**Factoring From A Global Perspective**

# **FACTORING FROM A GLOBAL PERSPECTIVE**

This section assesses the importance of factoring in different countries, including the conditions that determine that importance. The discussion begins with an analysis of where factoring fits in the menu of lending products for SMEs. Next it considers the special case of factoring foreign receivables. After that, the global factoring market is summarized. The section ends with a discussion of how a country’s information infrastructure and legal environment affect the use of factoring relative to other financing techniques.

# **LENDING PRODUCTS: WHERE FACTORING FITS**

Private debt markets offer highly structured, complex contracts to informationally opaque SMEs. Except for trade credit, most external financing to SMEs is extended by financial intermediaries that produce information about small businesses to solve the problems that arise from information asymmetries. The access to credit information and the technology in local lending environments determine the extent to which SMEs obtain sufficient external financing to exploit profitable projects. The extent to which the business environment inhibits the optimal provision of credit determines the size of the funding gap that SMEs might face.

This section examines how factoring and the other lending products used in SME financing differ in terms of the underwriting process and the contracts associated with each product, and how each product addresses asymmetric information. This discussion will be helpful for the sections that follow, and will help explain why factoring may be better suited for developing economies than some other lending products.

From a policy perspective the importance of these various types of lending stems from the possibility that SMEs face significant funding gaps, which would occur if firms encountered significant financial constraints due to systematic credit rationing.<sup>11</sup> In a Modigliani and Miller world with complete information transparency, there would be no financial constraints that would inhibit SME growth. Therefore, the severity of the funding gap problem depends on the magnitude of information problems in SME financing (i.e., deviations from information transparency) and the strength of lending technologies to mitigate these problems.

Evidence suggests that the funding gap is a serious problem for SMEs. For example, insider finance is extremely important in SME funding—suggesting an information-driven pecking order to such financing (Berger and Udell 1998). Personal net worth and personal assets are important factors in determining whether potential entrepreneurs decide to start businesses (Evans and Jovanovic 1989; Evans and Leighton 1989; Holtz-Eakin, Joulfaian, and Rosen 1994; Lel and Udell 2002) and how they initially invest in their firms (Ando 1985; Holtz-Eakin, Joulfaian, and Rosen 1994).<sup>12</sup> SME funding gaps are also indicated by the fact that small firms’ cash flows affect their investment decisions (Fazzari, Hubbard, and Petersen 1988).

> 11 There is a long theoretical literature on equilibrium credit rationing based on asymmetric information, beginning with Stiglitz and Weiss (1981). Around the world, governments invest billions of dollars a year in loan and equity guarantee schemes, venture capital trusts, soft loan schemes, grants, equity investments, and other programs to address the perceived funding gaps in their national economies. These initiatives are often partly motivated by the belief that SME growth is critical to solving unemployment problems (e.g., Cressy 2002).

> 12 Although these findings are generally consistent with the presence of funding constraints, they may also be consistent with other explanations. It may be that these results are driven by risk aversion rather than financial constraints. There is even evidence that informational opacity may lead to excess SME funding (de Meza 2002).

**7**

**THE WORLD BANK**