**The Role Of Factoring In the New EU Member States**

role.<sup>24</sup> Concern has been expressed that new international banking rules on bank capital (Basel II) may exacerbate this problem, but it is too early to assess their impact.

# **THE ROLE OF FACTORING IN THE NEW EU MEMBER STATES**

The previous sections laid the groundwork for this paper’s main focus: the current and future role of factoring in Eastern Europe, particularly in the eight countries that became EU members on May 1, 2004: the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia, referred to here as the EU 8. As discussed, factoring is one of the main lending technologies used in SME financing. Relative to other lending products—financial statement lending, relationship lending, asset-based lending, credit- scored lending, and trade credit—it has both strengths and weaknesses. For example, it is more costly than financial statement lending and it does not provide inventory financing like asset-based lending. But its advantages suggest that factoring should play an important role in developing economies such as those in the EU 8.

Several characteristics of factoring may give it an edge in the EU 8. First, the fact that factoring removes receivables from the borrower’s estate in bankruptcy may be useful if a country’s judicial system is primitive, inefficient, or both—conditions that apply to certain EU 8 countries, as indicated by World Bank Reports on Observance of Standards and Codes (ROSCs) for insolvency and creditor rights.<sup>25</sup> Second, as a type of asset-based financing, factoring has a distinct advantage in providing funding to high-risk SMEs. It is important that risky SMEs be able to develop in transition economies, as the private sector in these countries develops and works to catch up to systems and mechanisms in Western Europe.

Third, as an asset-based technology, factoring may have an advantage over other credit products in lending to informationally opaque borrowers. Factors can base their lending decisions primarily on the condition of SMEs’ underlying accounts rather than on their creditworthiness. This is likely to be particularly important in the EU 8, where business activity may be skewed toward SMEs that by nature are more informationally opaque than larger businesses. Two characteristics of a weak information infrastructure—weak accounting standards and a shortage of audited financial statements—are common in most EU 8 business environments.<sup>26</sup> But another aspect of a weak information infrastructure would be problematic for factors. Limited data on payment performance—such as that collected by public credit registries, private business credit bureaus, credit insurance companies, or by factors themselves—would be problematic for factoring domestic receivables. It would be much less problematic for factoring foreign receivables, where the account obligors are in industrial countries with stronger information infrastructure.

Fourth, and closely related, factoring may be extremely useful in the early years of development of SMEs that export to more developed economies. Large factors that operate in an importer’s country

> 24 Independent finance companies may also be vulnerable to procyclical prudential supervision if they are small and depend on banks for funding. Larger independents and captives of large industrial groups may be much more insulated because they have access to capital markets such as the eurobond market.

> 25 For selected country insolvency and creditor rights ROSC reports see http://www.worldbank.org/ifa/rosc.html.

> 26 While going forward the EU 8, as new EU member states, must comply with the requirements of the EU Acquis Communautaire in the accounting & auditing area, which should result in significant improvements in this respect, these requirements (e.g., the use of IFRS) apply primarily to listed companies rather than to SMEs and also will take time to translate into improved accounting and auditing practices and enforcement capacity.

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**THE WORLD BANK**