Duke Research Advantage

Operations Management Professor Paul Zipkin offers the following suggestions for easing the credit crisis with a supply chain management approach to banking.

Who needs banks, anyway? The enormous recent damage to the economy has been caused mainly by the disappearance of working capital for supply chains, plus consumer panic. Maybe firms in supply chains need to become their own banks, much as they do in impoverished countries. This is already happening on a small scale.1

Seriously, our economic civilization works much better with banks. The current crisis has amply demonstrated this fact. Various remedies have been proposed to unfreeze the financial system. Here is another one: Banks can fund whole supply chains, not just individual firms. This practice already exists, again on a small scale. It’s called supply-chain finance.2

To appreciate this notion, some background will help. Why did the subprime crisis lead to a full-blown credit crisis? Why did banks stop lending? Various plausible stories have been put forth, but none of them is based on convincing facts, and none is entirely satisfactory. Right, the banks own “toxic” assets of questionable worth, but the money already injected by the government should suffice to sustain a reasonable level of commercial lending. The banks are not talking. They say they are indeed lending, despite abundant evidence to the contrary.3

I don’t have any facts, either. But here’s a better story than any I’ve heard: Banks don’t trust each other. Each one can see only its own financial condition. Even that is not so certain. There have been lots of stories over the last year of seemingly solid banks, which turned out in fact to be broke, to their own surprise as well as to others’. Still, why should that prevent a bank from lending to a real business? The reason is, banks are tied to each other in part through real businesses.

Consider two firms, A and B. B buys things from A, processes them, and then sells them to others. To make those things in advance of orders from B, A borrows from its bank, say bank 1. And, to pay A and to do its own processing, B borrows from bank 2. (See Figure 1.)

But what if bank 2 doesn’t trust bank 1? It may worry that bank 1 will be unable or unwilling to lend to firm A, so that firm A will be unable to supply firm B, and therefore B will have nothing to sell and thus be unable to pay back its loan. Consequently, bank 2 refuses to lend to firm B. Likewise, if bank 1 doesn’t trust bank 2, it may be unwilling to lend to firm A. Moreover, if bank 1 merely suspects that bank 2 may not trust it, then the same thing happens. This story assumes that A and B were healthy businesses, and both banks know it. Even so, mistrust among the banks themselves hurts the two firms. (Bebchuk and Goldstein outline a similar scenario.4)

This appears to be a classic prisoners’ dilemma among the banks, with firms A and B caught in the middle. But there is a way out. One of the banks can take over the whole supply chain. If bank 1 refuses to lend to firm A, then firm A can go to bank 2 instead. Firm B should be happy to provide a friendly introduction. (SeeFigure 2.)

Alternatively, bank 1 can take over the supply chain. Indeed, firms A and B should encourage competition among the two banks for their joint lending needs.

In reality, of course, most firms have more than one customer and/or more than one supplier. Also, supply chains comprise more than two trading partners. Still, the same principle applies. B can approach bank 2 with each of its suppliers, and/or A can approach bank 1 with each of its customers.

It might be objected that such a system would be too complex. There are many firms in the world, but there are many more pairs of firms, not to mention larger groups. How can a bank accurately assess the credit-worthiness of such combinations? But many banks already have some practice with supply-chain finance. It’s hard but not impossible.

Anyway, such combination deals need not persist forever. Once the system gets going again, the banks can return to the simpler business of lending to one firm at a time. It is likely, however, that some of the relationships established during this transitory period will persist. Firm A should be happy to continue to borrow from bank 2, since its previous partner bank 1 disappeared during a tough time. This sort of competition is a good reason for banks to consider supply-chain finance. Indeed, a wise bank will retain this capability, to exploit future competitive opportunities.

If the banks find supply-chain finance too taxing, perhaps the government should stop injecting money into them and simply start over. Take some of those trillions of bailout dollars and start new banks, able and willing to perform their primary function of lubricating commerce, letting the old ones rot away amidst their toxic assets. What are the alternatives? Well, we can go back to trading goats and sheep.

1 “Supply chain news: If key suppliers are struggling financially, what should procurement organizations do?” January 7, 2009, www.SCDigest.com

“Supply chain news: Segmenting suppliers to understand those most likely to need investment,” February 17, 2009, www.SCDigest.com

2 “Supply chain finance benchmark report,” research report, Aberdeen Group, Inc., Boston, MA, 2006.

“Global supply chain transformation driving new partnerships in supply chain finance,” research report,Aberdeen Group, Inc., Boston, MA, 2008.

“Invoice-based supply chain finance: Driving strategic financial gains,” research report, Aberdeen Group, Inc., Boston, MA, 2008.

3 M. Campello, J. Graham and C. Harvey, “The real effects of financial constraints: Evidence from a financial crisis,” working paper, Fuqua School of Business, Duke University, Durham, NC, 2008.

V. Ivashina and D. Scharfstein, “Bank lending during the financial crisis of 2008,” working paper, Harvard Business School, Boston, MA, 2008.

4 L. Bebchuk and I. Goldstein, “How to give banks confidence to lend to businesses,” Financial Times, December 18, 2008.