Factoring & Forfaiting

Transcription

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

29 Italy In Italy, regulation and supervision of factoring is covered in the Single Banking Law, the codified text on banking and finance. Any bank may engage in factoring, subject to supervision by the central bank (Bank of Italy). Other financial intermediaries are registered with the Italian Foreign Exchange Office. Factoring companies are subject to capital adequacy rules, that stem from the European Union's capital requirements directives, and have therefore since January 1st 2007 been subject (under Law 15/2007) to a risk-based approach to prudential supervision based on the Basel II accord. This takes into account their credit, operational, exchange-rate and trading risk. The Bank of Italy has in fact placed factoring companies on the same footing as banks, standardizing the control of the capital adequacy in relation to the entity of the risks undertaken, with a weighting by type of counterparty aligned. The Bank of Italy expects this change to offer factoring companies potential for growth because it will reduce their cost of finance, due to the greater transparency of the risk involved in lending to them and the fact that they will de facto be as sound as banks. Although the approach to capital requirements calculation is the same as for financial institutions, there are some differences in the way the rules are applied in order to take the special characteristics of factoring companies into account. The Italian Regulator, starting from 2008, provides rules to determine RWA and differentiated individual ratios: 8%, if Factor collects savings from public (which means that it is a banking institution offering factoring services), 6% if Factor does not collect savings from public, and 4.5% if Factor does not collect savings from public and is part of a banking group, which is required to comply to Basel II regulations at the consolidated group level. For a transition period until 2011, factoring companies are offered another advantage, which concerns counterparty concentration. They are required to respect a limit of 40% over regulatory capital of single client exposure, which is set to 25% for banks, and a Large Exposure threshold of 15% over regulatory capital exposure to one client (compared to 10% for banks). However, it is expected that both capital requirements and Business and Regulatory Overview of Factoring 29

30 regulatory limits for factoring companies will be aligned to those for banks when the aforementioned transition period expires Spain In Spain, factoring companies are recognized as Specialized Credit Institutions (SCIs), which represent a subgroup of Credit Institutions (CIs), and are regulated and supervised by the Bank of Spain (BoS). Spain has introduced the Law 36/2007 of 16 November 2007 amending Law 13/1985 of 25 May 1985 on investment ratios, own funds and reporting requirements of financial intermediaries and other financial system rules. As Bank of Spain states in its Report on Banking Supervision in Spain (2007), this Law, which partially transposes Directive 2006/48/EC of the European Parliament and of the Council, incorporates the so-called Basel II Accord into the national legal framework with the aim, among others, of ensuring an appropriate level of solvency and a level playing field for CIs, making the regulatory capital required more sensitive to actual risks and encouraging better risk management. Similar to Italy, factoring companies in Spain enjoy preferential treatment in respect to the minimum capital level within the Basel II Framework. The Law 36/2007 states that the Bank of Spain may not require full compliance with individual requirements for credit risk from Spanish credit institutions, which form part of a consolidated group of credit [ ] where the parent company is a credit institution [and] has as main activity the activity of holding shares in banks (unofficial translation - Spanish text is available only). More specifically, factors that are part of a banking group, which is regulated at the consolidated level by BoS, are required to comply with a 4% minimum capital ratio, instead of the normal 8% that is required from Factors that operate independently. As an example for this provision, it is worth mentioning the full acquisition of Popular de Factoring (PdF) by the Banco Popular Group that was completed in In its 2006 annual report, PdF stresses the change in its minimum regulatory capital ratio to 4% from 8% in 2005, when it was operating on a stand-alone basis. Business and Regulatory Overview of Factoring 30

31 Full compliance France In France, factoring must be carried out by credit institutions that are subject to prudential requirements and supervision, and are members of the Association Française Des Sociétés Financières (ASF). Most of these companies are licensed as finance companies, while a few retain a banking license. Factoring institutions in France have been required to comply with the Basel II Framework, under the Order of the Minister of the Economy, Finance and Industry of 20 February 2007, which was amended in October 2007 and September Austria According to the Austrian Federal Banking Act (Bankwesengesetz), the purchase of trade receivables, assumption of the risk of non-payment associated with such receivables with the exception of credit insurance and the related collection of trade receivables (factoring business) is considered a banking transaction and is restricted to credit institutions, which are authorized by the Financial Market Authority (FMA). Article 22 of the aforementioned Act states that: Credit institutions and groups of credit institutions must have at their disposal eligible capital equal to the sum of the amounts under nos. 1 to 5 at all times: 1. 8% of the assessment base for credit risk calculated in accordance with para. 2; 2. the minimum capital requirement for all types of risk in the trading book in accordance with Article 22o para. 2; 3. the minimum capital requirement for commodities risk and foreign-exchange risk, including the risk arising from gold positions, each for positions outside the trading book; 4. the minimum capital requirement for operational risk in accordance with Article 22i; 5. additional capital requirements as necessary in accordance with Article 29 para. 4 and Article 70 para. 4a. The net position in a foreign currency may be calculated by offsetting positions within and outside of the trading book. Austrian credit institutions, including factoring companies, are required to calculate the appropriate capital requirements under the Basel framework, in accordance with the Business and Regulatory Overview of Factoring 31

32 Regulation of the Financial Market Authority on the Solvency of Credit Institutions (Solvabilitätsverordnung) Sweden Factoring institutions in Sweden are registered to and supervised by the Swedish Financial Supervisory Authority (Finansinspektionen) and are required to comply with Basel II requirements, as instructed in the Capital Requirements & Large Exposures Act (2006:1371) and the Capital Requirements & Large Exposures Ordinance (2006:1533). In contrast to Greek regulations, Sweden does not make use of the CRD national discretion option for the individual waiver of subsidiaries that operate within a regulated financial group, subject to the fulfillment of certain conditions Finland Factoring companies in Finland are under the supervision of Finnish Financial Services Authority (FIN-FSA) in accordance with its rules and regulations, which are in direct accordance to the CRD Basel II. However, according to the FIN-FSA The set of regulations is currently being reformed, the end result being that the separate regulations for credit institutions and capital markets will be abandoned in favor of subject-specific regulations. In this respect, and regarding factoring, the Finnish Bankers Association is quoted (Comments on Consultative Paper 3, ): The Consultative Document refers particularly to purchased retail and corporate receivables when defining the eligible collateral. We would like to draw attention to the fact that factoring business is carried out in different forms. Whereas in the Central Europe factoring normally means that the factoring company purchases the receivables, and thereby takes a credit risk (non- recourse factoring), factoring in Finland and other Scandinavian countries as a rule means that the factoring company lends money to this client with the receivables as collateral (recourse factoring). The loan to collateral value varies with the risk, but usually amounts to about 80 % of the total value of the invoices held as collateral. This means that the risk level is already taken into account when the factoring transaction is made. In addition, the client is normally obliged to take back receivables when the debtor is in default, including the credit risk. As a consequence, the risk level of factoring for factoring companies is extremely low. Finnish Banker s Business and Regulatory Overview of Factoring 32

33 Association proposes that the definition of eligible receivables would also cover lending against receivables (recourse factoring) Portugal According to the Credit Institutions and Financial Companies Legal Framework of Portugal, Factoring companies are considered as Credit Institutions. Thus, Factoring companies fall under the scope of the Banco de Portugal (BdP) supervision. Regarding Basel II, the new regulatory framework was adopted in Portugal with the publication of Decree-Law no. 103/2007 and Decree-Law no. 104/2007, both of 3 April, and with the issuance of a set of Notices and Instructions of BdP which regulate the provisions laid down in those Decree- Laws. These legal documents are replicating the CRD Basel II content Summary Table Country No Compliance Adapted Compliance Full Compliance Turnover 2008 (mil ) United Kingdom France Italy Germany Spain Netherlands Ireland Belgium Turkey Portugal Russia Sweden Finland Greece * Poland Austria Business and Regulatory Overview of Factoring 33

34 Country No Compliance Adapted Compliance Full Compliance Turnover 2008 (mil ) Denmark Czech Republic Lithuania Cyprus Hungary Switzerland Romania Slovakia Latvia Estonia Slovenia 650 Malta 52 * Regulation for full compliance to Basel II has been drafted in Greece 6. Basel II Standardized Implications Regulation and supervision for factoring companies is welcomed by all factoring associations around the world. It has been repeatedly stated that regulation enhances the transparency within an industry and promotes sustainable growth. However, there has been increased criticism for specific Basel II rules, in particular regarding the level of risk attributed to factoring transactions under the Standardized approach to credit risk capital requirements calculation. The International Chamber of Commerce (ICC) argues, in a paper released in March 2009, that the financial crisis has brought into sharp relief an ongoing trend whereby the implementation of the Basel II charter has eroded the incentive of banks to lend trade finance, due to pronounced capital weightings that are not fully reflective of the low risk level of the activity. Similarly, the European Banking Federation (FBE) has claimed that the Committee s proposals on the treatment of trade finance under both the standardized and foundation IRB approaches fail to reflect the low loss experience in trade finance and would lead to a significant increase in capital required. The Swedish Banker s Association, in a position paper, suggests the use of a 50% riskweight under the Standardised Approach for leasing and factoring [exposures], considering Business and Regulatory Overview of Factoring 34

35 the low risk level of these products in comparison with the risk level of ordinary bank loans Short-term maturity (less than 1 year) In general the Standardized approach to credit risk does not differentiate its treatment depending on the maturity of the exposures, with the exception of exposures to rated financial institutions with maturity up to three months. This results in excess risk being attributed to short-term exposures, which is another incentive for institutions to pursuit the application of advanced methodologies that take into account the maturity of each exposure when estimating the appropriate risk weight. This drawback of the Standardized approach normally has a greater impact on factoring exposures which have almost always a maturity of less than one year. If one also considers the following issue of nonrecognition of the collateral that recourse offers, it is clear that factoring transactions create a significant capital burden if the Standardized approach of the Basel framework is applied. Subsequently, the implementation of the IRB approach appears to be the only option for factoring institutions that are required to comply with the Basel requirements for capital adequacy Eligibility of collaterals Certain factoring associations have stressed the need for collateral recognition under the Basel II standardized approach, in particular for transactions with recourse. As stated by Assifact, the Italian Association of Factoring Companies, in factoring transactions with recourse, the Factor does not stand assured for the success of the transaction, so in the event of the assigned debtor s default the credit is passed to the assignor. In compliance with the supervisory reporting manual and the Risks Center of the Bank of Italy, the cash credit risk for the Factor is represented by the amount of the assigned asset that may have been paid in advance to the assignor. Such a transaction is characterized by the presence of two co-obligor figures; the assignor and the assigned debtor. According to this assignment arrangement, a default may only be ascertained when both the assigned debtor and the assignors jointly default (double default). Although the joint default of the obligor and the seller of the receivables would normally be considered as a low probability event, the Standardized approach to credit risk currently treats such exposures as uncovered and Business and Regulatory Overview of Factoring 35

36 assigns a conservative risk weight (usually 100%, since the majority of corporations involved in factoring are either unrated or rated below A-). Assifact argues that even in transactions without recourse, risk mitigation results from the information collected in the direct relations with the assigned debtor prior to maturity of the credit, due to the management component of the factoring service, as well as from the possibility that a plurality of assignments relates to a single assigned debtor and/or the assignment of the same debtor in a number of transactions on the part of the same assignor. In that sense, applying a risk weight equal to that of a loan to the same counterparty could be considered as extremely conservative. In the CEBS document titled CEBS Second advice on options and national discretions, Assifact states the following in respect to the eligible CRM techniques: With respect to risk mitigation techniques for insolvency, we highlight the absence of insurance policies on credits among the acceptable techniques for risk mitigation: these play a significant role in the type of risk management used in factoring. We underline that recourse to this technique for the transfer of risk associated with the debtors transferred is favoured by the fact that in both factoring and insurance the risk is accepted on portfolio logic, even though each unit in the aggregate is evaluated specifically. We believe that the evolution of the contract structures used, specifically on the matter of the effectiveness of the guarantee with respect to the insured party s obligations, the modality and the times of the execution of the guarantee as well as the maximum limit of the policy, can render this risk mitigation technique acceptable with respect to the requirements set out for personal guarantees. Assifact continues, covering the mitigation of dilution risk: With respect to the dilution risk, the obligations assumed by the guarantor are not based on mitigating the risks of the principal debtor s insolvency, but rather by mitigating the risk that the transferred debtor will not miss a payment for the outstanding debt due to the underlying commercial relationships, that is to say the supply of goods/services by the transferor. In this context, mitigating the risk of a missed payment by the debtor is reduced by the actions undertaken by the transferor (substituting goods/services, a discount being applied to the debtor purchaser, etc) whose effectiveness is not reflected by insolvency ratings. To this end, we believe that transferring companies with a rating Business and Regulatory Overview of Factoring 36

37 even below the minimum level set out in the Directive, i.e. class 2 should fall within the range of eligible guarantors if the contractual structures attribute to the transferor the role of guarantor for dilution risk as is the case with Italy. Moreover we highlight that the dilution risk involves different types of financial operations based on trade receivables: in light of an international comparison, these operations are different even at a national level, therefore the contractual structures of the guarantees may also be difficult to compare. In the contract structures adopted in Italy, there are, for example, certain obligations imposed on the assignor, under penalty of termination of the factoring contract. These obligations appear to be sufficient to mitigate dilution risk and allow the recognition of the assignor s role as guarantor with respect to such risk. Specifically, in the general conditions of the contract, the supplier is obligated to: Fulfill precisely and timely the underlying supply contracts, besides naturally guaranteeing certainty and collectability of receivables; Make available to the factor all the documentation and information concerning the qualitative characteristics of the assigned claims and the business relations from which these claims arise, including documentation on contracts and supplies, etc; Update this documentation and information to enable the factor to verify that the supplier s obligations are met; Timely communicate any relevant information concerning the relationship with the debtor, any possible objection, claim or complaint; Not modify, without the prior approval of the factor, the conditions of the sale and/or service provision, and not grant rebates, price reductions, return of goods, etc. In any event, consideration for the assigned claim, generally equal to the value of the claim, will be paid by the factor to the assignor already net of any discounts, rebates, deductions and anything else. These contractual provisions oblige the assignor to transparently and properly fulfill the supply transactions underlying the claim subject of the assignment, with the obligation to inform the factor of any actions undertaken to perform business relations and enable the factor to use the securities that are regulated by contract, besides putting in place Business and Regulatory Overview of Factoring 37

38 monitoring procedures and systems to verify the quality of the purchased receivables in correlation to the assignor s situation. In relation to this last passage, these operational requirements, that further protect against the dilution risk, are part of the consolidated good market practice on factoring, even beyond the contractual provisions, and in certain national contexts such as Italy, they are recognized and given value in the prudential supervision guidelines that expressly provide for the implementation of monitoring systems to verify the quality of the purchased portfolio, to resolve issues, check the availability of credit and collections. It is understood that this implication of the Basel II regulations represents one of the various incentives that the regulators give financial institutions to adopt more advanced and risk-sensitive approaches for the calculation of capital requirements of credit risk (i.e. Internal Ratings Based approaches). However, the implementation of IRB approaches by factoring companies involves several weaknesses that are discussed further down Definition of Past Due Another point raised by factoring associations has been the technical definition of Past Due, where the obligor is past due more than 90 days on any material credit obligation to the credit institution, the parent undertaking or any of its subsidiaries. It has been argued that factoring transactions, which may involve assets that are past due for more than 90 days, fall under the most unfavorable risk-weighting, even though they represent exposures with mitigated risk. Within a factoring activity, the purchase of past due credits is a standard transaction, since the Factor acts as a connection between the parties and takes over during the collection and the debt recovery phase, if any. In addition to the above, in the context of an assignment of a commercial claim, an individual default might stem from events related to the underlying supply contract, without entailing that the obligor s creditworthiness has deteriorated, or that its solvency has become questionable. As an amendment to the above Basel rule, Assifact has recommended that purchased receivables are identified as high-risk when the following conditions are jointly met: The assets are past due for more than 90 days The delay in payments is continuous and repetitive Business and Regulatory Overview of Factoring 38

39 In respect to the second point, the Italian Association claims that, assuming that a factor is the buyer of a number of claims from different creditors, but in respect of a single assigned debtor, then such a factor has access to considerable information to estimate whether the delay is caused by events related to a supply contract or the state of difficulty of the debtor. In that sense, factoring companies are able to note when a debtor repeatedly delays payments (continuing default), and therefore identify the related past due exposure to that party as high-risk, attributing the least favourable risk-weight treatment Non - recognition of insurance as a form of credit risk mitigation The recognition of non-payment insurance has been a well discussed issue in the context of the Basel II Standardized Approach to credit risk. It is a fact that the eligibility of insurance as a credit risk mitigant is not explicitly stated in the 2006/48 Capital Requirements Directive of the European Council, with the exception of life insurance policies pledged to the lending credit institution, which are permitted to be considered as guarantees by the insurance provider, as far as they meet certain conditions set in the Directive. The above issue was raised during 2002 in a BIS FAQ paper for the 3rd Quantitative Impact Study (QIS3), concerning credit risk mitigation (CRM) within the Basel II Framework. The question posed to BIS was: If a bank is using a credit risk mitigant, like insurance, that effectively functions like a guarantee is it allowed to treat such risk mitigants as an ordinary guarantee?. The official response from BIS was affirmative, provided that such a product meets the operational requirements for guarantees laid down in paragraph 154 to 165 of the Technical Guidance any product may be treated as a guarantee. These operational requirements that are related to guarantees (the rest are only applicable to credit derivatives) are listed below: 154. A guarantee/credit derivative must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures, so that the extent of the cover is clearly defined and incontrovertible. Other than non-payment by a protection purchaser of money due in respect of the credit protection contract it must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating Business and Regulatory Overview of Factoring 39

40 credit quality in the hedged exposure.42 It must also be unconditional; there should be no clause in the protection contract that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due Additional operational requirements for guarantees: a) On the qualifying default/non-payment of the counterparty, the bank [Factor in this context] may in a timely manner pursue the guarantor for monies outstanding under the documentation governing the transaction, rather than having to continue to pursue the counterparty. By making a payment under the guarantee the guarantor must acquire the right to pursue the obligor for monies outstanding under the documentation governing the transaction. b) The guarantee is an explicitly documented obligation assumed by the guarantor. c) The guarantor covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. This clarification, provided by BIS, is of high importance because it represents the only written evidence that financial insurance may be eligible, under Basel II rules, for credit risk mitigation, as far as it complies with the aforementioned operational requirements. However, it is important to note that this interpretation of insurance was not explicitly adopted in the 2006/48 Capital Requirements Directive and, subsequently, was not included in most national regulations, including the Bank of Greece Act 2588/ , leading to uncertainty on whether the regulators recognize financial insurance policies as CRM guarantees. 7. Basel II IRB Implications As mentioned previously, there has been significant incentive for factoring companies and banks that offer factoring and forfaiting services to adopt an IRB approach to credit risk, under the Basel II framework. One of the main advantages of the IRB against the Standardized approach is the recognition of collateral in a factoring transaction with recourse. As mentioned in the Capital Requirements Directive, issued by the European Union (2006/48), The risk-weighted exposure amounts for dilution risk for purchased Business and Regulatory Overview of Factoring 40

41 receivables shall be calculated according to Annex VII, Part 1, point 28. Where a credit institution has full recourse in respect of purchased receivables for default risk and for dilution risk, to the seller of the purchased receivables, the provisions of Articles 87 and 88 in relation to purchased receivables need not be applied. The exposure may instead be treated as a collateralized exposure (Article 87, Paragraph 2). Further to that, the Directive instructs that The competent authorities may recognize as eligible collateral amounts receivable linked to a commercial transaction or transactions with an original maturity of less than or equal to one year. Eligible receivables do not include those associated with securitizations, sub-participations or credit derivatives or amounts owed by affiliated parties (Annex VIII, Paragraph 20). Still, there has been debate about specific elements in the IRB methodology that prevent institutions from adopting it. These obstacles mainly relate to data and system issues, as well as the failure of the IRB approach in recognizing the particular nature and the typically short maturity of factoring exposures year horizon for the PD calculation The Basel II IRB regulation sets a horizon of 1 year for the calculation of Probability of Default (PD). Therefore, even though the risk attributed to exposures of more than a year long is risk-based (in contrast to the Standardized approach), this maturity floor results in a distorted picture of the risk linked to trade finance transactions, such as factoring which are of short-term nature. The Italian Factoring Association (Assifact) first raised this issue in 2001, suggesting that the waive of the floor would lead to the calculation of more realistic PDs, and to an appropriate capital relief to factoring companies, while continuing to reflect a prudent level of risk for exposures with maturities around 180 days. The aforementioned issue has been recently recalled by the International Chamber of Commerce (ICC) in a paper that discusses the impact of the Basel II Framework on the trade finance industry. The ICC argues that the contractual maturity of trade finance products is reflective of the time horizon, over which the Factor is exposed to credit risk, and that the maturity floor assigns excessive amounts of risk. Business and Regulatory Overview of Factoring 41

42 7.2. Definition of Default This implication has already been discussed in the previous section, in relation to the Standardized approach of the Basel II Framework. Similarly, the IRB approach fails to recognize the particular nature of factoring transactions, which are likely to breach the 90- days past-due threshold due to factors that are independent from the creditworthiness and solvency of the obligor. Therefore, the introduction of the term continuous and repetitive delay of payments, as a default indicator for factoring transactions, has been recommended by Assifact in the context of the IRB approach as well Contagion Effect Local regulators need to clarify which amounts should be treated as past due under the IRB approach of Basel II; In Greece, the issue of contagion of the default status is under discussion. This discussion affects the IRB implementation, since the Standardized approach treats the exposures at a facility level, thus taking as past due the whole amount of the accounts receivable even if only a portion is actually past due. The following approaches have already been suggested by Greek Factors: For the factoring transactions with recourse, it has been suggested that the Factor should not account as past due the whole portfolio of a certain Seller in case only one of his Buyers is in arrears. In other words, only the specific accounts that are over 90 days in arrears should be accounted as past due within the Basel II framework, and not the whole portfolio For the factoring transactions without recourse, it has been suggested that only the amount past due (of the accounts payable which are over 90 days in arrears) of a certain Buyer towards a specific Seller should by accounted as past due by the Factor within the Basel II framework, and not all the accounts payable of this Buyer to all Sellers that are served by the Factor. The above points are still under discussion between Greek Factors and the Bank of Greece, with relevant decisions being expected in the near future. Business and Regulatory Overview of Factoring 42

43 7.4. Dilution risk The Basel II Framework presents the method of calculating the capital requirements versus the Unexpected Losses (UL) for purchased receivables. For such assets, there are IRB capital charges for both default risk and dilution risk. The calculation of risk-weighted assets for dilution risk and the method of calculating expected losses, and for determining the difference between that measure and provisions is provided within the Capital Requirements Directive (Directive 2006/48/EC) text. Dilution refers to the possibility that the receivable amount is reduced through cash or non-cash credits to the receivable s obligor. For both corporate and retail receivables, unless the Factor can demonstrate to its supervisor that the dilution risk for the purchasing company is immaterial, the treatment of dilution risk must be the following: at the level of either the pool as a whole (top-down approach) or the individual receivables making up the pool (bottom-up approach), the purchasing Factor will estimate the oneyear EL for dilution risk, also expressed in percentage of the receivables amount. Institutions can utilize external and internal data to estimate Expected Losses. As with the treatments of default risk, this estimate must be computed on a stand-alone basis; that is, under the assumption of no recourse or other support from the seller or third-party guarantors. For the purpose of calculating risk weights for dilution risk, the corporate risk-weight function must be used with the following settings: the PD must be set equal to the estimated EL, and the LGD must be set at 100%. An appropriate maturity treatment applies when determining the capital requirement for dilution risk. If an institution can demonstrate that the dilution risk is appropriately monitored and managed to be resolved within one year, the supervisor may allow the institution to apply a one-year maturity. Examples include offsets or allowances arising from returns of goods sold, disputes regarding product quality, possible debts of the client to a receivables obligor, and any payment or promotional discounts offered by the client (e.g. a credit for cash payments within 30 days). This treatment is applied regardless of whether the underlying receivables are corporate or retail exposures, and regardless of the approach used for the computation of risk weights for default risk. Business and Regulatory Overview of Factoring 43

44 7.5. Limited availability of data Both Assifact and ICC have noted the challenges involved in the application of an IRB approach by a factoring company in respect to historical data pooling and analysis. The ICC stresses the difficulty in identifying and isolating sufficient data to produce validatable estimates of risk attributes for trade lending, when attempting to adopt an Advanced IRB approach. Inevitably this forces Factors to apply either the conservative parameters set by the national regulator under the Foundation IRB approach, or the, even more conservative, risk weights of the Standardized approach. Another specific data concern, raised by Assifact, is the estimation of default correlations, which are relevant to transactions with recourse, where the probability of joint default by the seller and the debtor has to be derived. It is generally accepted that default correlations represent one of the hardest-to-estimate parameters, even for creditors, for which an institution may have exhaustive relevant historical data. It is, therefore, expected that such correlation estimates for factoring exposures will heavily depend on expert judgment. The risk attributed to such a transaction may be very sensitive to the level of the estimated probability of joint default, which can be almost impossible to derive with accuracy, particularly when the obligor and the receivables seller operate in industries that do not offer sufficient correlation data (e.g. a dairy producer and a supermarket) System requirements In close relation to the previous issue, factoring companies that decide to follow an IRB approach to credit risk capital calculation will face significant trouble in respect to the systems required to support such approaches. Since Factors have typically implemented less advanced systems than banking institutions, the adoption of an IRB approach entails material cost. This reduces the incentives that Factors are given to pursuit advanced methodologies, especially when the factoring company represents a subsidiary in a financial group, with marginal materiality (if any) in terms of the group s risk and return profile. It is, thus, expected that, in many instances, the implementation of an IRB approach for a factoring subsidiary will be rejected upon the relevant cost/benefit analysis performed by the parent company. Business and Regulatory Overview of Factoring 44

45 8. Conclusions In the majority of the countries (22 out of 28 examined), Factoring and Forfaiting companies are not subject to Basel II Regulatory Capital calculation and reporting on a solo basis. In Italy and Spain, the local regulators have adopted an adjusted Basel II framework, posing lower minimum capital ratios to the Factoring companies. In countries such as France, Portugal and Finland, Factoring companies are regulated in direct accordance to the Basel II Capital Requirements Directive. Greece has recently drafted regulation that instructs the compliance of factoring companies to the Basel II CRD. In terms of the Basel II implications in case the Framework is applied to Factoring companies, there are certain issues worth mentioning, such as: The explicit identification of the counterparty of factoring claims, both in agreements with recourse and without recourse, under Standardized and IRB The recognition of purchased receivables as eligible under the Standardized approach; the current framework treats all factoring exposures as uncovered The use of insurance as a credit risk mitigant; currently, credit insurance in Factoring is not explicitly considered as eligible The maturity floor of 1 year for all exposures under the IRB Approach. This maturity floor, by not considering the short-term business nature of Factoring, results in a distorted picture of the risk linked to the transaction Additional issues requiring further discussion in respect to the IRB include risk parameters modeling complexities combined with the extensive data and systemic requirements Business and Regulatory Overview of Factoring 45

46 REFERENCES 1. The New Basel Capital Accord, Consultative Document No 3, Basel Committee on Banking Supervision (April 2003) 2. Directive 2006/48/EC Of The European Parliament And Of The Council (June 2006) 3. Quantitative Impact Study 3 Technical Guidance, Basel Committee on Banking Supervision (October 2002) 4. QIS3 FAQ: E. Credit Risk Mitigation, Bank for International Settlements ( 5. Draft of Bank of Greece Governor s Act 2142/ , Bank of Greece (November 2008) 6. Order of The Minister of the Economy, Finance and Industry of 20 February 2007 relating to capital requirements for credit institutions and investment firms, France (amendment of September 2008) 7. The 1993 Banking Law, Bank of Italy (February 2007) 8. Notice on the granting of authorization to provide financial services pursuant to section 32 (1) of the German Banking Act, Deutsche Bundesbank (December 2008) 9. Banking Law No. 5411, The Banks Association of Turkey (September 2008) 10. Receivables Finance % ABL: A study of Legal Environments across Europe, International Factors Group (2007) 11. Impact of Basel II on Trade Finance, International Chamber of Commerce (March 2009) 12. The Impact of the Basel II Rules On Factoring, Association Française Des Sociétés Financières (January 2008) 13. Comments on the QIS 3 Technical Guidance Note, Fédération Bancaire De L Union Européenne (December 2002) 14. Comments on the third consultative paper on the New Basel Capital Accord (CP3), Belgian Bankers Association (July 2003) 15. Factoring becomes a regulated financial service in Germany, DLA Piper Newsletter (February 2009) 16. Leasing & Factoring - Amendments to the German Banking Act, DLA Piper newsletter (December 2008) 17. Germany: Factoring Becomes A Regulated Business Under Supervision Of The German Financial Supervisory Authority, Article by Karl Friedrich Dumoulin, Business and Regulatory Overview of Factoring 46

47 ( r+supervision+of+the...-a ) 18. New German Licensing Requirements for Leasing and Factoring Companies, Clifford Chance Newsletter (December 2008) 19. Position paper of the factoring industry on the Basel capital accord, Assifact (May 2001) 20. Factoring and Banks, Presentation, Fausto Galmarini (September 2007) 21. Unicredit Factoring Annual Report and Financial Statements Italy finance - Top ten factoring firms, Economist Intelligence Unit ( e_title=profiles&rf=0) 23. Report on Banking Supervision in Spain 2007, Banco De Espana 24. Popular de Factoring Annual Report Press Release on Draft Act on Financial Leasing, Factoring and Financing Companies, Banking Regulation and Supervision Agency, Turkey (January 2008) 26. Press Release No 2008/11, Regulation and Supervision Agency, Turkey (May 2008) 27. Regulation of factoring companies, Article, Independent Factoring Brokers Association, UK ( 28. The changing shape of political risks insurance, Charles Berry, Coface Country Risk Conference Factors Chain International statistics 30. SDA Bocconi Business School, Factoring Survey FIN-FSA, Banca d Italia, Malta Financial Services Authority 34. Swedish Financial Supervisory Authority 35. Swedish Bankers Association 36. Central Bank of Austria 37. Austrian Financial Services Authority 38. CEBS Second Advice on options and national discretions 39. Presentation of Mr. Panos Papatheodorou at EEFA s (East-European Factors Association) at 4th Annual Conference in Vilnius, Lithuania (14-17 Sep. 2004). Topic: Factoring in the Balkans. Business and Regulatory Overview of Factoring 47

48 40. Presentation of Mr. Panos Papatheodorou at EEFA s 5th Annual Conference in Ljubljana, Slovenia (7-10 November 2005), Topic Independent Factoring Companies Vs Bank Divisions. 41. Article at Kerdos Newspaper, by Ms. Natassa Spagadorou (22/11/05). 42. Article/interview at Naftemporiki Newspaper (2003). Business and Regulatory Overview of Factoring 48