Factoring, Forfaiting Services and Off-Balance Sheet items: On Overview

06/02/2020

Table of Contents

Factoring, Forfaiting Services and Off-Balance Sheet items: On Overview

Dear bankers,

As we all know that is factoring, Forfaiting Services Off-Balance Sheet items,Bank Guarantee and Letter of Credit for JAIIB Exam. JAIIB exam conducted twice in a year. So, here we are providing the factoring, Forfaiting Services Off-Balance Sheet items,Bank Guarantee and Letter of Credit (Unit-6), Indian Financial system (Module A), Principle & Practice of Banking JAIIB Paper-1.

♦Factoring

Factoring implies a financial arrangement between the factor and client, in which the firm (client) gets advances in return for receivables, from a financial institution (factor). It is a financing technique, in which there is an outright selling of trade debts by a firm to a third party, i.e. factor, at discounted prices.

♣Process of Factoring

In finer terms factoring is a relationship between the factor and the client, in which the factor purchases the client’s account receivables and pay up to 80% (sometimes 90%) of the sum immediately, at the time of entering into the agreement. The factor pays the balance sum, i.e. 20% of the amount which includes finance cost and operating cost, to the client when the customer pays the obligation.

Borrowing company or the client sells the book debts to the lending institution (factor).
Factor acquires the receivables and extend money against the receivables, after deducting and retaining the following sum, i.e. an adequate margin, factor’s commission and interest on advance
Collection from the customer is forwarded by the client to the factor and in this way, the advance is settled.

Other services are also provided by the factor which includes:

Finance
Collection of debts
Maintenance of debts
Protection of Credit Risk
Maintenance of debtors ledger
Debtors follow-up
Advisory services
The factor gets control over the client’s debtors, to whom the goods are sold on credit or credit is extended and also monitors the client’s sales ledger.

♣Types of Factoring

Recourse and Non-recourse Factoring: In this type of arrangement, the financial institution, can resort to the firm, when the debts are not recoverable. So, the credit risk associated with the trade debts are not assumed by the factor.
On the other hand, in non-recourse factoring, the factor cannot recourse to the firm, in case the debt turn out to be irrecoverable.
Disclosed and Undisclosed Factoring: The factoring in which the factor’s name is indicated in the invoice by the supplier of the goods or services asking the purchaser to pay the factor, is called disclosed factoring.
Conversely, the form of factoring in which the name of the factor is not mentioned in the invoice issued by the manufacturer. In such a case, the factor maintains sales ledger of the client and the debt is realized in the name of the firm. However, the control is in the hands of the factor.
Domestic and Export Factoring: When the three parties to factoring, i.e. customer, client, and factor, reside in the same country, then this is called as domestic factoring.
Export factoring, or otherwise known as cross-border factoring is one in which there are four parties involved, i.e. exporter (client), the importer (customer), export factor and import factor. This is also termed as the two-factor system.
Advance and Maturity Factoring: In advance factoring, the factor gives an advance to the client, against the uncollected receivables.
In maturity factoring, the factoring agency does not provide any advance to the firm. Instead, the bank collects the sum from the customer and pays to the firm, either on the date on which the amount is collected from the customers or on a guaranteed payment date.

♣Advantages of Factoring

Factoring replaces high cost market credit and enables purchases on cash basis for availing cash discount.
The Customer gets instant finance against each invoice.
Low margin (Up to 20%) thereby improvement cash flow.
The customer gets large credit/grace period
Each invoice is following up for payment by the factor on the due date and thereafter.
MIS reports and sales ledge administration is totally taken care of by the factor.
Factoring accelerates receivables turnover and improves operating cycle, resulting in more production, larger scale, higher profits and increased ROI.

♦Forfaiting Services

Forfaiting is a mechanism, in which an exporter surrenders his rights to receive payment against the goods delivered or services rendered to the importer, in exchange for the instant cash payment from a forfaiter. In this way, an exporter can easily turn a credit sale into cash sale, without recourse to him or his forfaiter.

♣Process

♣Advantage of Forfaiting

Forfaiting provide a flexible, creative alternative to traditional international trade financing methods and is particularly useful for transactions with buyers in developing nations. The following are the advantages of forfaiting to the exporters:

(i)Forfaiting provided 100% financing-without recourse and not occupying exporter’s credit line. This is to say once the exporter obtains the financed fund, he will be exempted from the responsibility to repay the debt.
(ii)Forfaiting improves cash flow of the exporter-by converting receivables into current cash inflow and it is beneficial to the exporter to improve his liquidity and his ability to improve further the fund raising capability.
(iii)Forfaiting saves administration cost- by using forfaiting, the exporter will be freed from the management of the receivables. The relative costs, as a result, will be reduced greatly.
(iv)Forfaiting increase trade opportunity- with forfaiting, the exporter is able to grant credit to his buyer freely and thus, be more competitive in the market.

♣Comparison Chart

BASIS FOR COMPARISON	FACTORING	FORFAITING
Meaning	Factoring is an arrangement that converts your receivables into ready cash and you don’t need to wait for the payment of receivables at a future date.	Forfaiting implies a transaction in which the forfaiter purchases claims from the exporter in return for cash payment.
Maturity of receivables	Involves account receivables of short maturities.	Involves account receivables of medium to long term maturities.
Goods	Trade receivables on ordinary goods.	Trade receivables on capital goods.
Finance up to	80-90%	100%
Type	Recourse or Non-recourse	Non-recourse
Cost	Cost of factoring borne by the seller (client).	Cost of forfaiting borne by the overseas buyer.
Negotiable Instrument	Does not deals in negotiable instrument.	Involves dealing in negotiable instrument.
Secondary market	No	Yes

♦OFF-BALANCE SHEET ITEM

Also known as Off-Balance sheet items, Off-Balance sheet assets or liabilities, and Incognito Leverage. They are either a liability or an asset which are not shown on a company’s/Bank balance sheet as the business is not a legal owner of the respective item.
Off-Balance sheet items are generally shown in the notes to accounts along with the financial statements. These assets and liabilities may be used by a company/Bank; however, the legal ownership may or may not belong to them. In this case, the consumption of assets and payment of liabilities may ultimately be an indirect responsibility.
The term is very common with asset management companies, brokerage firms, wealth managers, etc. In this case, the assets being managed by firms do not belong to them but to the clients, so they are not recorded on the balance sheet.

There are item Include:

(a)Direct Credit substitutes, e.g. general guarantees of indebtedness (including stand by CLs serving as financial guarantees for loans and securities) and acceptance (including endorsements with the character of acceptance).
(b)Certain transaction-related contingent item (e.g performance bonds, bid bonds warranties and standby LCs related to particular transactions).
(c) Short-term self liquidating trade-related contingencies (such as documentary credits collateralized by the underlying shipment)
(d)Take-out finance in the books of taking over institution

Unconditional take-out finance
Conditional take-out finance
Non-funded exposures to commercial real estate

(e)Foreign exchange open position
(f)Open position in gold

♦Bank Guarantee

A guarantee means giving something as security. A bank guarantee is when a bank offers surety and guarantees for different business obligation on behalf of their customers within certain regulations. It is generally a promise made by the bank to any third person to undertake the payment risk on behalf of its customers.
Bank guarantee is given on a contractual obligation between the bank and its customers. Such guarantees are widely used in business and personal transactions to protect the third party from financial losses.

♣Advantage of Bank Guarantees

Bank guarantee reduces the financial risk involved in the business transaction.
Due to low risk, it encourages the seller/beneficiaries to expand their business on a credit basis.
Banks generally charge low fees for guarantees, which is beneficial to even small-scale business.
When banks analyse and certify the financial stability of the business, its credibility increases and this, in turn, increase business opportunities.
Mostly, the guarantee requires fewer documents and is processed quickly by the banks (if all the documents are submitted).

♣Disadvantage of Bank Guarantees

Sometimes, the banks are so rigid in assessing the financial position of the business. This makes the process complicated and time-consuming.
With the strict assessment of banks, it is very difficult to obtain a bank guarantee by loss-making entities.
For certain guarantees involving high-value or high-risk transactions, banks will require collateral security to process the guarantee.

♣Types of Guarantees

Financial Guarantee – These guarantees are generally issued in lieu of security deposits. Some contracts may require a financial commitment from the buyer such as a security deposit. In such cases, instead of depositing the money, the buyer can provide the seller with a financial bank guarantee using which the seller can be compensated in case of any loss.
Performance Guarantee – These guarantees are issued for the performance of a contract or an obligation. In case, there is a default in the performance, non-performance or short performance of a contract, the beneficiary’s loss will be made good by the bank.
Deferred payment guarantee: This refers to a bank guarantee or a payment guarantee that is offered to the exporter for a deferred period or for a certain time period. When a buyer purchases capital goods or machinery, the seller will give credit to the buyer when the buyer’s bank gives a guarantee that it will pay the unsettled dues of the buyer to the seller. Under this type of guarantee, payment will be made in installments by the bank for failure in supplying raw materials, machinery or equipment.

♦Letter of Credit

A letter of credit is a document that guarantees the buyer’s payment to the sellers. It is Issued by a bank and ensures the timely and full payment to the seller. If the buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer. A letter of credit is issued against a pledge of securities or cash. Banks typically collect a fee, ie, a percentage of the size/amount of the letter of credit.

♣Parties to a letter of Credit

Applicant (importer) requests the bank to issue the LC
Issuing bank (importer’s bank which issues the LC [also known as the Opening banker of LC])
Beneficiary (exporter)
Advising Bank
Confirming Bank

♣Types of Credit

Sight Credit: Under this LC, documents are payable at the sight/ upon presentation of the correct documentation. For example, a businessman can present a bill of exchange to a lender along with a sight letter of credit and take the necessary funds right away. A sight letter of credit is more immediate than other forms of letters of credit.
Acceptance Credit/ Time Credit: The Bills of Exchange which are drawn and payable after a period, are called usance bills. Under acceptance credit, these usance bills are accepted upon presentation and eventually honoured on their respective due dates.
Revocable and Irrevocable Credit: A revocable LC is a credit, the terms and conditions of which can be amended/ cancelled by the Issuing Bank. This cancellation can be done without prior notice to the beneficiaries. An irrevocable credit is a credit, the terms and conditions of which can neither be amended nor cancelled. Hence, the opening bank is bound by the commitments given in the LC.
Confirmed Credit: Only Irrevocable LC can be confirmed. A confirmed LC is one when a banker other than the Issuing bank, adds its own confirmation to the credit. In case of confirmed LCs, the beneficiary’s bank would submit the documents to the confirming banker.
Back-to-Back credit: In a back to back credit, the exporter (the beneficiary) requests his banker to issue an LC in favour of his supplier to procure raw materials, goods on the basis of the export LC received by him. This type of LC is known as Back-to-Back credit.
Transferable Credit: While an LC is not a negotiable instrument, the Bills of Exchange drawn under it are negotiable. A Transferable Credit is one in which a beneficiary can transfer his rights to third parties. Such LC should clearly indicate that it is a ‘Transferable’ LC.

♣Differences between Letter of Credit (LOC) and Bank Guarantee (BG)

Particulars	LOC	BG
Nature	LOC is an obligation accepted by a bank to make payment to a beneficiary if certain services are performed.	BG is an assurance given by the bank to the beneficiary to make the specified payment in case of default by the applicant.
Primary liability	Bank retains the primary liability to make the payment and later collects the same from the customer.	The bank assumes to make the payment only when the customer defaults to make payment.
Payment	Bank makes the payment to the beneficiary as and when it is due. It need not wait for a default to be made by the customer.	Only when the customer defaults the payment to the beneficiary, the bank makes the payment.
Way of working	LOC ensures that the amount will be paid as long as the services are performed as per the agreed terms.	BG assures to compensate for the loss if the applicant does not satisfy the specified conditions.
Number of parties involved	There are multiple parties involved here – LOC Issuing bank, its customer, the beneficiary (third party), and advising bank.	There are only three parties involved – banker, its customer, and the beneficiary (third party).
Suitability	Generally, this is more appropriate during the import and export of goods and services.	Suits any business or personal transactions.
Risk	Bank assumes more risk than the customer.	Customer assumes the primary risk.

♦Forward Rate Agreement (FRA) and Interest Rate Swap (IRS)

♣Forward Rate Agreement (FRA)

FRAs are forwards hence they are private contracts between counterparties.
The forward rate is locked in a FRA contract.
Buyer benefits when borrowing rate increases.
Seller benefits when borrowing rate decreases.

♣Interest Rate Swap (IRS)

Interest rate swap (IRS) is a type of swap and hence belongs to the class of derivatives. Its price is derived by market interest rates.
An interest rate swap is a financial agreement between parties to exchange fixed or floating payments over a period of time.

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