Factoring & Forfaiting

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1 Factoring & Forfaiting A business and regulatory perspective June 2009 t

2 Table of Contents 1. Executive Summary Factoring & Forfaiting Factoring Forfaiting Intrinsic Risks Credit Risk Definition of Credit Risk Credit Risk management, measurement and control Credit Risk mitigation techniques Market Risk FX Risk Interest Rate Risk Operational Risk IFRS Treatment & Implications Accounts Receivable Payables and outstanding securities Hedging activities Provisions for risks and charges Income Foreign currency transactions Regulatory Framework Bank of Greece Foreign Regulations No compliance required Partial/Adapted compliance Italy Spain Full compliance France Austria Sweden Finland Portugal Business and Regulatory Overview of Factoring 2

3 Summary Table Basel II Standardized Implications Short-term maturity (less than 1 year) Eligibility of collaterals Definition of Past Due Non - recognition of insurance as a form of credit risk mitigation Basel II IRB Implications year horizon for the PD calculation Definition of Default Contagion Effect Dilution risk Limited availability of data System requirements Conclusions Business and Regulatory Overview of Factoring 3

4 This research paper A business and regulatory perspective of Factoring and Forfaiting is the result of an independent study by Ernst & Young, commissioned and supported by Marfin Factors and Forfaiters SA (MFF) in June MFF s objective for this project was to describe in high-level the Factoring and Forfaiting Business, present the regulatory treatment in international level and pinpoint certain important Basel II implications, affecting Standardized and IRB approaches for the calculation of Regulatory Capital Requirements. Marfin Factors & Forfaiters SA was established under this name in May 2007, as the legal continuation of its predecessor company Laiki Factoring SA, after the merger of Popular (Laiki) Bank of Cyprus with Marfin Financial Group and Egnatia Bank. It has been established as a 100% subsidiary of Marfin Egnatia Bank, the subsidiary bank in Greece of Marfin Popular Bank, Cyprus, and currently employs 33 people in Greece- seated in Athens and with a Representative Office in Thessaloniki, and 8 people in the Belgrade Serbia Branch. Ernst & Young is a global leader in assurance, tax, transaction, and advisory services. Worldwide, our 140,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients, and our wider communities achieve potential. At the foundation of our working approach rests our mutual commitment for operational excellence, providing high quality services to our clients Business and Regulatory Overview of Factoring 4

5 1. Executive Summary In this paper we examine the Factoring & Forfaiting types of financing from a business and regulatory perspective. The document presents the approaches that currently exist in the regulatory environment in peer countries, as well as the implications of the Basel II Framework in respect to the Regulatory Capital Calculation for the Factors. Our report is based on current practices and regulatory approaches and does not comprise any subjective opinion from Ernst & Young. In the first part of the document, the business of Factoring and Forfaiting is described, the intrinsic risks are introduced and the accounting treatment according to the IFRS is presented. Elements such as the counterparties per type of transaction, as well as the amount of the claims created, are analyzed. We refer to the main risks for the Factor: Credit Risk (which includes Default Risk and Dilution Risk) and Operational risk, which is of significance to the Factoring companies, mainly due to the fact that it incorporates the risk of internal & external fraud. We also refer to Market Risks (Liquidity and FX Risks). Existing approaches to Risk measurement, management and mitigation are presented in this section. Finally, the accounting principles in respect to valuation and record of main Balance Sheet items are illustrated. In the second part of the paper, the Regulatory environment is examined, along with the implications of the Basel II Framework regarding current and potential capital requirements. The regulatory environment is broken down to countries were full Basel II, adapted Basel II and no Basel II regulatory frameworks exist for Factoring companies. Implications of Basel II are discussed, also in combination with propositions made by relevant working groups. Issues cover the Short-term maturity (less than 1 year), Eligibility of collaterals, Definition of Default, recognition of insurance as a form of credit risk mitigation etc. Business and Regulatory Overview of Factoring 5

6 2. Factoring & Forfaiting 2.1. Factoring Factoring is a type of supplier financing in which firms sell their credit-worthy accounts receivable at a discount (equal to interest plus service fees) and receive immediate cash. Transactions with recourse may be perceived technically as credit facilities, providing working capital. It needs to be noted that most factoring is done without recourse meaning that the Factor that purchases the receivables assumes the credit risk for the buyer s ability to pay. Thus, factoring is an integrated financial mechanism that includes credit protection and mitigation, accounts receivable book-keeping and management, collection services and financing. What does factoring represent? Survey SDA Bocconi 2008 A source of funding complementary to bank loan 26% A guarantee against debtor s insolvency 25% A tool for professional credit management 19% A source of funding, alternative to bank loan 16% A way to recover bad debts 7% Other 6% No opinion 1% It needs to be noted that Factoring transactions involve three parties: The Factor, which is a financial institution The Seller, that is a business entity providing goods and services The Buyer, who is the one purchasing the goods or services from the Seller Factoring services can be classified according to the risk approach and the origin of the transaction (Ref: Naftemporiki 2003, Kerdos newspaper 22/11/05): Business and Regulatory Overview of Factoring 6

7 According to the risk approach, factoring services are offered with recourse (the Seller bears the Buyers credit risk) or non-recourse (the Factor covers the Buyers credit risk) According to the origin of the transaction, factoring services are domestic, for trade in the domestic market, and international, for cross-border trade, i.e. Export or Import factoring. It should also be noted that this paper does not cover the service of accounts receivable management, since this service is not considered material from a Risk management and Capital Requirements point of view. The key advantage of Factoring is that underwriting is based on the risk of the accounts receivable themselves rather than the risk of the client. For example, factoring may be particularly well suited for financing receivables from large or foreign firms when those receivables are obligations of buyers who are more creditworthy than the seller itself. Factoring may also be particularly important in financial systems with weak commercial laws and law enforcement. Like traditional forms of commercial credit extension, factoring provides small and medium enterprises (SMEs) with short to medium term financing. However, unlike traditional forms of working capital financing, factoring involves the outright purchase of the accounts receivable by the Factor, rather than the collateralization of a loan. The advantage of factoring in a weak business environment is that the factored receivables are removed from the bankruptcy estate of the client and become the property of the Factor. Thus, access to historical credit information, which is necessary in order to assess the credit risk of factoring transactions, is of significant value. An important feature of the factoring relationship is that a Factor will typically advance less than 100% of the face value of the receivable even though it takes ownership of the entire receivable. The difference between this advance amount and the invoice amount (adjusted for any netting effects such as sales rebates) is accounted as reserve held by the Factor. This reserve will be used to cover any deficiencies in the payment of the related invoice. Thus even in non-recourse factoring there is risk sharing between the Factor and the client (the Seller) in the form of this reserve account. Factoring can be done either on a non-recourse or recourse basis against the Factor s client (the Seller). In nonrecourse factoring, the Factor not only assumes title to the receivable accounts, but also assumes most of the default risk because the Factor does not have recourse against the Business and Regulatory Overview of Factoring 7

8 supplier if the accounts default. Under recourse factoring, on the other hand, the Factor has a claim (i.e. recourse) against its client (the Seller) for any account payment deficiency. Therefore, losses occur only if the underlying accounts default and the Seller cannot make up the deficiency. Furthermore, factoring can be done on either a notification or non-notification basis. Notification means that the buyers are notified that their invoices (accounts payable) have been sold to a Factor. Under notification factoring, the buyers typically provide the Factor with delivery receipts, an assignment of the accounts and duplicate invoices prepared in a form that indicates clearly to the supplier that their account has been purchased by the Factor. In addition to the financing component, Factors typically provide two other complementary services to their clients: credit services and collection services. The credit services involve the credit assessment of the borrower s customers whose accounts will be purchased by the Factor. Factors typically base this assessment on a combination of their own proprietary data and publicly available data on account payment performance. The collection services involve the activities associated with collecting delinquent accounts and minimizing the losses associated with these accounts. This includes notifying a buyer that an account is delinquent (i.e. past due) and pursuing collection and legal action. Factoring allows (mainly) Small and Medium sized companies to effectively outsource their credit and collection functions to their Factor. This represents another important distinction between Factors and traditional commercial lenders. These credit and collection services are often especially important for receivables from buyers located overseas. For example, export factoring, the sale of foreign receivables, can facilitate and reduce the risk of international sales by collecting foreign accounts receivables. The Factor is also required to do a credit check on the foreign customer before agreeing to purchase the receivable, so the approval of a factoring arrangement also sends an important signal to the seller before entering a business relationship. This can facilitate the expansion of sales to overseas markets. It should be noted that, in contrast to the Banking Institutions, Factors do not face the issue of borrowing capital in short term and extending long term credit, since all transactions are short term and of matching maturities. Therefore, liquidity management is Business and Regulatory Overview of Factoring 8

9 simpler in this case, with no need for complicated Asset-Liability Management. Liquidity management in Factoring companies is not much different than the one of other companies that have financial obligations. It should also be mentioned that independent Factors present operational differences comparing to Factoring divisions of Banks (Ref: Presentation of Mr. Panos Papatheodorou at EEFA s 4 th and 5 th Annual Conferences, 09/2004, 11/2005) : Different organizational and operational approach, dictating also a different structure than a Bank (example follows): Different Credit approach: Banks base their credit decisions in Balance Sheet analysis and collateral or securities offered, whereas Factors on the Accounts Receivable flows and in the good knowledge and management of the commercial agreements and monetary flows. o Factoring companies pay great importance in quality of product and monetary flows, future development, soundness of management and creditworthiness of the buyers, managing the cash flows day-to-day. o In Factoring, Advances to clients are linked to the increase of sales. Different positioning in the marketing channel: a Factoring Company is a buyer of an A/R a Bank is a lender. Factors are Debtors, whereas Banks are Creditors Business and Regulatory Overview of Factoring 9

10 The tables below illustrate the Factoring business Volumes and Turnover: Total Factoring Volume by Country in the last 7 years (in Million of EUR) (Ref: Factors Chain International statistics) EUROPE Austria Belgium Bulgaria Croatia Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Business and Regulatory Overview of Factoring 10

11 Italy Latvia Lithuania With Estonia With Estonia until until Luxembourg Malta Netherlands Norway Poland Portugal Romania Russia Serbia Slovakia Slovenia Spain Sweden Switzerland Turkey Ukraine Business and Regulatory Overview of Factoring 11

12 United Kingdom Total Europe U.S.A. 91,143 80,696 81,860 94,160 96,000 97, ,000 Total Americas ,450 TOTAL WORLD Factoring Turnover by Country 2008 (in Million of EUR) (Ref: Factors Chain International statistics) Nr. of Country Domestic International Total Companies Turnover Turnover EUROPE 90 United Kingdom France Italy Germany Spain Netherlands Ireland Belgium Turkey Portugal Russia Sweden Norway Finland Greece Poland Austria Denmark Czech Republic Business and Regulatory Overview of Factoring 12

13 Nr. of Country Domestic International Total Companies Turnover Turnover 8 Lithuania Cyprus Hungary Switzerland Croatia Romania Slovakia Latvia Estonia Ukraine Slovenia Luxembourg Bulgaria Serbia Malta Iceland Total Europe U.S.A ,011 Total ,809 TOTAL WORLD Forfaiting Forfaiting is a form of international supply chain financing. It involves the discount of future payment obligations on a non-recourse basis. Forfaiting can be applied to a wide range of trade related and purely financial receivables. Although discounted receivables typically have medium term maturities (3 5 years) they can be as short as 6 months or as long as 10 years. Forfaiting is a flexible invoice discounting technique that can be tailored to the needs of a wide range of counterparties and domestic and international transactions. Its key characteristics are: Full face financing without recourse to the seller of the debt Business and Regulatory Overview of Factoring 13

14 The payment obligation is often covered by a bank guarantee; this does not hold at all times The debt usually takes the form of a legally enforceable and transferable payment obligation such as a bill of exchange, promissory note, letter of credit or note purchase agreement. Transaction values can range from 50 thousand Euro to 50 million Euro Debt instruments are typically denominated in one of the world s major currencies, with Euro and US Dollars being most common. The Financing part can be arranged on a fixed or floating interest rate basis. Forfaiting brings along a number of benefits to the involved parties: Mitigates significantly the transaction risks o Removes political, transfer and commercial risk o Provides financing for 100% of contract value o Protects against risks of interest rate increase and exchange rate fluctuation Enhances Competitive Advantage o Enables sellers of goods to offer credit to their customers, making their products more attractive o Helps sellers to be active in countries where the risk of non-payment would otherwise be too high Improves Cash Flow o Forfaiting enables sellers to receive cash payment while offering credit terms to their customers o Removes accounts receivable, bank loans or contingent liabilities from the balance sheet Increases Speed and Simplicity of Transactions o Fast, tailor-made financing solutions o Financing commitments can be issued quickly o Documentation is typically concise and straightforward o No restrictions on origin of export o Relieves seller of administration and collection burden Business and Regulatory Overview of Factoring 14

15 3. Intrinsic Risks 3.1. Credit Risk Definition of Credit Risk As a rule, when the Factor provides the finance and/or guarantee service within a Factoring contract, the possibility of registering a loss (Default risk) is determined in the first place by the deterioration of the credit worthiness of the counterparts or rather the risk of non-payment by the assigned debtor (in the case of both with recourse and without recourse factoring) or the risk of failure to return the payments advanced by the assignor in the event of with recourse transactions. This type of risk is flanked by the so-called dilution risk. Dilution refers to the possibility that contractual amounts payable by the underlying obligors may be reduced. When a Factor extends a credit to a debtor, the latter s default is determined by the temporary or definitive incapability of paying. The risk of delayed payment, i.e. the uncertainty regarding the date when the debtor s fulfillment will actually take place creates liquidity risks (obviously, when the debtor is in default, this risk is included in the credit risk). In contrast to traditional banking exposure, the Factor provides its services within the sphere of a pre-existent commercial relationships; the dilution effect is the possibility that the debtor may refuse to pay (or make partial payments) in consideration of events regarding the performance of the underlying supply relationship. These situations include, by way of example, the off-settings, the allowances, the disputes concerning product quality, the invoicing discrepancies and the promotional discounts Credit Risk management, measurement and control At the time of undertaking the transaction, the credit risk needs to be assessed by the responsible unit (e.g. Risk Division). The constant control of the progress of the relationship with the counterpart needs to be ensured. In this sense, one of the tasks is to perceive any signs of deterioration in the assigning counterpart and to therefore prevent any potential losses deriving from the counterpart. All daily relationships with the debtors should be handled accordingly, carrying out checks on assigned receivables and surveys on the punctuality of the payments (checking of maturities and payment requests). The Monitoring function is entrusted with the task of ensuring that the quality of the portfolio is maintained over time by means of on-going Business and Regulatory Overview of Factoring 15

16 monitoring action which makes it possible to intervene systematically when a deterioration of the risk profile of either an assignor or an assigned debtor is detected. This function should be located within the Risk Function Credit Risk mitigation techniques The Credit Risk Mitigation (CRM) techniques cover a role of fundamental importance within the factoring relationship in respect to the parties involved. These techniques, with regard to the contractual clauses established for the individual transactions, are more or less significant for the Factor. At the time the risk is undertaken, the factoring company takes steps to assess the two counterparts, the assigning supplier (Seller of the receivable) and the assigned debtor (Buyer of the good or service sold), who should be both analyzed so as to qualify over the lending profile; in relation to this analysis, the undertaking of risk on these counterparts can assume different operating configurations in relation to the product type requested by the customer/assignor. In fact, in the event that a factoring transaction is finalized for the sole purpose of granting the assignor credit facilities for freeing up the factored receivables (under the so-called with recourse formula, or which offers the possibility of recourse by the Factor on the assignor), a combined analysis of the credit worthiness of both the assignor and the assigned debtor/s will be carried out. In the event that the factoring relationship is aimed at granting the guarantee of the satisfactory outcome of the factored receivables, the analysis of the credit worthiness will be concentrated to a particular extent on the assigned debtor, as the main lending counterpart of the relationship. Notification of factoring to the assigned debtor (via commercial correspondence or process server) makes it possible to considerably mitigate the risk inherent to the factoring transaction, obliging the debtor to pay the Factor (with repetition of the payment in the event of payment to the assignor) and make the assignment opposable to by third parties (effective as from the moment of communication). The acceptance of the assignment by the assigned debtor prevents any compensation and also contains the acknowledgement of the debit. The transfer may be opposed to by third parties if the acceptance has a specific date, and in the event of bankruptcy of the assignor the opposability excludes action for revocation. Like the banks, the Factor usually requests collateral guarantees on the credit facilities granted to; much more rarely, the risks of the Factor (both with regard to the assignor and the debtor) are guaranteed by bonds issued Business and Regulatory Overview of Factoring 16

17 by banks. Factoring companies make extensive use of another instrument for mitigating risks undertaken without recourse vis-à-vis assigned debtors: insurance coverage. This instrument, although not explicitly mentioned as eligible by Basel II legislation, helps to mitigate the credit risk deriving from the default of the debtor assigned without recourse Market Risk FX Risk Foreign Exchange (FX) risk is the possibility of economic loss arising from movements in currency exchange rates, their volatilities or correlations. More specifically, FX Risk in the Factoring business is created by the denomination of advances given by the Factor and of the payments received, in different currencies. The common practice to mitigate FX risk, is that all flows of the transaction take place in the invoice currency. In addition, any differences (costs) stemming from currency conversions should be covered by specific contracts with customers, according to which any exchange risks have to be attributed to them (customers) Interest Rate Risk The interest rate risk is caused by the differences in expiration and re-pricing time of the assets and liabilities interest rate. With these differences, the fluctuations of the interest rates could determine both a change in the expected interest rate and a variation of assets and liabilities, and therefore of the value of the shareholders equity. Given the type of Factoring business and its short-term loans and deposits, the risk of a change in market rates is expected to influence the value of assets and liabilities only marginally, also considering the close re-pricing both for the collection and the rotation of loans. However, apart from the Asset-Liability Management point of view, interest rate risks may also be created when the payments for the disposal of the receivables are deferred or are subject to discounting with the application of variable rates Operational Risk Business and Regulatory Overview of Factoring 17

18 Operational risk is defined as the risk of economic loss resulting from inadequate or failed internal processes, people and systems or from external events. Fraud (internal and external) and legal and compliance risk are considered part of operational risk. Furthermore, the operational loss events may derive from inadequate work practices or safety in the workplace, customer complaints, product distribution, fines or penalties for the failure to observe forecasts or legislative fulfillments (Compliance risk), damage to company assets, interruptions in information or communications systems, execution of the processes. Strategic, business or reputation-related risks are not included within the operational risk; Factoring and Forfaiting companies are significantly exposed to fraud, mainly external. The following types of Invoicing Fraud are the main ones: Internal Fraud: A simple example is an employee who has the authority to raise purchase orders will raise purchase orders for some fictitious company that they will have previously set up. The company then raises invoices against these purchase orders that will then get matched and honored. External Fraud: An example of an external fraud would be employees working for a supplier of a firm who registers a company with a very similar name to the company they are working for. They then issue invoices against known purchase order numbers with this name. Purchase Order Value: The Invoice value is much greater than the purchase order value. It may simply be ten times the purchase order value, which can easily go unnoticed. Unknown Vendors: Organizations often receive invoices from unknown vendors for fictitious work or goods. The senders of the invoices may have sent the same invoice to hundreds of organizations in the hope that just one busy accounts department lets it slip through. Unsolicited Goods: Goods are delivered and signed for and then an invoice is sent. The sender will often have some knowledge of the organization s regular supply of consumables or current projects. Low Value Invoices: Many organizations try and manage the workload associated with invoices by operating much stricter authorization procedures for invoice values above a threshold. Invoices that are received whose value is below this threshold are much more likely to get authorized and a potential fraudster will exploit this information, which may be gleaned from an employee or by sending test invoices or a disgruntled employee who may have already left the company. Under or Over Invoicing: This is not really a type of invoicing fraud, more a type of tax fraud. Under-invoicing is used when importing goods from a foreign supplier. An Business and Regulatory Overview of Factoring 18

19 arrangement is made whereby the supplier raises an invoice for the goods with a value much less than the agreed price. By artificially lowering the documented value of the goods, less import duty is payable. The difference is then paid via a different route and sometimes the saving in import duty is split between the importer and the supplier. Over-invoicing is a means of exploiting exchange rates and export subsidies. 4. IFRS Treatment & Implications The financial statements of the major European Factoring companies are structured in compliance with the international accounting principles (IAS/IFRS), standardized by the European Commission. The financial statements include the balance sheet, the profit & loss account, the statement of changes in shareholders equity, the cash flow Statement and the notes to the financial statements. The criteria adopted for the valuation of the most important items are provided below Accounts Receivable Loans and receivables include non-derivative financial assets, due from customers and banks, with fixed or determinable payments and which are not listed on an active market. Following the general principle of the priority of economic substance over legal form, a company can derecognize a financial asset from its financial statements only if, as a result of a transfer, it has assigned all risks and benefits associated with the transferred instrument. IAS 39 sets forth that a company can derecognize a financial asset only if: It is transferred together with all risks, and the contractual rights on cash flows resulting from the asset expire; The benefits related to the ownership of the asset cease to be valid. In order to transfer financial assets, the following conditions alternatively apply: o the company has transferred the rights to receive the cash flows of the financial asset; o the company has maintained the rights to receive the cash flows of the financial asset, but has to pay them to one or more beneficiaries within an agreement in which all the following conditions have been satisfied: Business and Regulatory Overview of Factoring 19

20 the company has no obligation to pay predetermined amounts to any beneficiary apart from what it receives from the original financial asset the company cannot sell or pledge the financial asset the company has to transfer each cash flow it receives, on behalf of the beneficiaries and on time. Any investment of the cash flows in the period between collection and payment has to be carried out only for financial assets equal to liquidity and, in any case, with no rights to the interests accrued on the invested amounts. In order to transfer a financial asset and derecognize it from the assignor s financial statements, upon each transfer the assignor has to assess the extent of any risks and benefits related to the financial asset still owned. For the assessment of the effective transfer of risks and benefits, it is necessary to compare the exposure of the assignor with the variability of the current value or of the cash flows generated by the assigned financial asset, before and after the transfer. The assignor essentially maintains all risks and benefits when its exposure to the variability of the present value of future net cash flows of the financial asset does not change significantly after its transfer. On the other hand, the transfer can be carried out when the exposure to this variability is not significant anymore. In summary, there are three possible cases, to which some specific effects correspond, i.e.: When the company essentially transfers all risks and benefits resulting from owning the financial asset, it has to reverse the financial asset and separately record all rights and obligations deriving from the transfer itself as assets or liabilities when the company essentially maintains all risks and benefits deriving from owning the financial asset, it has to keep on recognizing it when the company neither transfers nor maintains all risks and benefits deriving from owning the financial asset, it has to evaluate the control elements regarding the financial asset, and o in case it does not have the control, it has to reverse the financial asset and separately recognize the single assets/liabilities deriving from the rights/obligations of the transfer o in case it keeps the control, it has to go on recognizing the financial asset, until the limit of its commitment in the investment. For the purposes of verifying control, the discriminating factor that has to be taken into account is the beneficiary s ability to transfer the financial asset unilaterally, without any Business and Regulatory Overview of Factoring 20

21 type of restrictions by the assignor. When the beneficiary of a financial asset s transfer has the operational ability to sell the whole financial asset to a nonrelated third party and in a unilateral way, without any other transfer limitations, the assignor no longer has control over the financial asset. In all other cases, it keeps control over the financial asset. The most frequently used types of transfer for a financial instrument can have very different accounting effects: In the case of a non-recourse assignment (without any guarantee obligations), the transferred assets can be derecognized from the assignor s financial statements; in the majority of cases it should be considered that the risk connected to the transferred asset is held by the Factor. Thus, the Factor has a direct claim over the obligor (Buyer) to the full amount of the invoice. This holds irrespectively of the approach that the Financial Institution adopts (Standardized or IRB). With regard to portfolios transferred with recourse, receivables are recorded and recognized in the financial statements solely in relation to the amounts paid to the assignor by way of an advance payment. Since the assets are not recognized as truly sold from the Seller to the Factor, these are registered to the Seller s financial statements as loans with the receivables as collaterals. This means that, when the Financial Institution follows the Standardized approach for the calculation of Credit Risk capital requirements, the counterparty shall be the Seller, not the obligor (Buyer). In the case of IRB, there will be the Double Default approach, first to the obligor (Buyer) and then to the Seller. Type of transaction With Recourse Without Recourse Standardized Approach Counterparty: Seller Exposure: The advance payment amount Counterparty: Obligor (Buyer) Exposure: The full amount of the invoice Internal Ratings Based Approach Counterparty: Double Default (Seller & Buyer) Exposure: The advance payment amount Business and Regulatory Overview of Factoring 21

22 After the initial recognition of receivables at fair value - including transaction costs that are directly related to the financial asset s acquisition these are valued at amortized cost, using the effective interest method. As at each balance sheet date, if there is objective evidence that receivables were impaired, the amount of the loss is gauged as the difference between the book value of the asset and the present value of future expected cash flows discounted at the original effective interest rate. In particular, the criteria for determining write-downs of receivables are based on the discounting of expected cash flows for principal and interest, net of collection charges and any advances received. In order to determine the current value of the flows, the main elements are the identification of expected collections and related expires, as well as of the discounting rate that has to be applied. A receivable can be defined as impaired when it is considered that probably it would not be possible to collect the whole amount - on the basis of the original contract terms - or an equivalent value. A receivable can be integrally derecognized when it is considered irrecoverable or it is completely written off. Impaired positions are divided into the following categories: NPL/Rs - The loans/receivables that are formally impaired, represented by the exposure to customers who are in a state of insolvency (even not legally recognized) or in similar positions. The valuation is carried out on an analytical basis. Doubtful loans/receivables This category contains transactions with parties who are experiencing a temporary difficulty, that it is felt can be solved within an appropriate period of time. The valuation is carried out on an analytical basis. Restructured positions These are exposures towards counterparties with which specific agreements have been entered into. These agreements envisage a postponement for the payment of the debt and the parallel renegotiation of conditions. The valuation is carried out on an analytical basis. Past due positions These represent the whole exposure towards counterparties, which are different from those classified in the above-mentioned categories and show receivables past due 180 days as at the reference date. The valuation is carried out on a lump-sum basis. The valuation of performing receivables concerns asset portfolios for which no objective loss elements have been observed and that are subject to a collective valuation. Business and Regulatory Overview of Factoring 22

23 4.2. Payables and outstanding securities Payables and issued subordinated liabilities are initially recorded at fair value, which generally corresponds to the consideration received, net of transaction costs that are directly attributable to the financial liability. After the initial accounting, these instruments are valued at amortized cost, using the effective interest method. Payables arising from factoring transactions reflect the amount remaining to be paid to assignors resulting from the difference between the value of the receivables acquired with recourse and the advance paid, and the full invoice amount, in the case of non recourse transactions. Financial liabilities are derecognized from the financial statements upon settlement or maturity Hedging activities Hedging instruments are defined as a fair value hedge of a recorded asset. The hedge is considered highly effective if, both at the beginning and during its life, the changes in the fair value of the hedged monetary amount are almost entirely counterbalanced by the changes in the fair value of the hedging derivative. This means that the effective results should be comprised between 80% and 125% Provisions for risks and charges The allocations of provisions for risks and charges are accounted for only in the following cases: There is a current obligation (legal or implicit) as a result of a past event; It is likely that, in order to fulfill the obligation, it will be necessary to use resources that create economic benefits Reliable estimate of the amount resulting from the fulfillment of the obligation can be carried out. The amount recorded as a provision represents the best estimate of the expense required in order to fulfill the existing obligation as at the financial statement reference date and reflects all risks and uncertainties that inevitably characterize a plurality of facts and circumstances. Business and Regulatory Overview of Factoring 23

24 A provision is used only with respect to the charges for which it was originally recorded. No provision is recorded against liabilities that are only potential and not probable; however, a description of the type of liability is provided Income As defined in IAS 18, income is a gross flow of economic benefits resulting from the ordinary activities of the company. Income is valued at the fair value of the received or due consideration and is accounted for when it can be reliably estimated. The result of a service rendered can be reliably estimated when all following conditions are met: The income amount can be reliably valued It is likely that the company will profit from the economic benefits resulting from said operation The stage of completion of the transaction as at the financial statement reference date can be reliably gauged The costs met for the transaction and the future expenses in order to complete it can be reliably calculated. Income is recognized only when it is likely that the company will take advantage of the economic benefits resulting from the transaction. However, when the recoverability of a value that is already included in the income is characterized by uncertainty, the unrecoverable value or the value whose recovery is highly improbable is recorded as a cost rather than as an adjustment of the income that was originally recognized Foreign currency transactions Foreign currency is different from the reporting currency of the company. The latter is the currency of the main economic environment in which the company carries out its activities. A foreign currency transaction is initially recognized using the reporting currency, applying the spot exchange rate between the reporting and the foreign currency as at the date of the transaction to the amount in foreign currency. As at each balance sheet date: Foreign currency monetary items are converted using the closing rate Foreign currency non-monetary items valued at historical cost are converted using the exchange rate in force as at the date of the transaction Business and Regulatory Overview of Factoring 24

25 Foreign currency non-monetary items valued at fair value are converted using exchange rates as at the date when the fair value is determined. The exchange differences - resulting from the de-recognition or conversion of monetary items at rates different from those at which they were initially converted during the year or in previous financial statements are registered in the profit and loss account for the financial year in which they occur. 5. Regulatory Framework Regarding the regulatory capital framework of Basel II, the following classification in terms of scope needs to be noted: When the Factor is a stand alone company and not a member of a Banking Group or Financial Holding Group, it is directly subject to the requirements of the local regulator. If the local regulator requires Factoring companies to calculate, hold and report regulatory capital, then the Factor would provide a solo calculation and reporting to the regulator, without further implications When the Factor is a subsidiary of a Banking Group or Financial Holding Group, then there are the following different outcomes: o The local regulator requires Factors to calculate, hold and report regulatory capital: Then, the Factor would report on a Solo basis, and would also be included in the Group consolidation, also bearing capital requirements for the Group o The local regulator does not require Factors to calculate, hold and report regulatory capital: Then, the Factor would only be included in the Group consolidation, bearing capital requirements It also needs to be noted that if the Factor is accounting-wise consolidated in a Banking Group or Financial Holding Group but not consolidated for Basel II regulatory capital calculation purposes, then the parent company (e.g. Bank) would have to calculate specific capital for the exposures to the Factor. The risk weight under the Standardized Approach would depend on the external rating of the counterparty (Factor) if such a rating exists, while under the IRB Approach the risk weight would depend on the internal rating. Business and Regulatory Overview of Factoring 25

26 5.1. Bank of Greece Currently there is no regulation requiring Factors to calculate Basel II capital requirements. Bank of Greece (BoG) issued in late November 2008 a draft Act in respect to Requirements for founding and operating license and supervisory rules for leasing firms, credit institutions and factoring companies. The draft paper, which has not been finalized to date, brings the factoring industry under the supervision of BoG and requires almost full compliance of factoring companies with Basel II capital requirements, as these have been imposed to banking institutions that are based in Greece Foreign Regulations No compliance required The United Kingdom represents an example of unregulated factoring industry within developed European countries. Until recently no supervision of factoring companies was performed and those companies have been operating under a framework developed by their own association, which is currently titled The Asset Based Finance Association. The framework is limited to setting some basic business and ethics standards and does not refer to risk management or capital adequacy requirements. Factoring institutions in the UK are solely required to comply with Anti-Money Laundering Laws introduced during 2008, and their compliance is supervised by the Financial Services Authority (FSA). The same conditions, regarding the regulatory environment for factoring companies, are met in Ireland. Additional examples of unregulated factoring industry are offered by Belgium, the Netherlands, Poland, Slovakia, Switzerland, Russia, the Czech Republic, Lithuania, Denmark, Estonia, Latvia, Slovenia, Hungary, Romania and Cyprus. In Malta, Factors are characterized as Financial Institutions and not as Credit Institutions. The Financial Services Authority of Malta, which is the regulating and supervisory body of the credit and financial system of the Country, have set specific legal requirements (the Financial Institutions Act 1994) for the licensing and operations of the Factoring firms (as they are financial institutions). The Malta FSA has adopted the Basel II CRD framework under L.N 76/2008 Banking Act (Capital Adequacy) Regulations However, this law covers only Credit institutions and Investment firms and not Financial Institutions. Thus, Business and Regulatory Overview of Factoring 26

27 Factoring companies are not subject to calculate, hold and report regulatory capital on a Solo basis. Factoring companies in Germany have recently gone under regulatory developments. The Enactment of the Annual Tax Act 2009 defined that activities of factoring and finance leasing have become regulated activities under the German Banking Act. This implied that, starting from 25 December 2008, anyone who wishes to provide factoring or finance leasing services in Germany needs a license under the German Banking Act from the German Regulator Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin). Even though the new law treats factoring services in the same way as banking services, it does give factoring companies significant relief from certain requirements that would otherwise apply under the German Banking Act. The major relief is the absence of a minimum capital requirement. In addition to the latter, certain control mechanisms regarding liquidity and solvency are not applicable to factoring companies and only one reliable and competent manager of the relevant factoring company who has been formally approved by the German Authority is required. However, it is expected that the German Authority, through its continuing supervision of factoring companies, will subject those entities to considerable financial reporting and other obligations (including the submission of annual accounts, management and auditor s reports). The German Authority s costs of such supervision are expected to be allocated to the factoring companies themselves. In Turkey, the Central Bank is not responsible for the supervision of financial institutions. Supervision is under the authority of Banking Regulation & Supervision Agency (BRSA), which has recently issued a draft act in respect to leasing, factoring and financing companies. The draft regulation has been open to comments from institutions and agencies concerned, as well as representatives of the banking sector. The scope of the draft includes the following: The abolishment of the Law on Leasing nr and the Decree in the power of Law on Lending Nr.90. The minimum paid-in capitals that the related firms are required to have become compatible with current conditions. The required legal sub-structure for on-site and off-site supervision of the firms is being established. Business and Regulatory Overview of Factoring 27

28 A reserve provision is imposed, in order for the companies concerned to cover potential losses from receivables emanated from the transactions of the firms. The Leasing Firms Association, Financing Companies Association and Factoring Firms Association are recognized as professional institutions and obtain legal entity status of a public institution nature. Leasing, financing and factoring firms are obliged to register as members in the appropriate association. A System for Central Record of Invoice is expected to be established in Factoring firms Association, aiming to prevent the use of certain receivables under multiple factoring transactions. Juridical and administrative penalties are introduced, in order to safeguard all relevant transactions from potential practices that contradict the legislation. Although factoring companies will be regulated and supervised by the BRSA in accordance with the aforementioned legal act (when finalized), it appears that they are not required to comply with any requirements that stem from the Basel II framework. An additional requirement has been imposed by BRSA to banks that have a factoring company as a subsidiary at the consolidated group level, with the issuance of Banking Law No (September 2008). According to this, the Bank shall establish a Risk Center in order to collect information about the risk status of the clients of the deposit banks, participation banks, development and investment banks, financial holding companies, financial leasing companies, factoring companies, financing companies operating in Turkey and other financial institutions to be considered appropriate by the Bank and the Banking Regulation and Supervision Board, and to share such information with the Banking Regulation and Supervision Agency and other relevant institutions. These institutions shall provide any information to be requested in connection with the risk status of their clients, including the protests notice of lodged by banks. All transactions and records of the Risk Center shall be confidential Partial/Adapted compliance In certain countries, regulation for factoring companies has been introduced and has been aligned to a big extent to the Basel II capital adequacy requirements. However, factoring companies enjoy preferential treatment in specific issues, mainly in respect to the minimum capital requirement set. Business and Regulatory Overview of Factoring 28

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