The Hidden Cost of Open Account
When I completed my 2006 Biannual Import Payment and Finance study, 62% of firms surveyed indicated anyone can use open account – it’s the “we will move anyone we can or who is willing to open account” mentality. I started wondering if anyone really has thought this through. I also started to wonder if banks are their own worst enemies, not educating their clients as to the true costs of open account. It is like filling up a car with petrol for US$75 and thinking that is expensive, without realising that oil is priced well below its true cost if the military costs are added.1
Coincidently, I have had a few recent discussions with investment grade companies that have moved significant payment volume from letter of credit (LC) to open account, only to say the internal administration effort was more than they expected. And most of these companies were not paying for their LCs, given their rating status.
While companies did not explicitly state this, the push to open account is recognition, right or wrong, that the substitution of a bank’s capital in the payment process is not inherently necessary. Thus, credit lines once devoted to issuing LCs are now freed up to do other things. There may be a misperception here, as banks will think very carefully before replacing a trade credit line with a working capital line or project finance facility that is not as safe as a trade line.
In addition, while many treasurers do not understand Basel II implications (or even know what Basel II means), the upcoming Basel II charges for operating risk and corporate capital based on risk rating grade will continue to affect finance costs.
Again, like the gasoline that actually costs a lot more at the pump than we pay the oil companies, open account has its own hidden costs.
When selling, exporters need to manage country risk, establish buyers’ credit lines, and manage the drawdown process – all of this can be an expensive process.
Certainly OECD sellers must factor this cost into their financial supply chain. Take the example of how a company would measure and integrate country risk into a customer risk assessment, to be able to justify the need of a guarantee when customer financials may not be acceptable? That takes having a country risk capability (even if outsourced to Fitch, etc.), customer risk assessment software, algorithms for setting buyer credit lines, a line management process and an understanding of bank regulations and payment/FX restrictions, etc. Think Venezuela, Pakistan, Turkey, etc. These activities are not typically done by low-cost labour either.
It has become pretty commonplace to try and create a post-shipment funding source for suppliers who are trading on open account. While an LC once took care of the financing, be it a pre-shipment line to procure materials to a post-shipment finance negotiation structure, now sellers have an option to finance post-shipment receivables, hopefully at a rate substantially lower than before. In moving to open account finance structures, one must consider:
Sellers typically don’t need insurance on an LC. Sure, they could confirm it based on the issuing bank’s standing and country risk, and that information is very accessible. But open account? Have you ever tried to secure receivable insurance as a middle market seller? Few insurers will look at it from a transactional basis. They want a premium based on some holistic package, typically selling you a BMW when all you need is a Volkswagen.
As for buyers providing payment indemnities to enable purchase order financing, the model for the underwriting of pre-shipment finance and what form the indemnity takes is unclear. It is not clear what form of enhancement the buyers’ bank will be comfortable in providing, what the sellers’ bank is most comfortable in receiving and who will pay for this payment indemnity. Michael McDonough, Bank of New York’s global trade product head, commented, “the quest for indemnification from the buyer that will facilitate the credit extension to the seller is the Holy Grail of the open account chase. Buyers who grant these indemnifications, under US GAAP, may face a situation where the former trade obligation needs to be re-classified as bank debt.”
Trade services are difficult to automate given their paper intensity, leading to high semi-fixed staff costs for all involved (banks, forwarders, agents, corporates). Moving vendors to open account generally does not decrease the financial or customs documentation requirements. Custom requirements drive paperwork. What moving to open account does is enable importers to streamline documentation that is absolutely necessary to approve payment. It does nothing to streamline customs clearance.
When companies do not use LCs as a payment method with their suppliers, the connection to the bank is lost. They are no longer outsourcing documentation management to banks. This is where it can become an internal administrative burden for corporates with hundreds, if not thousands, of suppliers.
Moving to open account from LCs involves replicating features inherent in the LC, including:
It is important to understand the distinction between trade deductions, trade disputes, trade discrepancies and open account deductions.
A trade deduction is a standard practice. For example, best buy and target have different requirements on how their vendor ships products, in fact, a several-inch thick book that spells these out. For every infraction there is a penalty assessed. A trade dispute is a WTO disagreement. For example, the disagreement could concern subsidies, (e.g. softwood lumber with Canada) or tax issues (e.g. gambling with Antigua), etc.
A trade discrepancy comes from the LC world, but is applicable to any purchase order/proforma invoice comparison with the final invoice. In a discrepancy situation, the word white paint is used when the technical term is titanium oxide. Not all discrepancies are trivial, and most get resolved at great cost and delay.
One of the great things about an LC is that it does not allow for trade deductions. In an open account world, deductions can be taken by the buyer for whatever they determined. There is a cost to resolve and manage these deductions, and it is not trivial.
From my discussions with treasurers, there continues to be a lack of awareness around risk exposure and the necessary controls required to be in compliance with regulatory requirements like Know Your Customer (KYC), OFAC, valuation issues, goods classification, etc. when dealing with not only overseas suppliers, but the myriad of agents that are involved in the process. For example, when commissions are paid to third parties, they need to track the money flow to those parties.
Compliance and risk requires the increased involvement of the treasurer. Companies must recognise that they need to incorporate US rules globally. Not being adequately aware of risk exposure, not establishing necessary controls and procedures, or overlooking regulatory requirements, can expose the enterprise to potential fines and penalties. Compliance involves both technology and people. In our work, we found training is recognised as the biggest investment required, particularly of sales staff. As to technology, most companies should do restricted party screening at the time the customer does a request for quote (RFQ). The important thing is to be able to follow the order from RFQ to shipment. If an export licence is required on an order, smart companies will not build or accept an order until they start processing an export licence. Defense industry orders can take up to six months to approve export licences.
1 Rocky Mountain Institute’s “Winning the Oil Endgame”