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Factoring & Forfaiting

A business and regulatory perspective

June 2009

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Business and Regulatory Overview of Factoring 2

Table of Contents

1. Executive Summary .................................................................................... 5

2. Factoring & Forfaiting ................................................................................. 6

2.1. Factoring ................................................................................................................ 6

2.2. Forfaiting ............................................................................................................. 13

3. Intrinsic Risks .......................................................................................... 15

3.1. Credit Risk ........................................................................................................... 15

3.1.1. Definition of Credit Risk ............................................................................. 15

3.1.2. Credit Risk management, measurement and control ............................ 15

3.1.3. Credit Risk mitigation techniques ............................................................ 16

3.2. Market Risk .......................................................................................................... 17

3.2.1. FX Risk .......................................................................................................... 17

3.2.2. Interest Rate Risk........................................................................................ 17

3.3. Operational Risk ................................................................................................. 17

4. IFRS Treatment & Implications .................................................................. 19

4.1. Accounts Receivable .......................................................................................... 19

4.2. Payables and outstanding securities .............................................................. 23

4.3. Hedging activities ............................................................................................... 23

4.4. Provisions for risks and charges ...................................................................... 23

4.5. Income .................................................................................................................. 24

4.6. Foreign currency transactions ......................................................................... 24

5. Regulatory Framework ............................................................................. 25

5.1. Bank of Greece .................................................................................................... 26

5.2. Foreign Regulations ........................................................................................... 26

5.2.1. No compliance required .............................................................................. 26

5.2.2. Partial/Adapted compliance ...................................................................... 28

5.2.2.1 Italy ................................................................................................................ 29

5.2.2.2 Spain .............................................................................................................. 30

5.2.3. Full compliance ............................................................................................ 31

5.2.3.1 France ............................................................................................................ 31

5.2.3.2 Austria ........................................................................................................... 31

5.2.3.3 Sweden .......................................................................................................... 32

5.2.3.4 Finland ........................................................................................................... 32

5.2.3.5 Portugal......................................................................................................... 33

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5.2.4. Summary Table ............................................................................................ 33

6. Basel II Standardized Implications ............................................................. 34

6.1. Short-term maturity (less than 1 year) ........................................................ 35

6.2. Eligibility of collaterals ...................................................................................... 35

6.3. Definition of Past Due ........................................................................................ 38

6.4. Non - recognition of insurance as a form of credit risk mitigation ............ 39

7. Basel II IRB Implications ........................................................................... 40

7.1. 1-year horizon for the PD calculation ............................................................. 41

7.2. Definition of Default ........................................................................................... 42

7.3. Contagion Effect ................................................................................................. 42

7.4. Dilution risk .......................................................................................................... 43

7.5. Limited availability of data ............................................................................... 44

7.6. System requirements......................................................................................... 44

8. Conclusions ............................................................................................. 45

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This research paper “A business and regulatory perspective of Factoring and Forfaiting” is

the result of an independent study by Ernst & Young, commissioned and supported by

Marfin Factors and Forfaiters SA (MFF) in June 2009. MFF’s objective for this project was

to describe in high-level the Factoring and Forfaiting Business, present the regulatory

treatment in international level and pinpoint certain important Basel II implications,

affecting Standardized and IRB approaches for the calculation of Regulatory Capital

Requirements.

Marfin Factors & Forfaiters SA was established under this name in May 2007, as the legal

continuation of its predecessor company Laiki Factoring SA, after the merger of Popular

(Laiki) Bank of Cyprus with Marfin Financial Group and Egnatia Bank. It has been

established as a 100% subsidiary of Marfin Egnatia Bank, the subsidiary bank in Greece of

Marfin Popular Bank, Cyprus, and currently employs 33 people in Greece- seated in Athens

and with a Representative Office in Thessaloniki, and 8 people in the Belgrade Serbia

Branch.

Ernst & Young is a global leader in assurance, tax, transaction, and advisory services.

Worldwide, our 140,000 people are united by our shared values and an unwavering

commitment to quality. We make a difference by helping our people, our clients, and our

wider communities achieve potential. At the foundation of our working approach rests our

mutual commitment for operational excellence, providing high quality services to our

clients

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1. Executive Summary

In this paper we examine the Factoring & Forfaiting types of financing from a business and

regulatory perspective. The document presents the approaches that currently exist in the

regulatory environment in peer countries, as well as the implications of the Basel II

Framework in respect to the Regulatory Capital Calculation for the Factors. Our report is

based on current practices and regulatory approaches and does not comprise any

subjective opinion from Ernst & Young.

In the first part of the document, the business of Factoring and Forfaiting is described, the

intrinsic risks are introduced and the accounting treatment according to the IFRS is

presented. Elements such as the counterparties per type of transaction, as well as the

amount of the claims created, are analyzed. We refer to the main risks for the Factor:

Credit Risk (which includes Default Risk and Dilution Risk) and Operational risk, which is of

significance to the Factoring companies, mainly due to the fact that it incorporates the risk

of internal & external fraud. We also refer to Market Risks (Liquidity and FX Risks).

Existing approaches to Risk measurement, management and mitigation are presented in

this section. Finally, the accounting principles in respect to valuation and record of main

Balance Sheet items are illustrated.

In the second part of the paper, the Regulatory environment is examined, along with the

implications of the Basel II Framework regarding current and potential capital

requirements. The regulatory environment is broken down to countries were full Basel II,

adapted Basel II and no Basel II regulatory frameworks exist for Factoring companies.

Implications of Basel II are discussed, also in combination with propositions made by

relevant working groups. Issues cover the Short-term maturity (less than 1 year),

Eligibility of collaterals, Definition of Default, recognition of insurance as a form of credit

risk mitigation etc.

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2. Factoring & Forfaiting

2.1. Factoring

Factoring is a type of supplier financing in which firms sell their credit-worthy accounts

receivable at a discount (equal to interest plus service fees) and receive immediate cash.

Transactions with recourse may be perceived technically as credit facilities, providing

working capital. It needs to be noted that most factoring is done “without recourse”

meaning that the Factor that purchases the receivables assumes the credit risk for the

buyer’s ability to pay. Thus, factoring is an integrated financial mechanism that includes

credit protection and mitigation, accounts receivable book-keeping and management,

collection services and financing.

16%A source of funding, alternative to bank loan

What does factoring represent? Survey SDABocconi 2008

A source of funding complementary to bank loan 26%

A guarantee against debtor’s insolvency 25%

A tool for professional credit management 19%

A way to recover bad debts 7%

Other 6%

No opinion 1%

16%A source of funding, alternative to bank loan

What does factoring represent? Survey SDABocconi 2008

A source of funding complementary to bank loan 26%

A guarantee against debtor’s insolvency 25%

A tool for professional credit management 19%

A way to recover bad debts 7%

Other 6%

No opinion 1%

It needs to be noted that Factoring transactions involve three parties:

• The Factor, which is a financial institution

• The Seller, that is a business entity providing goods and services

• The Buyer, who is the one purchasing the goods or services from the Seller

Factoring services can be classified according to the risk approach and the origin of the

transaction (Ref: Naftemporiki 2003, Kerdos newspaper 22/11/05):

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• According to the risk approach, factoring services are offered with recourse (the

Seller bears the Buyers’ credit risk) or non-recourse (the Factor covers the Buyers’

credit risk)

• According to the origin of the transaction, factoring services are domestic, for trade

in the domestic market, and international, for cross-border trade, i.e. Export or

Import factoring.

It should also be noted that this paper does not cover the service of accounts receivable

management, since this service is not considered material from a Risk management and

Capital Requirements point of view.

The key advantage of Factoring is that underwriting is based on the risk of the accounts

receivable themselves rather than the risk of the client. For example, factoring may be

particularly well suited for financing receivables from large or foreign firms when those

receivables are obligations of buyers who are more creditworthy than the seller itself.

Factoring may also be particularly important in financial systems with weak commercial

laws and law enforcement. Like traditional forms of commercial credit extension, factoring

provides small and medium enterprises (SMEs) with short to medium term financing.

However, unlike traditional forms of working capital financing, factoring involves the

outright purchase of the accounts receivable by the Factor, rather than the

collateralization of a loan. The advantage of factoring in a weak business environment is

that the factored receivables are removed from the bankruptcy estate of the client and

become the property of the Factor. Thus, access to historical credit information, which is

necessary in order to assess the credit risk of factoring transactions, is of significant

value.

An important feature of the factoring relationship is that a Factor will typically advance

less than 100% of the face value of the receivable even though it takes ownership of the

entire receivable. The difference between this advance amount and the invoice amount

(adjusted for any netting effects such as sales rebates) is accounted as reserve held by

the Factor. This reserve will be used to cover any deficiencies in the payment of the related

invoice. Thus even in non-recourse factoring there is risk sharing between the Factor and

the client (the Seller) in the form of this reserve account. Factoring can be done either on

a “non-recourse” or “recourse” basis against the Factor’s client (the Seller). In non-

recourse factoring, the Factor not only assumes title to the receivable accounts, but also

assumes most of the default risk because the Factor does not have recourse against the

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supplier if the accounts default. Under recourse factoring, on the other hand, the Factor

has a claim (i.e. recourse) against its client (the Seller) for any account payment

deficiency. Therefore, losses occur only if the underlying accounts default and the Seller

cannot make up the deficiency.

Furthermore, factoring can be done on either a notification or non-notification basis.

Notification means that the buyers are notified that their invoices (accounts payable)

have been sold to a Factor. Under notification factoring, the buyers typically provide the

Factor with delivery receipts, an assignment of the accounts and duplicate invoices

prepared in a form that indicates clearly to the supplier that their account has been

purchased by the Factor.

In addition to the financing component, Factors typically provide two other complementary

services to their clients: credit services and collection services. The credit services involve

the credit assessment of the borrower’s customers whose accounts will be purchased by

the Factor. Factors typically base this assessment on a combination of their own

proprietary data and publicly available data on account payment performance. The

collection services involve the activities associated with collecting delinquent accounts and

minimizing the losses associated with these accounts. This includes notifying a buyer that

an account is delinquent (i.e. past due) and pursuing collection and legal action. Factoring

allows (mainly) Small and Medium sized companies to effectively outsource their credit

and collection functions to their Factor. This represents another important distinction

between Factors and traditional commercial lenders.

These credit and collection services are often especially important for receivables from

buyers located overseas. For example, “export factoring”, the sale of foreign receivables,

can facilitate and reduce the risk of international sales by collecting foreign accounts

receivables. The Factor is also required to do a credit check on the foreign customer before

agreeing to purchase the receivable, so the approval of a factoring arrangement also sends

an important signal to the seller before entering a business relationship. This can facilitate

the expansion of sales to overseas markets.

It should be noted that, in contrast to the Banking Institutions, Factors do not face the

issue of borrowing capital in short term and extending long term credit, since all

transactions are short term and of matching maturities. Therefore, liquidity management is

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simpler in this case, with no need for complicated Asset-Liability Management. Liquidity

management in Factoring companies is not much different than the one of other companies

that have financial obligations.

It should also be mentioned that independent Factors present operational differences

comparing to Factoring divisions of Banks (Ref: Presentation of Mr. Panos Papatheodorou

at EEFA’s 4th and 5th Annual Conferences, 09/2004, 11/2005) :

• Different organizational and operational approach, dictating also a different structure

than a Bank (example follows):

• Different Credit approach: Banks base their credit decisions in Balance Sheet analysis

and collateral or securities offered, whereas Factors on the Accounts Receivable flows

and in the good knowledge and management of the commercial agreements and

monetary flows.

o Factoring companies pay great importance in quality of product and monetary

flows, future development, soundness of management and creditworthiness of

the buyers, managing the cash flows day-to-day.

o In Factoring, Advances to clients are linked to the increase of sales.

Different positioning in the marketing channel: a Factoring Company is a buyer of an A/R –

a Bank is a lender. Factors are Debtors, whereas Banks are Creditors

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The tables below illustrate the Factoring business Volumes and Turnover:

Total Factoring Volume by Country in the last 7 years (in Million of EUR)

(Ref: Factors Chain International. 2009 statistics)

2002 2003 2004 2005 2006 2007 2008

EUROPE

Austria

2.275

2.932

3.692

4.273

4.733

5.219

6.350

Belgium

9.391

11.500

13.500

14.000

16.700

19.200

22.500

Bulgaria 0 0 0 0 35 300 450

Croatia 0 0 28 175 340

1.100

2.100

Cyprus

1.997

2.035

2.140

2.425

2.546

2.985

3.255

Czech

Republic

1.681

1.880

2.620

2.885

4.025

4.780

5.000

Denmark

5.200

5.570

6.780

7.775

7.685

8.474

5.500

Estonia

2.143

2.262

3.920

2.400

2.900

1.300

1.427

Finland

9.067

8.810

9.167

10.470

11.100

12.650

12.650

France

67.398

73.200

81.600

89.020

100.009

121.660

135.000

Germany

30.156

35.082

45.000

55.110

72.000

89.000

106.000

Greece

2.694

3.680

4.430

4.510

5.230

7.420

10.200

Hungary 580

1.142

1.375

1.820

2.880

3.100

3.200

Iceland 16 25 16 15 25 5 5

Ireland

8.620

8.850

13.150

23.180

29.693

22.919

24.000

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2002 2003 2004 2005 2006 2007 2008

Italy

134.804

132.510

121.000

111.175

120.435

122.800

128.200

Latvia

With

Estonia

until

2003 155 20 276

1.160

1.520

Lithuania

With

Estonia

until

2003

1.040

1.640

1.896

2.690

3.350

Luxembourg 197 257 285 280 306 490 600

Malta 0 0 0 0 1 25 52

Netherlands

20.120

17.500

19.600

23.300

25.500

31.820

30.000

Norway

7.030

7.625

8.620

9.615

11.465

17.000

15.000

Poland

2.500

2.580

3.540

3.700

4.425

7.900

7.800

Portugal

11.343

12.181

14.700

16.965

16.886

16.888

18.000

Romania 141 225 420 550 750

1.300

1.650

Russia 168 485

1.130

2.540

8.555

13.100

16.150

Serbia 0 0 0 0 150 226 370

Slovakia 240 384 665 830

1.311

1.380

1.600

Slovenia 75 170 185 230 340 455 650

Spain

31.567

37.486

45.376

55.515

66.772

83.699

100.000

Sweden

10.229

10.950

14.500

19.800

21.700

21.700

16.000

Switzerland

2.250

1.514

1.400

1.900

2.000

2.513

2.590

Turkey

4.263

5.330

7.950

11.830

14.925

19.625

18.050

Ukraine 0 0 0 333 620 890

1.314

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2002 2003 2004 2005 2006 2007 2008

United

Kingdom

156.706

160.770

184.520

237.205

248.769

286.496

188.000

Total

Europe

522.851

546.935

612.504

715.486

806.983

932.269

888.533

U.S.A. 91,143 80,696 81,860 94,160 96,000 97,000 100,000

Total

Americas 115.301 104.542 110.094 135.630 140.944 150.219 154,450

TOTAL

WORLD 724.196 760.391 860.215 1.016.546 1.134.238 1.301.590 1.325.111

Factoring Turnover by Country 2008 (in Million of EUR)

(Ref: Factors Chain International. 2009 statistics)

Nr. of

Companies

Country Domestic

Turnover

International

Turnover

Total

EUROPE

90 United Kingdom 175.000 13.000 188.000

19 France 115.000 20.000 135.000

45 Italy 120.000 8.200 128.200

50 Germany 77.000 29.000 106.000

24 Spain 94.000 6.000 100.000

5 Netherlands 20.000 10.000 30.000

8 Ireland 22.000 2.000 24.000

6 Belgium 16.500 6.000 22.500

80 Turkey 15.050 3.000 18.050

11 Portugal 16.500 1.500 18.000

15 Russia 16.000 150 16.150

50 Sweden 15.000 1.000 16.000

9 Norway 13.300 1.700 15.000

4 Finland 12.000 650 12.650

11 Greece 9.300 900 10.200

20 Poland 6.100 1.700 7.800

5 Austria 5.000 1.350 6.350

9 Denmark 3.500 2.000 5.500

8 Czech Republic 4.000 1.000 5.000

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Nr. of

Companies

Country Domestic

Turnover

International

Turnover

Total

8 Lithuania 2.100 1.250 3.350

3 Cyprus 3.200 55 3.255

28 Hungary 3.000 200 3.200

5 Switzerland 1.900 690 2.590

10 Croatia 2.000 100 2.100

10 Romania 1.300 350 1.650

8 Slovakia 1.000 600 1.600

7 Latvia 1.150 370 1.520

4 Estonia 1.100 327 1.427

40 Ukraine 1.300 14 1.314

5 Slovenia 500 150 650

1 Luxembourg 350 250 600

6 Bulgaria 400 50 450

8 Serbia 300 70 370

2 Malta 32 20 52

1 Iceland 0 5 5

615 Total Europe 774.882 113.651 888.533

120 U.S.A. 90.000 10.000 100.000

1,011 Total 142.050 12.400 154.450

1,809 TOTAL WORLD 1.148.943 176.168 1.325.111

2.2. Forfaiting

Forfaiting is a form of international supply chain financing. It involves the discount of

future payment obligations on a non-recourse basis. Forfaiting can be applied to a wide

range of trade related and purely financial receivables. Although discounted receivables

typically have medium term maturities (3 – 5 years) they can be as short as 6 months or

as long as 10 years. Forfaiting is a flexible invoice discounting technique that can be

tailored to the needs of a wide range of counterparties and domestic and international

transactions. Its key characteristics are:

• Full face financing without recourse to the seller of the debt

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• The payment obligation is often covered by a bank guarantee; this does not hold at

all times

• The debt usually takes the form of a legally enforceable and transferable payment

obligation such as a bill of exchange, promissory note, letter of credit or note

purchase agreement.

• Transaction values can range from 50 thousand Euro to 50 million Euro

• Debt instruments are typically denominated in one of the world’s major currencies,

with Euro and US Dollars being most common.

• The Financing part can be arranged on a fixed or floating interest rate basis.

Forfaiting brings along a number of benefits to the involved parties:

• Mitigates significantly the transaction risks

o Removes political, transfer and commercial risk

o Provides financing for 100% of contract value

o Protects against risks of interest rate increase and exchange rate fluctuation

• Enhances Competitive Advantage

o Enables sellers of goods to offer credit to their customers, making their

products more attractive

o Helps sellers to be active in countries where the risk of non-payment would

otherwise be too high

• Improves Cash Flow

o Forfaiting enables sellers to receive cash payment while offering credit

terms to their customers

o Removes accounts receivable, bank loans or contingent liabilities from the

balance sheet

• Increases Speed and Simplicity of Transactions

o Fast, tailor-made financing solutions

o Financing commitments can be issued quickly

o Documentation is typically concise and straightforward

o No restrictions on origin of export

o Relieves seller of administration and collection burden

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3. Intrinsic Risks

3.1. Credit Risk

3.1.1. Definition of Credit Risk

As a rule, when the Factor provides the finance and/or guarantee service within a

Factoring contract, the possibility of registering a loss (Default risk) is determined in the

first place by the deterioration of the credit worthiness of the counterparts or rather the

risk of non-payment by the assigned debtor (in the case of both with recourse and without

recourse factoring) or the risk of failure to return the payments advanced by the assignor

in the event of with recourse transactions. This type of risk is flanked by the so-called

dilution risk. Dilution refers to the possibility that contractual amounts payable by the

underlying obligors may be reduced. When a Factor extends a credit to a debtor, the

latter’s default is determined by the temporary or definitive incapability of paying. The risk

of delayed payment, i.e. the uncertainty regarding the date when the debtor’s fulfillment

will actually take place creates liquidity risks (obviously, when the debtor is in default, this

risk is included in the credit risk). In contrast to traditional banking exposure, the Factor

provides its services within the sphere of a pre-existent commercial relationships; the

dilution effect is the possibility that the debtor may refuse to pay (or make partial

payments) in consideration of events regarding the performance of the underlying supply

relationship. These situations include, by way of example, the off-settings, the allowances,

the disputes concerning product quality, the invoicing discrepancies and the promotional

discounts.

3.1.2. Credit Risk management, measurement and control

At the time of undertaking the transaction, the credit risk needs to be assessed by the

responsible unit (e.g. Risk Division). The constant control of the progress of the

relationship with the counterpart needs to be ensured. In this sense, one of the tasks is to

perceive any signs of deterioration in the assigning counterpart and to therefore prevent

any potential losses deriving from the counterpart.

All daily relationships with the debtors should be handled accordingly, carrying out checks

on assigned receivables and surveys on the punctuality of the payments (checking of

maturities and payment requests). The Monitoring function is entrusted with the task of

ensuring that the quality of the portfolio is maintained over time by means of on-going

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monitoring action which makes it possible to intervene systematically when a deterioration

of the risk profile of either an assignor or an assigned debtor is detected. This function

should be located within the Risk Function.

3.1.3. Credit Risk mitigation techniques

The Credit Risk Mitigation (CRM) techniques cover a role of fundamental importance

within the factoring relationship in respect to the parties involved. These techniques, with

regard to the contractual clauses established for the individual transactions, are more or

less significant for the Factor.

At the time the risk is undertaken, the factoring company takes steps to assess the two

counterparts, the assigning supplier (Seller of the receivable) and the assigned debtor

(Buyer of the good or service sold), who should be both analyzed so as to qualify over the

lending profile; in relation to this analysis, the undertaking of risk on these counterparts

can assume different operating configurations in relation to the product type requested by

the customer/assignor. In fact, in the event that a factoring transaction is finalized for the

sole purpose of granting the assignor credit facilities for freeing up the factored

receivables (under the so-called with recourse formula, or which offers the possibility of

recourse by the Factor on the assignor), a combined analysis of the credit worthiness of

both the assignor and the assigned debtor/s will be carried out. In the event that the

factoring relationship is aimed at granting the guarantee of the satisfactory outcome of the

factored receivables, the analysis of the credit worthiness will be concentrated to a

particular extent on the assigned debtor, as the main lending counterpart of the

relationship. Notification of factoring to the assigned debtor (via commercial

correspondence or process server) makes it possible to considerably mitigate the risk

inherent to the factoring transaction, obliging the debtor to pay the Factor (with repetition

of the payment in the event of payment to the assignor) and make the assignment

opposable to by third parties (effective as from the moment of communication). The

acceptance of the assignment by the assigned debtor prevents any compensation and also

contains the acknowledgement of the debit. The transfer may be opposed to by third

parties if the acceptance has a specific date, and in the event of bankruptcy of the assignor

the opposability excludes action for revocation. Like the banks, the Factor usually requests

collateral guarantees on the credit facilities granted to; much more rarely, the risks of the

Factor (both with regard to the assignor and the debtor) are guaranteed by bonds issued

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by banks. Factoring companies make extensive use of another instrument for mitigating

risks undertaken without recourse vis-à-vis assigned debtors: insurance coverage. This

instrument, although not explicitly mentioned as eligible by Basel II legislation, helps to

mitigate the credit risk deriving from the default of the debtor assigned without recourse.

3.2. Market Risk

3.2.1. FX Risk

Foreign Exchange (FX) risk is the possibility of economic loss arising from movements in

currency exchange rates, their volatilities or correlations. More specifically, FX Risk in the

Factoring business is created by the denomination of advances given by the Factor and of

the payments received, in different currencies. The common practice to mitigate FX risk, is

that all flows of the transaction take place in the invoice currency. In addition, any

differences (costs) stemming from currency conversions should be covered by specific

contracts with customers, according to which any exchange risks have to be attributed to

them (customers).

3.2.2. Interest Rate Risk

The interest rate risk is caused by the differences in expiration and re-pricing time of the

assets and liabilities interest rate. With these differences, the fluctuations of the interest

rates could determine both a change in the expected interest rate and a variation of assets

and liabilities, and therefore of the value of the shareholders’ equity. Given the type of

Factoring business and its short-term loans and deposits, the risk of a change in market

rates is expected to influence the value of assets and liabilities only marginally, also

considering the close re-pricing both for the collection and the rotation of loans. However,

apart from the Asset-Liability Management point of view, interest rate risks may also be

created when the payments for the disposal of the receivables are deferred or are subject

to discounting with the application of variable rates.

3.3. Operational Risk

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Operational risk is defined as the risk of economic loss resulting from inadequate or failed

internal processes, people and systems or from external events. Fraud (internal and

external) and legal and compliance risk are considered part of operational risk.

Furthermore, the operational loss events may derive from inadequate work practices or

safety in the workplace, customer complaints, product distribution, fines or penalties for

the failure to observe forecasts or legislative fulfillments (Compliance risk), damage to

company assets, interruptions in information or communications systems, execution of the

processes. Strategic, business or reputation-related risks are not included within the

operational risk; Factoring and Forfaiting companies are significantly exposed to fraud,

mainly external. The following types of Invoicing Fraud are the main ones:

• Internal Fraud: A simple example is an employee who has the authority to raise

purchase orders will raise purchase orders for some fictitious company that they

will have previously set up. The company then raises invoices against these

purchase orders that will then get matched and honored.

• External Fraud: An example of an external fraud would be employees working for a

supplier of a firm who registers a company with a very similar name to the company

they are working for. They then issue invoices against known purchase order

numbers with this name.

• Purchase Order Value: The Invoice value is much greater than the purchase order

value. It may simply be ten times the purchase order value, which can easily go

unnoticed.

• Unknown Vendors: Organizations often receive invoices from unknown vendors for

fictitious work or goods. The senders of the invoices may have sent the same

invoice to hundreds of organizations in the hope that just one busy accounts

department lets it slip through.

• Unsolicited Goods: Goods are delivered and signed for and then an invoice is sent.

The sender will often have some knowledge of the organization’s regular supply of

consumables or current projects.

• Low Value Invoices: Many organizations try and manage the workload associated

with invoices by operating much stricter authorization procedures for invoice values

above a threshold. Invoices that are received whose value is below this threshold

are much more likely to get authorized and a potential fraudster will exploit this

information, which may be gleaned from an employee or by sending test invoices or

a disgruntled employee who may have already left the company.

• Under or Over Invoicing: This is not really a type of invoicing fraud, more a type of

tax fraud. Under-invoicing is used when importing goods from a foreign supplier. An

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arrangement is made whereby the supplier raises an invoice for the goods with a

value much less than the agreed price. By artificially lowering the documented value

of the goods, less import duty is payable. The difference is then paid via a different

route and sometimes the saving in import duty is split between the importer and the

supplier. Over-invoicing is a means of exploiting exchange rates and export

subsidies.

4. IFRS Treatment & Implications

The financial statements of the major European Factoring companies are structured in

compliance with the international accounting principles (IAS/IFRS), standardized by the

European Commission. The financial statements include the balance sheet, the profit & loss

account, the statement of changes in shareholders’ equity, the cash flow Statement and

the notes to the financial statements. The criteria adopted for the valuation of the most

important items are provided below.

4.1. Accounts Receivable

Loans and receivables include non-derivative financial assets, due from customers and

banks, with fixed or determinable payments and which are not listed on an active market.

Following the general principle of the priority of economic substance over legal form, a

company can derecognize a financial asset from its financial statements only if, as a result

of a transfer, it has assigned all risks and benefits associated with the transferred

instrument. IAS 39 sets forth that a company can derecognize a financial asset only if:

• It is transferred together with all risks, and the contractual rights on cash flows

resulting from the asset expire;

• The benefits related to the ownership of the asset cease to be valid. In order to

transfer financial assets, the following conditions alternatively apply:

o the company has transferred the rights to receive the cash flows of the

financial asset;

o the company has maintained the rights to receive the cash flows of the

financial asset, but has to pay them to one or more beneficiaries within an

agreement in which all the following conditions have been satisfied:

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§ the company has no obligation to pay predetermined amounts to any

beneficiary apart from what it receives from the original financial

asset

§ the company cannot sell or pledge the financial asset

§ the company has to transfer each cash flow it receives, on behalf of

the beneficiaries and on time.

Any investment of the cash flows in the period between collection and payment has to be

carried out only for financial assets equal to liquidity and, in any case, with no rights to the

interests accrued on the invested amounts. In order to transfer a financial asset and

derecognize it from the assignor’s financial statements, upon each transfer the assignor

has to assess the extent of any risks and benefits related to the financial asset still owned.

For the assessment of the effective transfer of risks and benefits, it is necessary to

compare the exposure of the assignor with the variability of the current value or of the

cash flows generated by the assigned financial asset, before and after the transfer. The

assignor essentially maintains all risks and benefits when its exposure to the “variability”

of the present value of future net cash flows of the financial asset does not change

significantly after its transfer. On the other hand, the transfer can be carried out when the

exposure to this “variability” is not significant anymore. In summary, there are three

possible cases, to which some specific effects correspond, i.e.:

• When the company essentially transfers all risks and benefits resulting from owning

the financial asset, it has to “reverse” the financial asset and separately record all

rights and obligations deriving from the transfer itself as assets or liabilities

• when the company essentially maintains all risks and benefits deriving from owning

the financial asset, it has to keep on recognizing it

• when the company neither transfers nor maintains all risks and benefits deriving

from owning the financial asset, it has to evaluate the control elements regarding

the financial asset, and

o in case it does not have the control, it has to reverse the financial asset and

separately recognize the single assets/liabilities deriving from the

rights/obligations of the transfer

o in case it keeps the control, it has to go on recognizing the financial asset,

until the limit of its commitment in the investment.

For the purposes of verifying control, the discriminating factor that has to be taken into

account is the beneficiary’s ability to transfer the financial asset unilaterally, without any

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type of restrictions by the assignor. When the beneficiary of a financial asset’s transfer has

the operational ability to sell the whole financial asset to a nonrelated third party and in a

unilateral way, without any other transfer limitations, the assignor no longer has control

over the financial asset. In all other cases, it keeps control over the financial asset. The

most frequently used types of transfer for a financial instrument can have very different

accounting effects:

In the case of a non-recourse assignment (without any guarantee obligations), the

transferred assets can be derecognized from the assignor’s financial statements; in the

majority of cases it should be considered that the risk connected to the transferred asset is

held by the Factor. Thus, the Factor has a direct claim over the obligor (Buyer) to the

full amount of the invoice. This holds irrespectively of the approach that the Financial

Institution adopts (Standardized or IRB).

With regard to portfolios transferred with recourse, receivables are recorded and

recognized in the financial statements solely in relation to the amounts paid to the

assignor by way of an advance payment. Since the assets are not recognized as truly sold

from the Seller to the Factor, these are registered to the Seller’s financial statements as

loans with the receivables as collaterals. This means that, when the Financial Institution

follows the Standardized approach for the calculation of Credit Risk capital requirements,

the counterparty shall be the Seller, not the obligor (Buyer). In the case of IRB, there will

be the “Double Default” approach, first to the obligor (Buyer) and then to the Seller.

Type of transaction Standardized Approach

Internal Ratings Based

Approach

With Recourse

Counterparty:

Seller

Exposure:

The advance payment

amount

Counterparty:

Double Default (Seller &

Buyer)

Exposure:

The advance payment

amount

Without Recourse

Counterparty:

Obligor (Buyer)

Exposure:

The full amount of the invoice

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After the initial recognition of receivables at fair value - including transaction costs that

are directly related to the financial asset’s acquisition – these are valued at amortized cost,

using the effective interest method. As at each balance sheet date, if there is objective

evidence that receivables were impaired, the amount of the loss is gauged as the

difference between the book value of the asset and the present value of future expected

cash flows discounted at the original effective interest rate. In particular, the criteria for

determining write-downs of receivables are based on the discounting of expected cash

flows for principal and interest, net of collection charges and any advances received. In

order to determine the current value of the flows, the main elements are the identification

of expected collections and related expires, as well as of the discounting rate that has to

be applied. A receivable can be defined as “impaired” when it is considered that probably it

would not be possible to collect the whole amount - on the basis of the original contract

terms - or an equivalent value. A receivable can be integrally derecognized when it is

considered irrecoverable or it is completely written off. Impaired positions are divided into

the following categories:

• NPL/Rs - The loans/receivables that are formally impaired, represented by the

exposure to customers who are in a state of insolvency (even not legally

recognized) or in similar positions. The valuation is carried out on an analytical

basis.

• Doubtful loans/receivables – This category contains transactions with parties who

are experiencing a temporary difficulty, that it is felt can be solved within an

appropriate period of time. The valuation is carried out on an analytical basis.

• Restructured positions – These are exposures towards counterparties with which

specific agreements have been entered into. These agreements envisage a

postponement for the payment of the debt and the parallel renegotiation of

conditions. The valuation is carried out on an analytical basis.

• Past due positions – These represent the whole exposure towards counterparties,

which are different from those classified in the above-mentioned categories and

show receivables past due 180 days as at the reference date. The valuation is

carried out on a lump-sum basis. The valuation of performing receivables concerns

asset portfolios for which no objective loss elements have been observed and that

are subject to a collective valuation.

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4.2. Payables and outstanding securities

Payables and issued subordinated liabilities are initially recorded at fair value, which

generally corresponds to the consideration received, net of transaction costs that are

directly attributable to the financial liability. After the initial accounting, these instruments

are valued at amortized cost, using the effective interest method. Payables arising from

factoring transactions reflect the amount remaining to be paid to assignors resulting from

the difference between the value of the receivables acquired with recourse and the

advance paid, and the full invoice amount, in the case of non recourse transactions .

Financial liabilities are derecognized from the financial statements upon settlement or

maturity.

4.3. Hedging activities

Hedging instruments are defined as a fair value hedge of a recorded asset. The hedge is

considered highly effective if, both at the beginning and during its life, the changes in the

fair value of the hedged monetary amount are almost entirely counterbalanced by the

changes in the fair value of the hedging derivative. This means that the effective results

should be comprised between 80% and 125%.

4.4. Provisions for risks and charges

The allocations of provisions for risks and charges are accounted for only in the following

cases:

• There is a current obligation (legal or implicit) as a result of a past event;

• It is likely that, in order to fulfill the obligation, it will be necessary to use resources

that create economic benefits

• Reliable estimate of the amount resulting from the fulfillment of the obligation can be

carried out.

The amount recorded as a provision represents the best estimate of the expense required

in order to fulfill the existing obligation as at the financial statement reference date and

reflects all risks and uncertainties that inevitably characterize a plurality of facts and

circumstances.

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A provision is used only with respect to the charges for which it was originally recorded. No

provision is recorded against liabilities that are only potential and not probable; however, a

description of the type of liability is provided.

4.5. Income

As defined in IAS 18, income is a gross flow of economic benefits resulting from the

ordinary activities of the company. Income is valued at the fair value of the received or due

consideration and is accounted for when it can be reliably estimated. The result of a

service rendered can be reliably estimated when all following conditions are met:

• The income amount can be reliably valued

• It is likely that the company will profit from the economic benefits resulting from said

operation

• The stage of completion of the transaction as at the financial statement reference date

can be reliably gauged

• The costs met for the transaction and the future expenses in order to complete it can

be reliably calculated.

Income is recognized only when it is likely that the company will take advantage of the

economic benefits resulting from the transaction. However, when the recoverability of a

value that is already included in the income is characterized by uncertainty, the

unrecoverable value – or the value whose recovery is highly improbable – is recorded as a

cost rather than as an adjustment of the income that was originally recognized.

4.6. Foreign currency transactions

Foreign currency is different from the reporting currency of the company. The latter is the

currency of the main economic environment in which the company carries out its activities.

A foreign currency transaction is initially recognized using the reporting currency, applying

the spot exchange rate between the reporting and the foreign currency as at the date of

the transaction to the amount in foreign currency. As at each balance sheet date:

• Foreign currency monetary items are converted using the closing rate

• Foreign currency non-monetary items valued at historical cost are converted using the

exchange rate in force as at the date of the transaction

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• Foreign currency non-monetary items valued at fair value are converted using

exchange rates as at the date when the fair value is determined.

The exchange differences - resulting from the de-recognition or conversion of monetary

items at rates different from those at which they were initially converted during the year or

in previous financial statements – are registered in the profit and loss account for the

financial year in which they occur.

5. Regulatory Framework

Regarding the regulatory capital framework of Basel II, the following classification in terms

of scope needs to be noted:

• When the Factor is a stand alone company and not a member of a Banking Group or

Financial Holding Group, it is directly subject to the requirements of the local regulator.

If the local regulator requires Factoring companies to calculate, hold and report

regulatory capital, then the Factor would provide a solo calculation and reporting to the

regulator, without further implications

• When the Factor is a subsidiary of a Banking Group or Financial Holding Group, then

there are the following different outcomes:

o The local regulator requires Factors to calculate, hold and report regulatory

capital: Then, the Factor would report on a Solo basis, and would also be

included in the Group consolidation, also bearing capital requirements for the

Group

o The local regulator does not require Factors to calculate, hold and report

regulatory capital: Then, the Factor would only be included in the Group

consolidation, bearing capital requirements

It also needs to be noted that if the Factor is accounting-wise consolidated in a Banking

Group or Financial Holding Group but not consolidated for Basel II regulatory capital

calculation purposes, then the parent company (e.g. Bank) would have to calculate

specific capital for the exposures to the Factor. The risk weight under the Standardized

Approach would depend on the external rating of the counterparty (Factor) if such a

rating exists, while under the IRB Approach the risk weight would depend on the internal

rating.

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5.1. Bank of Greece

Currently there is no regulation requiring Factors to calculate Basel II capital requirements.

Bank of Greece (BoG) issued in late November 2008 a draft Act in respect to

“Requirements for founding and operating license and supervisory rules for leasing firms,

credit institutions and factoring companies”. The draft paper, which has not been finalized

to date, brings the factoring industry under the supervision of BoG and requires almost full

compliance of factoring companies with Basel II capital requirements, as these have been

imposed to banking institutions that are based in Greece.

5.2. Foreign Regulations

5.2.1. No compliance required

The United Kingdom represents an example of unregulated factoring industry within

developed European countries. Until recently no supervision of factoring companies was

performed and those companies have been operating under a framework developed by

their own association, which is currently titled “The Asset Based Finance Association”. The

framework is limited to setting some basic business and ethics standards and does not

refer to risk management or capital adequacy requirements. Factoring institutions in the

UK are solely required to comply with Anti-Money Laundering Laws introduced during

2008, and their compliance is supervised by the Financial Services Authority (FSA). The

same conditions, regarding the regulatory environment for factoring companies, are met in

Ireland. Additional examples of unregulated factoring industry are offered by Belgium, the

Netherlands, Poland, Slovakia, Switzerland, Russia, the Czech Republic, Lithuania,

Denmark, Estonia, Latvia, Slovenia, Hungary, Romania and Cyprus.

In Malta, Factors are characterized as Financial Institutions and not as Credit Institutions.

The Financial Services Authority of Malta, which is the regulating and supervisory body of

the credit and financial system of the Country, have set specific legal requirements (the

Financial Institutions Act 1994) for the licensing and operations of the Factoring firms (as

they are financial institutions). The Malta FSA has adopted the Basel II CRD framework

under L.N 76/2008 Banking Act (Capital Adequacy) Regulations 2008. However, this law

covers only Credit institutions and Investment firms and not Financial Institutions. Thus,

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Factoring companies are not subject to calculate, hold and report regulatory capital on a

Solo basis.

Factoring companies in Germany have recently gone under regulatory developments. The

Enactment of the Annual Tax Act 2009 defined that activities of factoring and finance

leasing have become regulated activities under the German Banking Act. This implied that,

starting from 25 December 2008, anyone who wishes to provide factoring or finance

leasing services in Germany needs a license under the German Banking Act from the

German Regulator Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin).

Even though the new law treats factoring services in the same way as banking services, it

does give factoring companies significant relief from certain requirements that would

otherwise apply under the German Banking Act. The major relief is the absence of a

minimum capital requirement. In addition to the latter, certain control mechanisms

regarding liquidity and solvency are not applicable to factoring companies and only one

reliable and competent manager of the relevant factoring company who has been formally

approved by the German Authority is required. However, it is expected that the German

Authority, through its continuing supervision of factoring companies, will subject those

entities to considerable financial reporting and other obligations (including the submission

of annual accounts, management and auditor’s reports). The German Authority’s costs of

such supervision are expected to be allocated to the factoring companies themselves.

In Turkey, the Central Bank is not responsible for the supervision of financial institutions.

Supervision is under the authority of Banking Regulation & Supervision Agency (BRSA),

which has recently issued a draft act in respect to leasing, factoring and financing

companies. The draft regulation has been open to comments from institutions and agencies

concerned, as well as representatives of the banking sector. The scope of the draft

includes the following:

• The abolishment of the Law on Leasing nr. 3226 and the Decree in the power of Law

on Lending Nr.90.

• The minimum paid-in capitals that the related firms are required to have become

compatible with current conditions.

• The required legal sub-structure for on-site and off-site supervision of the firms is

being established.

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• A reserve provision is imposed, in order for the companies concerned to cover

potential losses from receivables emanated from the transactions of the firms.

• The Leasing Firms Association, Financing Companies Association and Factoring

Firms Association are recognized as professional institutions and obtain legal entity

status of a public institution nature. Leasing, financing and factoring firms are

obliged to register as members in the appropriate association.

• A System for Central Record of Invoice is expected to be established in Factoring

firms Association, aiming to prevent the use of certain receivables under multiple

factoring transactions.

• Juridical and administrative penalties are introduced, in order to safeguard all

relevant transactions from potential practices that contradict the legislation.

Although factoring companies will be regulated and supervised by the BRSA in accordance

with the aforementioned legal act (when finalized), it appears that they are not required

to comply with any requirements that stem from the Basel II framework.

An additional requirement has been imposed by BRSA to banks that have a factoring

company as a subsidiary at the consolidated group level, with the issuance of Banking Law

No. 5411 (September 2008). According to this, “the Bank shall establish a Risk Center in

order to collect information about the risk status of the clients of the deposit banks,

participation banks, development and investment banks, financial holding companies,

financial leasing companies, factoring companies, financing companies operating in Turkey

and other financial institutions to be considered appropriate by the Bank and the Banking

Regulation and Supervision Board, and to share such information with the Banking

Regulation and Supervision Agency and other relevant institutions. These institutions shall

provide any information to be requested in connection with the risk status of their clients,

including the protests notice of lodged by banks. All transactions and records of the Risk

Center shall be confidential”.

5.2.2. Partial/Adapted compliance

In certain countries, regulation for factoring companies has been introduced and has been

aligned to a big extent to the Basel II capital adequacy requirements. However, factoring

companies enjoy preferential treatment in specific issues, mainly in respect to the

minimum capital requirement set.

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5.2.2.1 Italy

In Italy, regulation and supervision of factoring is covered in the Single Banking Law, the

codified text on banking and finance. Any bank may engage in factoring, subject to

supervision by the central bank (Bank of Italy). Other financial intermediaries are

registered with the Italian Foreign Exchange Office. Factoring companies are subject to

capital adequacy rules, that stem from the European Union's capital requirements

directives, and have therefore since January 1st 2007 been subject (under Law 15/2007)

to a risk-based approach to prudential supervision based on the Basel II accord. This takes

into account their credit, operational, exchange-rate and trading risk.

The Bank of Italy has in fact placed factoring companies on the same footing as banks,

standardizing the control of the capital adequacy in relation to the entity of the risks

undertaken, with a weighting by type of counterparty aligned. The Bank of Italy expects

this change to offer factoring companies potential for growth because it will reduce their

cost of finance, due to the greater transparency of the risk involved in lending to them and

the fact that they will de facto be as sound as banks.

Although the approach to capital requirements calculation is the same as for financial

institutions, there are some differences in the way the rules are applied in order to take the

special characteristics of factoring companies into account. The Italian Regulator, starting

from 2008, provides rules to determine RWA and differentiated individual ratios:

• 8%, if Factor collects savings from public (which means that it is a banking

institution offering factoring services),

• 6% if Factor does not collect savings from public, and

• 4.5% if Factor does not collect savings from public and is part of a banking group,

which is required to comply to Basel II regulations at the consolidated group level.

For a transition period until 2011, factoring companies are offered another advantage,

which concerns counterparty concentration. They are required to respect a limit of 40%

over regulatory capital of single client exposure, which is set to 25% for banks, and a

“Large Exposure” threshold of 15% over regulatory capital exposure to one client

(compared to 10% for banks). However, it is expected that both capital requirements and

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regulatory limits for factoring companies will be aligned to those for banks when the

aforementioned transition period expires.

5.2.2.2 Spain

In Spain, factoring companies are recognized as “Specialized Credit Institutions” (SCIs),

which represent a subgroup of Credit Institutions (CIs), and are regulated and supervised

by the Bank of Spain (BoS). Spain has introduced the “Law 36/2007 of 16 November

2007 amending Law 13/1985 of 25 May 1985 on investment ratios, own funds and

reporting requirements of financial intermediaries and other financial system rules”. As

Bank of Spain states in its Report on Banking Supervision in Spain (2007), “this Law,

which partially transposes Directive 2006/48/EC of the European Parliament and of the

Council, incorporates the so-called Basel II Accord into the national legal framework with

the aim, among others, of ensuring an appropriate level of solvency and a level playing field

for CIs, making the regulatory capital required more sensitive to actual risks and

encouraging better risk management.”

Similar to Italy, factoring companies in Spain enjoy preferential treatment in respect to the

minimum capital level within the Basel II Framework. The Law 36/2007 states that “the

Bank of Spain may not require full compliance with individual requirements for credit risk

from Spanish credit institutions, which form part of a consolidated group of credit […]

where the parent company is a credit institution [and] has as main activity the activity of

holding shares in banks” (unofficial translation - Spanish text is available only). More

specifically, factors that are part of a banking group, which is regulated at the consolidated

level by BoS, are required to comply with a 4% minimum capital ratio, instead of the normal

8% that is required from Factors that operate independently. As an example for this

provision, it is worth mentioning the full acquisition of Popular de Factoring (PdF) by the

Banco Popular Group that was completed in 2006. In its 2006 annual report, PdF stresses

the change in its minimum regulatory capital ratio to 4% from 8% in 2005, when it was

operating on a stand-alone basis.

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5.2.3. Full compliance

5.2.3.1 France

In France, factoring must be carried out by credit institutions that are subject to prudential

requirements and supervision, and are members of the Association Française Des Sociétés

Financières (ASF). Most of these companies are licensed as finance companies, while a

few retain a banking license. Factoring institutions in France have been required to comply

with the Basel II Framework, under the “Order of the Minister of the Economy, Finance and

Industry of 20 February 2007”, which was amended in October 2007 and September 2008.

5.2.3.2 Austria

According to the Austrian Federal Banking Act (Bankwesengesetz), “the purchase of

trade receivables, assumption of the risk of non-payment associated with such receivables –

with the exception of credit insurance – and the related collection of trade receivables

(factoring business)” is considered a banking transaction and is restricted to “credit

institutions”, which are authorized by the Financial Market Authority (FMA). Article 22 of

the aforementioned Act states that:

“Credit institutions and groups of credit institutions must have at their disposal eligible

capital equal to the sum of the amounts under nos. 1 to 5 at all times:

1. 8% of the assessment base for credit risk calculated in accordance with para. 2;

2. the minimum capital requirement for all types of risk in the trading book in accordance

with Article 22o para. 2;

3. the minimum capital requirement for commodities risk and foreign-exchange risk,

including the risk arising from gold positions, each for positions outside the trading book;

4. the minimum capital requirement for operational risk in accordance with Article 22i;

5. additional capital requirements as necessary in accordance with Article 29 para. 4 and

Article 70 para. 4a. The net position in a foreign currency may be calculated by offsetting

positions within and outside of the trading book.”

Austrian credit institutions, including factoring companies, are required to calculate the

appropriate capital requirements under the Basel framework, in accordance with the

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“Regulation of the Financial Market Authority on the Solvency of Credit Institutions”

(Solvabilitätsverordnung).

5.2.3.3 Sweden

Factoring institutions in Sweden are registered to and supervised by the Swedish Financial

Supervisory Authority (Finansinspektionen) and are required to comply with Basel II

requirements, as instructed in the Capital Requirements & Large Exposures Act

(2006:1371) and the Capital Requirements & Large Exposures Ordinance (2006:1533).

In contrast to Greek regulations, Sweden does not make use of the CRD national discretion

option for the individual waiver of subsidiaries that operate within a regulated financial

group, subject to the fulfillment of certain conditions.

5.2.3.4 Finland

Factoring companies in Finland are under the supervision of Finnish Financial Services

Authority (FIN-FSA) in accordance with its rules and regulations, which are in direct

accordance to the CRD Basel II. However, according to the FIN-FSA “The set of regulations

is currently being reformed, the end result being that the separate regulations for credit

institutions and capital markets will be abandoned in favor of subject-specific regulations”.

In this respect, and regarding factoring, the Finnish Bankers Association is quoted

(Comments on Consultative Paper 3, 12.8.2003):

“The Consultative Document refers particularly to purchased retail and corporate

receivables when defining the eligible collateral. We would like to draw attention to the fact

that factoring business is carried out in different forms. Whereas in the Central Europe

factoring normally means that the factoring company purchases the receivables, and

thereby takes a credit risk (non- recourse factoring), factoring in Finland and other

Scandinavian countries as a rule means that the factoring company lends money to this

client with the receivables as collateral (recourse factoring). The loan to collateral value

varies with the risk, but usually amounts to about 80 % of the total value of the invoices

held as collateral. This means that the risk level is already taken into account when the

factoring transaction is made. In addition, the client is normally obliged to take back

receivables when the debtor is in default, including the credit risk. As a consequence, the

risk level of factoring for factoring companies is extremely low. Finnish Banker’s

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Association proposes that the definition of eligible receivables would also cover lending

against receivables (recourse factoring)”.

5.2.3.5 Portugal

According to the Credit Institutions and Financial Companies Legal Framework of Portugal,

Factoring companies are considered as Credit Institutions. Thus, Factoring companies fall

under the scope of the Banco de Portugal (BdP) supervision. Regarding Basel II, the new

regulatory framework was adopted in Portugal with the publication of Decree-Law no.

103/2007 and Decree-Law no. 104/2007, both of 3 April, and with the issuance of a set of

Notices and Instructions of BdP which regulate the provisions laid down in those Decree-

Laws. These legal documents are replicating the CRD Basel II content.

5.2.4. Summary Table

Country No Compliance Adapted

Compliance

Full Compliance Turnover 2008

(mil€)

United Kingdom ü 188.000

France ü 135.000

Italy ü 128.200

Germany ü 106.000

Spain ü 100.000

Netherlands ü 30.000

Ireland ü 24.000

Belgium ü 22.500

Turkey ü 18.050

Portugal ü 18.000

Russia ü 16.150

Sweden ü 16.000

Finland ü 12.650

Greece * ü 10.200

Poland ü 7.800

Austria ü 6.350

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Country No Compliance Adapted

Compliance

Full Compliance Turnover 2008

(mil€)

Denmark ü 5.500

Czech Republic ü 5.000

Lithuania ü 3.350

Cyprus ü 3.255

Hungary ü 3.200

Switzerland ü 2.590

Romania ü 1.650

Slovakia ü 1.600

Latvia ü 1.520

Estonia ü 1.427

Slovenia ü 650

Malta ü 52

* Regulation for full compliance to Basel II has been drafted in Greece

6. Basel II Standardized Implications

Regulation and supervision for factoring companies is welcomed by all factoring

associations around the world. It has been repeatedly stated that regulation enhances the

transparency within an industry and promotes sustainable growth. However, there has

been increased criticism for specific Basel II rules, in particular regarding the level of risk

attributed to factoring transactions under the Standardized approach to credit risk capital

requirements calculation. The International Chamber of Commerce (ICC) argues, in a

paper released in March 2009, that “the financial crisis has brought into sharp relief an

ongoing trend whereby the implementation of the Basel II charter has eroded the incentive

of banks to lend trade finance, due to pronounced capital weightings that are not fully

reflective of the low risk level of the activity”. Similarly, the European Banking Federation

(FBE) has claimed that “the Committee’s proposals on the treatment of trade finance

under both the standardized and foundation IRB approaches fail to reflect the low loss

experience in trade finance” and “would lead to a significant increase in capital required”.

The Swedish Banker’s Association, in a position paper, suggests the “use of a 50% risk-

weight under the Standardised Approach for leasing and factoring [exposures], considering

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the low risk level of these products in comparison with the risk level of ordinary bank

loans”.

6.1. Short-term maturity (less than 1 year)

In general the Standardized approach to credit risk does not differentiate its treatment

depending on the maturity of the exposures, with the exception of exposures to rated

financial institutions with maturity up to three months. This results in excess risk being

attributed to short-term exposures, which is another incentive for institutions to pursuit

the application of advanced methodologies that take into account the maturity of each

exposure when estimating the appropriate risk weight. This drawback of the Standardized

approach normally has a greater impact on factoring exposures which have almost always

a maturity of less than one year. If one also considers the following issue of non-

recognition of the collateral that recourse offers, it is clear that factoring transactions

create a significant capital “burden” if the Standardized approach of the Basel framework

is applied. Subsequently, the implementation of the IRB approach appears to be the only

option for factoring institutions that are required to comply with the Basel requirements

for capital adequacy.

6.2. Eligibility of collaterals

Certain factoring associations have stressed the need for collateral recognition under the

Basel II standardized approach, in particular for transactions with recourse. As stated by

Assifact, the Italian Association of Factoring Companies, in factoring transactions with

recourse, the Factor does not stand assured for the success of the transaction, so in the

event of the assigned debtor’s default the credit is “passed” to the assignor. In compliance

with the supervisory reporting manual and the Risks Center of the Bank of Italy, the cash

credit risk for the Factor is represented by the amount of the assigned asset that may have

been paid in advance to the assignor. Such a transaction is characterized by the presence

of two co-obligor figures; the assignor and the assigned debtor. According to this

assignment arrangement, a default may only be ascertained when both the assigned debtor

and the assignors jointly default (double default). Although the joint default of the obligor

and the seller of the receivables would normally be considered as a low probability event,

the Standardized approach to credit risk currently treats such exposures as uncovered and

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assigns a conservative risk weight (usually 100%, since the majority of corporations

involved in factoring are either unrated or rated below A-).

Assifact argues that even in transactions without recourse, risk mitigation results from the

information collected in the direct relations with the assigned debtor prior to maturity of

the credit, due to the management component of the factoring service, as well as from the

possibility that a plurality of assignments relates to a single assigned debtor and/or the

assignment of the same debtor in a number of transactions on the part of the same

assignor. In that sense, applying a risk weight equal to that of a loan to the same

counterparty could be considered as extremely conservative.

In the CEBS document titled “CEBS Second advice on options and national discretions”,

Assifact states the following in respect to the eligible CRM techniques:

“With respect to risk mitigation techniques for insolvency, we highlight the absence of

insurance policies on credits among the acceptable techniques for risk mitigation: these

play a significant role in the type of risk management used in factoring. We underline that

recourse to this technique for the transfer of risk associated with the debtors transferred

is favoured by the fact that in both factoring and insurance the risk is accepted on portfolio

logic, even though each unit in the aggregate is evaluated specifically. We believe that the

evolution of the contract structures used, specifically on the matter of the effectiveness of

the guarantee with respect to the insured party’s obligations, the modality and the times of

the execution of the guarantee as well as the maximum limit of the policy, can render this

risk mitigation technique acceptable with respect to the requirements set out for personal

guarantees.”

Assifact continues, covering the mitigation of dilution risk:

“With respect to the dilution risk, the obligations assumed by the guarantor are not based

on mitigating the risks of the principal debtor’s insolvency, but rather by mitigating the risk

that the transferred debtor will not miss a payment for the outstanding debt due to the

underlying commercial relationships, that is to say the supply of goods/services by the

transferor. In this context, mitigating the risk of a missed payment by the debtor is

reduced by the actions undertaken by the transferor (substituting goods/services, a

discount being applied to the debtor purchaser, etc) whose effectiveness is not reflected

by insolvency ratings. To this end, we believe that transferring companies with a rating

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even below the minimum level set out in the Directive, i.e. class 2 should fall within the

range of eligible guarantors if the contractual structures attribute to the transferor the

role of guarantor for dilution risk as is the case with Italy. Moreover we highlight that the

dilution risk involves different types of financial operations based on trade receivables: in

light of an international comparison, these operations are different even at a national level,

therefore the contractual structures of the guarantees may also be difficult to compare.

In the contract structures adopted in Italy, there are, for example, certain obligations

imposed on the assignor, under penalty of termination of the factoring contract. These

obligations appear to be sufficient to mitigate dilution risk and allow the recognition of the

assignor’s role as guarantor with respect to such risk.

Specifically, in the general conditions of the contract, the supplier is obligated to:

• Fulfill precisely and timely the underlying supply contracts, besides naturally

guaranteeing certainty and collectability of receivables;

• Make available to the factor all the documentation and information concerning the

qualitative characteristics of the assigned claims and the business relations from

which these claims arise, including documentation on contracts and supplies, etc;

• Update this documentation and information to enable the factor to verify that the

supplier’s obligations are met;

• Timely communicate any relevant information concerning the relationship with the

debtor, any possible objection, claim or complaint;

• Not modify, without the prior approval of the factor, the conditions of the sale

and/or service provision, and not grant rebates, price reductions, return of goods,

etc.

In any event, consideration for the assigned claim, generally equal to the value of the

claim, will be paid by the factor to the assignor already net of any discounts, rebates,

deductions and anything else.

These contractual provisions oblige the assignor to transparently and properly fulfill the

supply transactions underlying the claim subject of the assignment, with the obligation to

inform the factor of any actions undertaken to perform business relations and enable the

factor to use the securities that are regulated by contract, besides putting in place

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monitoring procedures and systems to verify the quality of the purchased receivables in

correlation to the assignor’s situation.

In relation to this last passage, these operational requirements, that further protect

against the dilution risk, are part of the consolidated good market practice on factoring,

even beyond the contractual provisions, and in certain national contexts such as Italy, they

are recognized and given value in the prudential supervision guidelines that expressly

provide for the implementation of monitoring systems to verify the quality of the

purchased portfolio, to resolve issues, check the availability of credit and collections.

It is understood that this implication of the Basel II regulations represents one of the

various incentives that the regulators give financial institutions to adopt more advanced

and risk-sensitive approaches for the calculation of capital requirements of credit risk (i.e.

Internal Ratings Based approaches). However, the implementation of IRB approaches by

factoring companies involves several weaknesses that are discussed further down.

6.3. Definition of Past Due

Another point raised by factoring associations has been the technical definition of Past

Due, where “the obligor is past due more than 90 days on any material credit obligation to

the credit institution, the parent undertaking or any of its subsidiaries”. It has been argued

that factoring transactions, which may involve assets that are past due for more than 90

days, fall under the most unfavorable risk-weighting, even though they represent

exposures with mitigated risk. Within a factoring activity, the purchase of past due credits

is a standard transaction, since the Factor acts as a connection between the parties and

takes over during the collection and the debt recovery phase, if any. In addition to the

above, in the context of an assignment of a commercial claim, an individual default might

stem from events related to the underlying supply contract, without entailing that the

obligor’s creditworthiness has deteriorated, or that its solvency has become questionable.

As an amendment to the above Basel rule, Assifact has recommended that purchased

receivables are identified as “high-risk” when the following conditions are jointly met:

• The assets are past due for more than 90 days

• The delay in payments is continuous and repetitive

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In respect to the second point, the Italian Association claims that, “assuming that a factor

is the buyer of a number of claims from different creditors, but in respect of a single

assigned debtor, then such a factor has access to considerable information to estimate

whether the delay is caused by events related to a supply contract or the state of difficulty

of the debtor”. In that sense, factoring companies are able to note when a debtor

repeatedly delays payments (continuing default), and therefore identify the related past

due exposure to that party as high-risk, attributing the least favourable risk-weight

treatment.

6.4. Non - recognition of insurance as a form of credit risk mitigation

The recognition of non-payment insurance has been a well discussed issue in the context of

the Basel II Standardized Approach to credit risk. It is a fact that the eligibility of insurance

as a credit risk mitigant is not explicitly stated in the 2006/48 Capital Requirements

Directive of the European Council, with the exception of “life insurance policies pledged to

the lending credit institution”, which are permitted to be considered as guarantees by the

insurance provider, as far as they meet certain conditions set in the Directive.

The above issue was raised during 2002 in a BIS FAQ paper for the 3rd Quantitative Impact

Study (QIS3), concerning credit risk mitigation (CRM) within the Basel II Framework. The

question posed to BIS was: “If a bank is using a credit risk mitigant, like insurance, that

effectively functions like a guarantee is it allowed to treat such risk mitigants as an ordinary

guarantee?”. The official response from BIS was affirmative, “provided that such a product

meets the operational requirements for guarantees laid down in paragraph 154 to 165 of

the Technical Guidance any product may be treated as a guarantee”. These operational

requirements that are related to guarantees (the rest are only applicable to credit

derivatives) are listed below:

154. A guarantee/credit derivative must represent a direct claim on the protection provider

and must be explicitly referenced to specific exposures, so that the extent of the cover is

clearly defined and incontrovertible. Other than non-payment by a protection purchaser of

money due in respect of the credit protection contract it must be irrevocable; there must be

no clause in the contract that would allow the protection provider unilaterally to cancel the

credit cover or that would increase the effective cost of cover as a result of deteriorating

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credit quality in the hedged exposure.42 It must also be unconditional; there should be no

clause in the protection contract that could prevent the protection provider from being

obliged to pay out in a timely manner in the event that the original counterparty fails to

make the payment(s) due.

155. Additional operational requirements for guarantees:

a) On the qualifying default/non-payment of the counterparty, the bank [Factor in

this context] may in a timely manner pursue the guarantor for monies

outstanding under the documentation governing the transaction, rather than

having to continue to pursue the counterparty. By making a payment under the

guarantee the guarantor must acquire the right to pursue the obligor for

monies outstanding under the documentation governing the transaction.

b) The guarantee is an explicitly documented obligation assumed by the

guarantor.

c) The guarantor covers all types of payments the underlying obligor is expected

to make under the documentation governing the transaction, for example

notional amount, margin payments etc.

This clarification, provided by BIS, is of high importance because it represents the only

written evidence that financial insurance may be eligible, under Basel II rules, for credit

risk mitigation, as far as it complies with the aforementioned operational requirements.

However, it is important to note that this interpretation of insurance was not explicitly

adopted in the 2006/48 Capital Requirements Directive and, subsequently, was not

included in most national regulations, including the Bank of Greece Act 2588/20.08.2007,

leading to uncertainty on whether the regulators recognize financial insurance policies as

CRM guarantees.

7. Basel II IRB Implications

As mentioned previously, there has been significant incentive for factoring companies and

banks that offer factoring and forfaiting services to adopt an IRB approach to credit risk,

under the Basel II framework. One of the main advantages of the IRB against the

Standardized approach is the recognition of collateral in a factoring transaction with

recourse. As mentioned in the Capital Requirements Directive, issued by the European

Union (2006/48), “The risk-weighted exposure amounts for dilution risk for purchased

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receivables shall be calculated according to Annex VII, Part 1, point 28. Where a credit

institution has full recourse in respect of purchased receivables for default risk and for

dilution risk, to the seller of the purchased receivables, the provisions of Articles 87 and 88

in relation to purchased receivables need not be applied. The exposure may instead be

treated as a collateralized exposure” (Article 87, Paragraph 2). Further to that, the

Directive instructs that “The competent authorities may recognize as eligible collateral

amounts receivable linked to a commercial transaction or transactions with an original

maturity of less than or equal to one year. Eligible receivables do not include those

associated with securitizations, sub-participations or credit derivatives or amounts owed by

affiliated parties (Annex VIII, Paragraph 20).

Still, there has been debate about specific elements in the IRB methodology that prevent

institutions from adopting it. These “obstacles” mainly relate to data and system issues, as

well as the failure of the IRB approach in recognizing the particular nature and the typically

short maturity of factoring exposures.

7.1. 1-year horizon for the PD calculation

The Basel II IRB regulation sets a horizon of 1 year for the calculation of Probability of

Default (PD). Therefore, even though the risk attributed to exposures of more than a year

long is risk-based (in contrast to the Standardized approach), this maturity floor results in

a distorted “picture” of the risk linked to trade finance transactions, such as factoring

which are of short-term nature.

The Italian Factoring Association (Assifact) first raised this issue in 2001, suggesting that

the waive of the floor would lead to the calculation of more realistic PDs, and to an

appropriate capital relief to factoring companies, while continuing to reflect a prudent level

of risk for exposures with maturities around 180 days.

The aforementioned issue has been recently recalled by the International Chamber of

Commerce (ICC) in a paper that discusses the impact of the Basel II Framework on the

trade finance industry. The ICC argues that the contractual maturity of trade finance

products is reflective of the time horizon, over which the Factor is exposed to credit risk,

and that the maturity floor assigns excessive amounts of risk.

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7.2. Definition of Default

This implication has already been discussed in the previous section, in relation to the

Standardized approach of the Basel II Framework. Similarly, the IRB approach fails to

recognize the particular nature of factoring transactions, which are likely to breach the 90-

days past-due threshold due to factors that are independent from the creditworthiness and

solvency of the obligor. Therefore, the introduction of the term “continuous and repetitive

delay of payments”, as a default indicator for factoring transactions, has been

recommended by Assifact in the context of the IRB approach as well.

7.3. Contagion Effect

Local regulators need to clarify which amounts should be treated as past due under the IRB

approach of Basel II; In Greece, the issue of contagion of the default status is under

discussion. This discussion affects the IRB implementation, since the Standardized

approach treats the exposures at a facility level, thus taking as past due the whole amount

of the accounts receivable even if only a portion is actually past due. The following

approaches have already been suggested by Greek Factors:

For the factoring transactions with recourse, it has been suggested that the Factor should

not account as past due the whole portfolio of a certain Seller in case only one of his

Buyers is in arrears. In other words, only the specific accounts that are over 90 days in

arrears should be accounted as past due within the Basel II framework, and not the whole

portfolio

For the factoring transactions without recourse, it has been suggested that only the

amount past due (of the accounts payable which are over 90 days in arrears) of a certain

Buyer towards a specific Seller should by accounted as past due by the Factor within the

Basel II framework, and not all the accounts payable of this Buyer to all Sellers that are

served by the Factor.

The above points are still under discussion between Greek Factors and the Bank of Greece,

with relevant decisions being expected in the near future.

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7.4. Dilution risk

The Basel II Framework presents the method of calculating the capital requirements versus

the Unexpected Losses (UL) for purchased receivables. For such assets, there are IRB

capital charges for both default risk and dilution risk. The calculation of risk-weighted

assets for dilution risk and the method of calculating expected losses, and for determining

the difference between that measure and provisions is provided within the Capital

Requirements Directive (Directive 2006/48/EC) text.

Dilution refers to the possibility that the receivable amount is reduced through cash or

non-cash credits to the receivable’s obligor. For both corporate and retail receivables,

unless the Factor can demonstrate to its supervisor that the dilution risk for the

purchasing company is immaterial, the treatment of dilution risk must be the following: at

the level of either the pool as a whole (top-down approach) or the individual receivables

making up the pool (bottom-up approach), the purchasing Factor will estimate the one-

year EL for dilution risk, also expressed in percentage of the receivables amount.

Institutions can utilize external and internal data to estimate Expected Losses. As with the

treatments of default risk, this estimate must be computed on a stand-alone basis; that is,

under the assumption of no recourse or other support from the seller or third-party

guarantors.

For the purpose of calculating risk weights for dilution risk, the corporate risk-weight

function must be used with the following settings: the PD must be set equal to the

estimated EL, and the LGD must be set at 100%. An appropriate maturity treatment applies

when determining the capital requirement for dilution risk. If an institution can

demonstrate that the dilution risk is appropriately monitored and managed to be resolved

within one year, the supervisor may allow the institution to apply a one-year maturity.

Examples include offsets or allowances arising from returns of goods sold, disputes

regarding product quality, possible debts of the client to a receivables obligor, and any

payment or promotional discounts offered by the client (e.g. a credit for cash payments

within 30 days).

This treatment is applied regardless of whether the underlying receivables are corporate or

retail exposures, and regardless of the approach used for the computation of risk weights

for default risk.

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7.5. Limited availability of data

Both Assifact and ICC have noted the challenges involved in the application of an IRB

approach by a factoring company in respect to historical data pooling and analysis. The ICC

stresses the difficulty in “identifying and isolating sufficient data to produce validatable

estimates of risk attributes for trade lending”, when attempting to adopt an Advanced IRB

approach. Inevitably this forces Factors to apply either the conservative parameters set by

the national regulator under the Foundation IRB approach, or the, even more conservative,

risk weights of the Standardized approach.

Another specific data concern, raised by Assifact, is the estimation of default correlations,

which are relevant to transactions with recourse, where the probability of joint default by

the seller and the debtor has to be derived. It is generally accepted that default

correlations represent one of the hardest-to-estimate parameters, even for creditors, for

which an institution may have exhaustive relevant historical data. It is, therefore, expected

that such correlation estimates for factoring exposures will heavily depend on expert

judgment. The risk attributed to such a transaction may be very sensitive to the level of

the estimated probability of joint default, which can be almost impossible to derive with

accuracy, particularly when the obligor and the receivables seller operate in industries that

do not offer sufficient correlation data (e.g. a dairy producer and a supermarket).

7.6. System requirements

In close relation to the previous issue, factoring companies that decide to follow an IRB

approach to credit risk capital calculation will face significant trouble in respect to the

systems required to support such approaches. Since Factors have typically implemented

less advanced systems than banking institutions, the adoption of an IRB approach entails

material cost. This reduces the incentives that Factors are given to pursuit advanced

methodologies, especially when the factoring company represents a subsidiary in a

financial group, with marginal materiality (if any) in terms of the group’s risk and return

profile. It is, thus, expected that, in many instances, the implementation of an IRB

approach for a factoring subsidiary will be rejected upon the relevant cost/benefit analysis

performed by the parent company.

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8. Conclusions

In the majority of the countries (22 out of 28 examined), Factoring and Forfaiting

companies are not subject to Basel II Regulatory Capital calculation and reporting on a solo

basis. In Italy and Spain, the local regulators have adopted an adjusted Basel II framework,

posing lower minimum capital ratios to the Factoring companies. In countries such as

France, Portugal and Finland, Factoring companies are regulated in direct accordance to

the Basel II Capital Requirements Directive. Greece has recently drafted regulation that

instructs the compliance of factoring companies to the Basel II CRD.

In terms of the Basel II implications in case the Framework is applied to Factoring

companies, there are certain issues worth mentioning, such as:

• The explicit identification of the counterparty of factoring claims, both in

agreements with recourse and without recourse, under Standardized and IRB

• The recognition of purchased receivables as eligible under the Standardized

approach; the current framework treats all factoring exposures as uncovered

• The use of insurance as a credit risk mitigant; currently, credit insurance in

Factoring is not explicitly considered as eligible

• The maturity floor of 1 year for all exposures under the IRB Approach. This maturity

floor, by not considering the short-term business nature of Factoring, results in a

distorted “picture” of the risk linked to the transaction

• Additional issues requiring further discussion in respect to the IRB include risk

parameters modeling complexities combined with the extensive data and systemic

requirements

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REFERENCES

1. The New Basel Capital Accord, Consultative Document No 3, Basel Committee on

Banking Supervision (April 2003)

2. Directive 2006/48/EC Of The European Parliament And Of The Council (June 2006)

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(http://www.bis.org/bcbs/qis/qis3qa_e.htm)

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(November 2008)

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(February 2009)

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http://www.bis.org/bcbs/qis/qis3qa_e.htm

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31. FIN-FSA, www.finanssivalvonta.fi

32. Banca d’Italia, www.bancaditalia.it

33. Malta Financial Services Authority

34. Swedish Financial Supervisory Authority

35. Swedish Bankers’ Association

36. Central Bank of Austria

37. Austrian Financial Services Authority

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Topic: “Factoring in the Balkans”.

http://www.thefreelibrary.com/Factoring+Becomes+A+Regulated+Business+Unde

http://www.eiu.com/index.asp?layout=iwArticleVW3&article_id=1942513779&pag

http://www.factoring-broker.org.uk/factoring_regulation.htm

http://www.finanssivalvonta.fi

http://www.bancaditalia.it

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40. Presentation of Mr. Panos Papatheodorou at EEFA’s 5th Annual Conference in

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42. Article/interview at Naftemporiki Newspaper (2003).

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