## **Factoring From A Global Perspective**

SMEs, the creditworthiness of the owner is likely closely intertwined with the creditworthiness of the business (Ang 1992; Mester 1997).<sup>16</sup> But like consumer credit scoring, SME and micro-enterprise credit scoring depends on a strong information infrastructure—particularly informative data from credit bureaus. The adoption of SME and micro-enterprise credit scoring by lenders in countries with weak information infrastructure may be problematic.

# **Asset-based lending**

Lenders may be able to overcome information asymmetry by using asset-based lending, where the borrower’s underlying assets are offered as collateral and considered the primary source of repayment. When providing working capital financing, banks look to short-term assets such as accounts receivable and inventory, and to equipment. The pledging of collateral does not, by itself, distinguish asset-based lending from the three previous lending technologies. Collateralization with accounts receivable, inventory, or equipment can be associated with financial statement lending, relationship lending, and credit scoring. The difference is that with the other lending types, collateral (if it is used) is viewed as a secondary source of repayment—whereas under asset-based lending, it is viewed as the primary source of repayment.

The amount of credit extended under an asset-based loan is explicitly linked on a formula basis to the liquidation value of the assets used as collateral. This link is continuously monitored to ensure that the value of the assets always exceeds the amount of the loan. A key benefit of asset-based lending is that an SME’s riskiness is not necessarily a barrier to finance if its underlying assets have sufficient liquidation value. Thus, asset-based lending is well suited to high-risk SMEs.<sup>17</sup> Another strength of asset-based lending is its ability to generate information about borrower performance through the continuous monitoring of the underlying assets. This helps eliminate the extreme form of risk shifting (moral hazard) that occurs when a firm’s insiders know that the company is in distress before outsiders do (Udell forthcoming). Asset-based lending is an important source of financing in the United States, where asset-based loans account for about one- third of total bank commercial and industrial loans. But it is only significant in two other countries, Canada and the United Kingdom. To be feasible, asset-based lending requires well-defined commercial law that clearly specifies security interests, an efficient lien registration system that clearly defines when liens are filed, and an efficient bankruptcy system that preserves lender priority (particularly security priority) and minimizes time in bankruptcy.

# **Factoring**

As discussed, factoring involves the purchase of accounts receivable by a lender known as a factor. Though factoring is similar to asset-based lending, there are three important differences. First, factoring involves only financing of accounts receivable, whereas asset-based lending also involves financing of inventory and equipment. Second, under factoring the underlying asset, accounts receivable, is sold to the lender (factor). Thus, title to them passes from the borrower to the lender—which means that if the borrower becomes insolvent, the underlying asset (the factored accounts receivable) is not part of the bankrupt’s estate. This distinction can be extremely important in financial systems with ambiguous commercial law or inefficient bankruptcy systems (see below).

> 16 Lenders can purchase small business credit scoring models from vendors such as Fair Isaac.

> 17 There is relatively little empirical evidence on asset- based finance. Among the exceptions are recent studies that find evidence consistent with practitioner and conventional wisdom that asset-based finance is associated with riskier borrowers (Carey, Post, and Sharpe 1998; Klapper 2000). For a more detailed and institutional perspective on asset-based lending, see Udell (forthcoming).

**10**

**THE WORLD BANK**