Recently, new forms of supply chain finance such as reverse factoring have emerged as cheaper alternatives to traditional letters of credit and factoring in international trade finance. The key innovation of reverse factoring is that in reverse factoring transactions, a large creditworthy importer (eg, Walmart) initiates its own program with its international bank (eg, Bank of America). The international bank then offers the importer’s suppliers from foreign countries to buy the importer’s trade credit from it. In fact, the importer’s bank grants credit directly to suppliers. This way, small suppliers with limited credit can access cheap financing by taking advantage of the low cost of capital of their international clients: instead of paying double-digit rates to advance accounts receivable, reverse factoring can cost international suppliers as little as a 1-2% margin over the benchmark rate.
While in theory reverse factoring offers significant benefits in easing credit constraints for small exporters, regulators fear that such transactions could be used as a channel to move illegal funds across international borders. As a result, international banks are required to perform extensive due diligence on foreign suppliers to be allowed to provide reverse factoring. Where the supplier’s country does not have strict Anti-Money Laundering (AML) and Know-Your-Client (KYC) regulations, even if the importer validates the supplier, international banks’ due diligence costs may be too high and prevent banks from providing supply chain finance as a whole. In other words, Bank of America could agree to provide reverse factoring programs only for Walmart suppliers from tightly regulated countries, thus limiting the formation of supplier-customer relationships.
In an effort to ease the due diligence burden on international financial institutions and boost trade, international institutions such as the Asian Development Bank (AfDB) and industry practitioners have called for the implementation of a uniform AML / KYC regulatory framework worldwide. This call for uniform regulation is particularly strong in Southeast Asia, a region with both high trade volumes and dispersed regulation.
Indeed, while typical AML provisions include, among others, the mandatory reporting and record keeping of suspicious transactions, the presence of a criminal offense for money laundering and provisions limiting secrecy for financial institutions , these provisions present substantial heterogeneity among the countries of Southeast Asia, both in terms of force and in terms of their application. For example, reviewing compliance with around 40 AML / KYC requirements of Financial Action Task Force (FATF) Mutual Evaluation Reports (MERs) in 2019 and 2020, Malaysia was found to be in compliance or largely compliant with 38 of the Financial Action Task Force (FATF). 40 criteria, while Myanmar was rated Compliant or Largely Compliant on only 20 of the 40 criteria.1
In an ongoing research project, we question whether strengthening AML / KYC regulations can stimulate the formation of supply-customer relationships between Southeast Asian exporters and overseas importers. The answer to this question is not immediately clear. On the one hand, strict AML regulations can stimulate the granting of credit by foreign banks and ease the financial constraints of small suppliers. On the other hand, the implementation of uniform regulations can be a source of distortions when countries differ in their institutional environment and economic conditions. Indeed, in the 2016 AfDB Trade Finance Gaps, Growth and Jobs Survey, banks asserted that AML / KYC regulations are the most constraining factor for them to provide banking services. trade finance across borders (Di Caprio, Beck, Yao & Khan, 2016)2. In addition, competition from international banks can lead to the failure of local banks, with possible negative consequences for local economies.
To study the impact of AML / KYC regulations on international supply chain relations, we have collected and organized data on the implementation of these regulations in Southeast Asia over the past ten years. While the strengthening of these laws has been gradual, for each country in the region, we have identified a year in which AML / KYC regulations were particularly tightened. Our overall sample consists of 40 countries in the Asia-Pacific region, and we found that eight countries and regions in Southeast Asia – Bangladesh, India, Indonesia, Myanmar, Malaysia, Thailand, Cambodia and Hong Kong – have radically strengthened their AML / KYC regulations between 2010 and 2015.
By leveraging granular international supplier-to-customer transactions between 2007 and 2018, we investigate whether an increase in the stringency of AML / KYC laws in a country is followed by changes in the structure of the supply chain networks for that country. ie if new supply chain relationships are formed or broken. To give a concrete example, we ask whether Thailand’s 2015 Money Laundering Law has increased or decreased the number of supply chain relationships between Thailand and foreign countries.
Our preliminary evidence suggests that strict AML / KYC regulations have a positive effect on supply chain formation. In Figure 1, we show that in the years surrounding an AML / KYC law change in Southeast Asia, on average one in two international companies added an additional supplier from countries that have tightened their AML / regulations. KYC, compared to other Southeastern countries. Asian countries that did not change their AML / KYC laws around the same time.
Our results shed light on a relatively unexplored question in academic finance: the role played by international banks in the intermediation of international supply chains. With this, this project aims to inform the current debate on the costs and benefits of uniform financial regulation in all countries. Our results suggest that ensuring smooth intermediation with stronger financial regulation could improve, rather than hamper, actual international trade flows. Thus, policymakers should consider effects beyond direct effects on local banking markets when considering strengthening AML / KYC regulations.
Supply chain finance recently gained media and policy attention with the collapse of Greensill Capital, a specialist lender. This controversial event further underscores the need for strong financial intermediation to ease other frictions that restrict international trade, such as a possible post-pandemic restructuring of supply chains and the collapse of trade liberalization.