In a factoring arrangement a business sells outstanding invoices to a factor in exchange for immediate cash.
Factoring is a common alternative to taking out a line of credit from a bank or other financing firm. However, many banks also offer factoring services themselves. So why would a financial institution offer a product that competes with its other products?
Factoring is safer than traditional lending
Factoring is an agreement whereby a company sells its invoices to a bank in exchange for an advance on a percentage of the amount of the invoices. The deal hangs primarily on the company’s customers’ ability to pay their invoices rather than on the overall soundness of the company’s balance sheet.
The essential risk to the bank is that the customer might fail to pay. Even if that happens, the bank that offered a “recourse” factoring contract to the company is not responsible for the debt, and will still collect payment and fees. Meanwhile, the company remains responsible for chasing down the uncollected debt. This sort of arrangement represents less risk exposure than traditional lending and other activities banks use to generate income.
Regulations spelled out in Basel II require banks to keep a certain level of capital in reserve so that they can deal with risks in their operations. In the wake of the recent financial crisis, the justification for such regulations seems to have become even stronger.
Since financing is secured by the sale of invoices which will eventually be paid by the contracting company, if not by the company’s customers, bank factoring services represent a more secure income stream than traditional lending. They also tend to generate higher fee rates than lending.