I was talking to a friend yesterday about a pub called The Old Mill which recently went bankrupt. The doors finally closed when the electricity company turned off the power. The electricity company was not the only creditor, in fact this small business distributed losses equivalent to several months of turnover across at least a dozen local counterparties. These losses now threaten those creditors directly, and they, in turn, threaten others. The pub failed because the owner was utterly incompetent, in fact she had a history of past failures and bad debts, but now healthy companies who simply failed to correctly judge the credit worthiness of a customer are at risk.
As a general rule, goods and services exchanged between business counterparties are invoiced with 30 day payment terms. However, studies in the UK show that invoices generally take around 60 days to actually settle. This delay creates credit risks and cash flow imbalances. Across the economy, small business tends to be waiting to receive money, and big business tends to be waiting to pay money. Although some banks offer Invoice Finance schemes, they are an expensive niche, and businesses owed money tend to rely on overdraft facilities.
Does capitalism have to work this way? Is it efficient? Is it dangerous? This article looks at the problem of invoice credit by focusing on the aforementioned example of The Old Mill. These days economists are revisiting the foundation stones of modern capitalism, because the Credit Crisis has revealed how inefficient and fragile modern capitalism has become. In this brave new world, economists no longer assume that intervention is unnecessary because free markets self optimize.
Let's begin our analysis by looking at the difficulty of assessing the credit worthiness of counterparties. Looking inside the credit analysis toolbox, perhaps the first item to reach for is the counterparty's bank statement. Does this business have money in the bank or are they overdrawn? The next tool to reach for might be the counterparty's credit history. Is this counterparty currently struggling to pay other suppliers? Has it been unable to meet obligations in the past? The next tool one might reach for is a P&L analysis. How much money is it making? Are profits volatile or stable? Is it growing? How much debt is it servicing? Finally we could deploy subjective and intuitive tools. Do we trust the owner? For example: does he know what he is doing? does he tell the truth? is he a gambler? is he driving a brand new BMW and still asking for three months credit?
The problem is, suppliers to The Old Mill pretty much had only the subjective and intuitive credit analysis tools at their disposal, the least useful tools in the aforementioned toolbox. In practice, it's very difficult to make these sorts of subjective judgements. A person can look perfectly reasonable and still be a total crook, also, some pushy types wrongly come across as crooks.
In fact, even if the suppliers had gotten hold of The Old Mill's accounts, they might still have found it difficult to make an accurate assessment. Credit Analysis is complex problem, in practice most business will not have access to a credit analyst. Also, it would be very expensive for every supplier to conduct an independent investigation into The Old Mill.
Because The Old Mill represents a credit risk to suppliers, suppliers have to charge higher prices and are reluctant to do business. Also, because the suppliers can not make accurate forecasts, they have to charge a risk premium over fair value. This is why, in difficult times, when many businesses are in trouble, credit fears are stagflationary.
So we can see that capitalism might work more effectively if suppliers either had access to reliable credit ratings on their customers, or if they simply refused to give their customers credit. Lets look the second case. If credit was forbidden, if business had to pay for goods and services immediately, what might the impact on the economy be?
The Old Mill benefited from the gap between the supply of goods and payment. Does that mean that removing invoice payment terms would damage the growth of the Old Mill? I don't think so, because that credit is not really free, the suppliers increase their margins to account for credit risk. So I am saying that in practice, although The Old Mill might then have to pay overdraft fees to a bank, at least the bank specializes in credit risks and can give optimal prices, so these should be lower than supplier credit margin premiums (one of the principles of financial markets is that risk drives higher margins).
A big advantage of ending payment terms would be psychological - it imposes discipline, something especially valuable for small businesses. I think that in a world without supplier credit, The Old Mill would not have run into trouble. Discipline is a difficult psychological achievement, just as consumers are seduced by credit cards, small businesses frequently get carried away. The Old Mill was a popular pub, it went bankrupt because it was badly run, the freedom to run up debts was a large part of that.
Finally, without supplier credit, if The Old Mill had a failing business model, it would have probably gone bankrupt much faster and it would have failed with much smaller debts.
So I believe that a world without supplier credit would be a less dangerous world because financial discipline is enforced, because credit decisions are limited to those who specialise in them and can charge a competitive price, and also because bankruptcy will be more quickly detected, reducing systemic risk.
I do not claim to have covered every base in this short article, but I think it is an interesting idea.