher amounts that can be borrowed	Not necessarily. DD’s main argument is for the Buyer being able to exploit the restricted financing capacity of its Suppliers, offering typically 2% flat for 20 days faster payments. The Buyer can thus use its free cash to improve its yields. DD is in this respect an improvement of early payment (static) discounts where many times the payment arrived late but the discount was anyway taken off the amount
Time and Date secure collection	A very good argument for the Suppliers since it provides predictability of the collections and facilitates liquidity planning. Even large Suppliers with no particular need for the extra financing can choose RF for this reason. May improve rating and save money on reduced lending
On- or off balance sheet treatment, i.e. decrease of working capital for the Buyer	This is possible in RF however it has some requirements i.a. Buyer’s arms’-length relation to the banks’ lending to the Suppliers	Highly unlikely this will be anything other than on-balance. Decrease cash holdings and AP
Decrease working capital for Buyer, that is removing payables from the balance sheet (decreasing DPO)	Yes, if requirements of arms’-length to banks providing the loans is fulfilled	No
Full automation of P2P (purchase to pay) process	This is a requirement
Repair need of P2P process	Full automation decreases the risk of error and late payment and extra costs for repair of payments and/or bookings. Requires fully standardized processes
Suppliers have the flexibility to choose which invoice to be requested for earlier payments	Yes, BUT in this solution many (smaller) suppliers may have collateralized all its receivables to one bank making it difficult to “sell” individual invoices to the Buyer’s bank	Yes
Supplier on-boarding	Historically a problem since RF is a very complex solution and many times hard for procurement and Suppliers to grasp. Many stakeholders create a risk of delays and obstacles in the on-boarding. Important to remember RF is not only an IT rollout. RF is often expensive to maintain	Easier than RF but still requires IT connectivity, education of the Suppliers and set-up of internal administrative processes for support and requires IT rollout
Changes in lending capacity of the Buyer affecting the financial strength of the supply chain and Suppliers’ funding may be jeopardized	Can happen if e.g. the bank(s) are not able to provide sufficient funds, or attractive interest rates. Another reason can be that the Buyer gets downgraded or the banks want to reduce the exposure to the Buyer.	DD in its most basic form uses the Buyer’s cash and no banking facilities. The risk is that the Buyer’s cash headroom is not sufficient at all times for funding. Just consider in a situation when the Buyer makes a significant acquisition. Does the DD challenge the cash head room capacity?
Suppliers acquire new behavior	The suppliers get used to this financing alternative and have no short term backup facilities. This means that the Buyer cannot expect to easily withdraw from this SCF program. It can not be regarded as a swing line facility
Banks’ involvement	In RF the bank prefers the Buyer to use the bank’s own proprietary solution but a bank independent platform can be an alternative. One shall be aware that the banks sometimes regard the bank independent platforms as competitors, which may inflict on the solution’s efficiency	DD is still uncharted territory for most banks. They are a bit concerned they will be left out. I have not yet heard of any banks providing solutions or special credit facilities for DD
Payment method	I believe the Seller shall only pay interest or discount from the date she or he has the amount available on its account. Payments shall therefore be some sort of wire transfers, checks are so much 20 century and such a silly payment method that it can not belong in fully automated processes. A success factor for a supply chain solution is that the Buyer does not try to delay payments from agreed terms. That is not a serious way of doing business. Remember that the Suppliers are usually the weaker part having the biggest relative financing burden
Applicability to local legislation	Must be analyzed and can provide stumbling blocks. Factoring or invoice discounting are regulated differently dependent on jurisdiction. A particular problem if RF does not allow off balance treatment according to local legislation	Should not provide a problem since it is only early payments from Buyer’s cash account

Please let me know if I've missed out on something and I will add or correct. Thanks

Comparing Central Banks

In our contacts with the central banks we can now draw conclusions on the two most important in Europe - the European Central Bank (ECB) and the Bank of England (BoE). One might believe that the central banks take a holistic perspective of the economy but that is not always the case. A central bank's main concern is the stability of the banking system, which makes sense. However the banking system provides a very tiny part of the growth and welfare in society. The welfare of the corporate sector is actually more important in a societal perspective. We saw during the peak of the recent credit crisis 2008 and 2009 how differently the central banks acted in seemingly small details, but those details were paramount for individual corporates. 

I believe the ECB very much draws the line with the banks and the sovereigns and expect other authorities to care for the rest of society. The risk for a gap is obviously huge in this case leaving the corporate sector in limbo during a credit crunch. Not caring for the corporate sector is jeopardous but unfortunately a continental European legacy. 

The BoE on the other hand takes a broader aspect on society than the ECB and is very keen on building a toolbox also to support the corporate sector during periods of severe credit stress. The BoE directly purchased commercial papers and other loan instruments from companies with a "substantial British presence". Protectionism in a less brutal form but regardless the BoE assisted many corporate treasuries from disaster scenarios. 

From this perspective my conclusion is that  it is safer to be a corporate based in the UK instead of continental Europe if you someday would require assistance from a central bank. 

Reverse Factoring and Dynamic Discounting

I recently mentioned the Dynamic Discounting solution, which is cash discounts on a gliding scale. Dynamic Discounting and Reverse Factoring (read Primerevenue's introduction for info) are two different solutions for supply chain financing with vendors pointing on each others weaknesses and its own strenghts. But from a corporate treasury perspective what are the pros and cons? And are the solutions mutually exclusive? Maybe they can be used in parallel to provide the suppliers with a spectrum of choices? Important to remember is the background to why supply chain financing has developed.

Over several decades we have had a trend for the large corporations to outsource production facilities, distribution networks etc. The aim has been to reduce working capital and capex. This trend continues. The problem however is that the working capital does not disappear, it just pops up somewhere else in the supply and demand chain. And if the most creditworthy company in the whole chain pushes it up or down, the funding requirements end up in the weaker parts of the chain. The weak parties have less availability of cash from the financial markets and definitely higher costs. This will become an even bigger problem with Basel III. (If you want to read my views on the Basel framework - go to "Labels in Blog" below in the right column of the page). This trend has created large finanical risks in the chain, which many industries experienced recently, e.g. the automotive business. The fact is that treasury must be the driver of financial risk mitigation because it is the financial supply chain and the treasurer sits on the competence.

I'm compiling a list of pros and cons for Dynamic Discounting and Reverse Factoring. It will soon appear on a laptop near you. Stay tuned  ;)

What are the Economic Scenarios?

Today I read a very good article of the present state of the global economy by Robert Bergqvist, chief economist at SEB. He has previously been a guest to one of our meetings in the European Treasurers' Peer Group. Basically Robert concludes the global debt problem, being built up during the past 25 years, was punctuated by the US toxic loans in 2007 and since the crisis has spread to the lenders of last resort, the sovereigns themselves. We are in a situation with overcapacity in many industries, a weak financial sector, and at the same time a requirement to deleverage sovereigns and households. The situation is now so complex it is basically impossible to foresee the future and take a position. 

Important instead for the treasurer is now to list the scenarios and create an action plan for each scenario. For that reason we have invited another bank's cheif economist (we aim to please all banks ;) ) to our meeting in London in September. He will help us list the scenarios. A task not very easy this time.

Dynamic Discounting One Way to Increase Yield on Cash Cushions

Discount according to a sliding scale.
Courtesy PurchasingInsights.com 

I recently learnt about a new initiative in the P2P (Purchase-to-Pay) space - Dynamic Discounting. What caught my attention was a successful round of raising venture capital by Taulia. Generally Early Payment Discounts have been a problem to make successful since the invoice approval processes were not sufficiently automated and the payments rarely arrived as agreed but the discount was anyway taken off the amount. This eventually led to that Early Payment Discount models never got off the ground. Dynamic Discounting is trying to solve this issue through providing discount on a gliding scale and related to the actual date the payment was made. The improvement in A/P automation and approval processes now provides a framework to implement Dynamic Discounting.

Dynamic Discounting requires though that the buying company has access to cash either as its own cash or from credit faciltities. I have recently mentioned the problem with the cost of having a cash cushion and that the board expects higher returns. This can be one way to increase yield on cash even though theoretical examples of 2% for 20 days may be unrealistic in reality. During ideal conditions Dynamic Discounting can be withdrawn and payment terms prolonged if the buyer needs its cash for other purposes. However one might expect the suppliers get used to this financing alternative and have no backup facilities forcing the buyer to keep Dynamic Discounting active even when he or she runs out of cash.

Tax on Financial Transactions

I found a very well written paper I want to share from the Adam Smith Institute discussing tax on financial transactions. It is not very supportive of a "Tobin" tax obviously. Neither am I. However I think this paper provides an excellent discussion and could even be read by those who support such a tax.

Quotes:

"Sweden is the only country to have tried a “pure” Tobin tax, of 0.5%. It raised only one thirtieth of the proceeds predicted by its proponents and was scrapped after five years. The taxes sparked an exodus of financial activity from Sweden."

"The claim that £20 billion (expected income from a tax, my comment) annually can be removed from the UK financial sector without causing significant disruption is both illadvised and reckless. This recklessness is augmented by the fact that we are emerging from one of the most accentuated cycles of boom and bust to date."

How to Adjust to the Economy?

One peer wisely said in the meeting last May: "Treasurer's job is not to predict but rather to prepare". So very true. I continue having discussions with peers being concerned of the economy. We are having a very complex economic situation presently. Much more complex than in 2008, I believe. This time we do not have a lender of last resort, actually it's the sovereigns themselves on stake. Quite predictable actually but nevertheless it has created another level of complexity. We also see a softening of the demand in many markets.

So what are the most successful treasuries doing to adjust to this level of uncertainty? 

1. They do not take a position on what's going to happen

2. They map all scenarios they can think of, even really bad worst cases

3. They stress test the scenarios in the perspectives of risk, financing, cash head room, liquidity etc

4. They adjust their strategies so they can manage all scenarios

5. They communicate to the stakeholders what scenarios they find and what actions they take. This serves two purposes; (i) it calms the stakeholders that treasury is on top of the situation, and (ii) it prepares the stakeholders for what is expected of them

Good Luck out there - be a Business Leader!

Shortselling Creates Budget Deficits?

Please, anyone, contact me and explain how shortselling and high liquidity in the financial markets create sovereign budget deficits. France, Italy, Spain and some other countries have prohibited short selling just to decrease budget deficits, replace bad economic policies, and improper governance and populism. What is the connection? 

Because volatility is created as a result of bad economic policies, not from short selling. Short selling increases the liquidity and thus decreases spreads and costs for society. 

I hear the next step is tax on financial transactions. Apparently all tax strategists (yes, they exist) agree it is a crazy tax but it is a politically correct thing to do. Sweden had that for a while in the 80-ties since the envy on the rich yuppies (Young Urban Professionals) was so immense that the government needed to tax them. They did and much of the financial transactions moved to London and stayed there until the tax was abolished. 

2 is a number and so is 1. Therefore 1 and 2 is the same....

Peer Focus Right Now

I've started the peer interview round for our meeting in September in London. It will definitely be an interesting meeting with exciting guests. Contact us if you want more information. 

There are many IT projects going on, as one peer said: "this is the year of IT". Obviously the other key issues revolve around funding, working capital and cash management. But this meeting's big issue will be the economy. The market volatility in September will probably be the same as in Q4 2008, but this time the situation is much more complex. The scenarios are so different that it will be hard to create contingency plans. As it looks now the we will spend lots of time to discuss this area in the meetings.

US Downgrade and Corporate Status

As expected the volatility has increased with large portfolio restructuring arising from the US downgrade. A Black Swan pushed us out from the eye of the storm to a real storm again. This is how our experiences from 2008-09 helped us prepare:

• We now have a liquidity focus and a much better control of where our cash is. Cash is first, earnings is second in priority
• We have an improved understanding of our risks since the 08-09 crisis exposed previously hidden risks
• We have lowered the break-even levels in the business with more flexible production sites and models to increase or decrease capex as we go

I conclude we have increased our organizational flexibility and we are definitely more agile to handle crises. We are better to react but what have we yet to develop? 

It concerns me that I hear few signs on how we can be more pro-active. Few corporates have a concerted program for discussing and analyzing the markets and economic conditions on a strategic level. Few companies dare to take positions on financial risk. We are still in a situation where financial risk is not a business risk and that financial risks can be hedged. Technically it is true but changing financial market conditions finally affects the business. Hedging only postpones the effects and hedge accounting hides them! Maybe this crisis will lead to more pro-actively managed market expectations. Shying away from that financial markets provide volatility directly affecting any corporate's business conditions seems to me as a highly risky strategy.

Buffet Provides Perspectives

I believe this video provides good perspectives for a day like this.

Opening Pandora's Box

We knew that the PIIGS countries had not been prudent enough allowing low retirement ages, too generous welfare systems, high real unemployment, huge public sector employment etc. Frankly, I do not believe many of us (in Europe particularly) was surprised when Portugal, Italy, Greece and Spain had to face the facts. Ireland was probably more of a wild card but so small they did not really matter. 

But what has lately happened in the US could not have been forseen. The US stupid political games have been the latest Black Swan. According to the newspapers quoting S&P the US could have avoided the downgrade if they only had agreed earlier on the debt ceiling. As I've said here previously, few US politicians is forcing the whole people of the US and the world the extra costs we now will have to pay in the form of higher inflation and higher interest rates. Messing around with the debt ceiling, leading to a credit downgrade has opened the Pandora's Box. Printing money like crazy, fighting to have the weakest currency, going on a borrowing spree PLUS acting stupidly will eventually led to investors requiring higher risk premiums and inflation forcing the interest rates up. We all know that. Before the risk was contained in the PIIGS countries, now it has spread. The uncertainties has spread outside the box. 

The good news however is that the US is the most entrepreneurial country in the world, the population has a drive to earn a living in a way we do not see in Europe. We shall be clear that the problems in the PI(I)GS countries are an effect of decades of populism and therefore will require decades to solve. The Americans go to themselves to solve their problems, the Europeans go to the state. I believe we will experience very nervous markets until we see the US political leadership regaining control and start acting in a predictable and professional manner. The financial problems in the US is much easier to control than those in the EMU. Of course it requires the US political leadership to start delivering.

How shall we act on Monday when markets open? Let us figure out our strategies.

Quotes from Previous Peer Group Meeting

I gathered some great and insightful comments at the peer group meeting in London in May 2011.  Enjoy

On the role of the treasurer:

“Treasurer’s job is not to predict but rather to prepare”

“A treasurer shall be very open, communication prone and focus on risk management”

“The challenge is to make cash forecasting dynamic and adaptive to changing market conditions”

“Treasury is moving from transactional processing to a business partnering role”

On banks:

“Basel III will cause banks to revisit their business models” was one opinion, challenged by “Banks lend to sovereigns so the banks set the terms. We shall not expect too many changes of the banking industry despite new regulation.”

“Banks think globally regardless of the economy”

“Banks are slow to innovate – but fast to follow” 

Comments on "Lack of Leadership in the USA"

The purpose of my post "Lack of Leadership in the USA" was to make the readers realize that now the unthinkable has become thinkable. I'm very impressed by the USA and its democratic model, which is much different from how democracy works in most European countries. My post was therefore not written to all Americans. It was written for them. Long term rates have for long been an accident waiting to happen, I believe. The timing has come closer now. It was really stupid for the politicians to take it this far. And nothing of real essence was won. All investors of US debt will likely sooner or later request a higher risk margin as a direct consequence. 

Investor Relations and Treasury Tie the Knot

I've come across corporate treasurers that have merged the departments of investor relations and treasury. Usually they remain separated but perform joint road shows and coordinate activities. IR takes on the role of describing the business model and the overall operations, while treasury describes the balance sheet and financial risks. The crisis has created an understanding that the investor base is not only the equity investors. Instead it consists of all investors, equity and debt.

For the peer group I have just issued a global benchmark study on how the organization of corporate treasury looks like. Please let me know if you want to participate.