How Risks are managed in Factoring
Factoring is a low loss given default financing solution as evidenced in the EUF’s Whitepaper, which identified loss rates of around 26 basis points compared to 96 basis points for traditional lending products across Europe in 2014. But despite this impressive safety record, Factoring is not without its risk and it is the result of many years of collective learning, knowledge, experience and skill that has led it to today’s position.
The types of risk may be categorized into two main classes; those which relate principally to the client, and those which principally arise from the debtor.
In respect of clients, the financial risk for the factor is that it will make advances that it cannot recover. This situation might arise if the factor provides funds against invoices which for any reason either are or become uncollectable, or if the client seller diverts funds which are due from the buyer debtors to the Factor.
- Invoices may become uncollectable if there is an issue that leads to genuine dispute and non- payment; for example, there is a mismatch in quantity, quality or nature of goods or services supplied compared to those invoiced, or goods and services prove in practice to be sub-standard or faulty.
- The client seller may raise invoices fraudulently, creating paperwork for incomplete or imaginary “fresh air” goods and services; this may be done with or without active collusion from the buyer debtor. If the Factor advances funds against such invoices in these circumstances, then these will prove to be uncollectable.
- The client might advise debtors that payment is due directly to them and not to the factoring company, meaning that they effectively receive double payment for the invoice.
The factor will protect itself through a range of sophisticated risk assessment and control mechanisms which may include initial underwriting techniques, ongoing monitor and control, client audits, automated and manual verification of invoices and accounts as well as trend monitoring and client industry competitor comparisons.
A principal risk for the seller and the factor is the creditworthiness of the client’s buyers which reflects their ability to pay. The factor will use a range of methods to assess the creditworthiness by using a selection of indicators; these will include information from professional credit reference agencies, filed and management accounting information, statutory reporting (where information is held on centralized government registers) as well as analysis of payment performance and past operational experience.
Based upon this array of information, it will set a debtor limit which it considers appropriate to the level of credit risk. In a non-recourse environment, this will generally represent the maximum level of funding that will be available to the seller. This position can be secured by providing credit cover, which may protect the seller (and the factor) against such credit default loss in the event of debtor failure. If the client requires funding at a higher level than the debtor limit, the factor may consider providing this on a non-covered basis.
In a recourse environment, where there are other compensating features (for example if the debt is a very small percentage of the outstanding ledger) the funding may also be set at a higher level at the discretion of the factor.
Debtor limits will be reviewed on a regular basis to ensure they reflect the current level of risk.
The factor will also ensure that the level of funding in any one particular debtor is controlled so that it does not represent too high a proportion of the overall debt outstanding. In this way, by limiting the concentration risk, it can ensure that in the event of an individual debtor failing, the loss damage is recoverable and not fatal to the security of either party.
This active management, monitoring and control is typical of a factoring facility and clearly differentiates the solution from a traditional lending environment where decisions are based on historic performance strength and operational forecasts, and it also explains its far superior provision performance.