An alternative source of financing

Written by KC Chakrabarty | Updated: Feb 28 2014, 07:18am hrs
Timely payments from customers will help SMEs in reducing their working capital requirements, leading to lower interest costs, improved profitability and a positive impact on the long-term health and sustainability of India's SME sector. Delays in settlement of dues affect the recycling of funds and business operations of SMEs.

It is, therefore, critical to ensure that the small entities are able to raise liquidity against their receivables. This problem can be institutionally tackled by factoring, which provides liquidity to SMEs against their receivables and can be an alternative source of working capital.

World over, factoring is a preferred route of accessing working capital for SMEs and even larger organisations. Some banks and financial institutions in India have already launched factoring services and I would urge more banks to offer such services, particularly for the MSMEs.

Factoring service, which is perceived as complimentary to bank finance, enables the availability of much-needed working capital finance for the small and medium-scale industries especially those that have good quality receivables but may not be in a position to obtain enough bank finance due to lack of collateral or credit profile.

By having a continuous business relationship with the factoring companies, small traders, industries and exporters get the advantage of improving the cash flow and liquidity of their business, as also the facility of availing ancillary services like sales ledger accounting, collection of receivables, credit protection, etc. Factoring helps them to free their resources and have a one-stop arrangement for various business needs, enabling smooth running of their business.

The Kalyanasundaram Study Group set up by the Reserve Bank of India in January 1988 to examine the feasibility and mechanics of starting factoring organisations in the country paved the way for provision of domestic factoring services in India. The Banking Regulation Act, 1949 was amended to include factoring as a form of business in which the banks might engage.

The Reserve Bank of India issued guidelines permitting the banks to set up separate subsidiaries or invest in factoring companies jointly with other banks. However, it was generally felt that absence of a Factoring Law was one of the major impediments in the growth of the factoring business, including the heavy stamp duty over assignment deed, ambiguity in the legal rights of Factors in respect of receivables, etc.

The government of India enacted the Factoring Regulations Act, 2011 to bring in the much needed legal framework for the factoring business. It has provided definitions for the terms factoring, factor, receivables and assignment. The Act also specifies that any entity conducting the factoring business would need to be registered with the RBI as NBFCs, while exempting banks, government companies and corporations established under an Act of Parliament, from the requirement of registration with the RBI for conducting the factoring business.

The Act, thus, gave clarity to the activity of assignment of receivables and also granted exemption from stamp duty on documents executed for the purpose of assignment of receivables in favour of Factors, thereby making the business more viable. The Act also envisages that all transactions of assignment of receivables shall be registered with the Central Registry established under the Sarfaesi Act, 2002 to reduce the possibility of frauds and for strengthening the due diligence process for the clients.

The Act has given powers to the Reserve Bank to stipulate conditions for the principal business of a Factor, as also powers to give directions and collect information from Factors. Subsequent to the passing of the Act, the Reserve Bank has created a separate category of NBFCs viz; NBFC-Factors and issued directions for their regulation. The prudential norms as applicable to NBFCs engaged in the lending business has also been extended to the NBFC-Factors. Further, bank finance to factoring companies and the factoring business conducted by banks are also regulated by the RBI.

Though the enactment of the Factoring Regulation Act has potentially removed all the major impediments that the factoring sector faced in the country, nevertheless, the sector has a few other items on its wish list, the primary among which are introduction of credit insurance in the factoring business and extending the scope of the Sarfaesi Act to cover NBFCs for a speedy enforcement of security interest.

As regards credit insurance, the finance minister, in the Union Budget 2013-14, has made an announcement for setting up a Credit Guarantee Fund with Sidbi for factoring, with a R5-billion corpus. As far as extension of the provisions of the Sarfaesi Act to NBFC is concerned, the final call rests with the government of India.

The low penetration of the factoring business in the country still remains a challenge, which could be on account of lack of awareness among the users. With the necessary law now in place, sincere attempts need to be made by the industry through its associations and other fora for articulating the benefits of factoring as not just an alternative source of finance but also an avenue for providing a bouquet of financial services vis--vis traditional finance, to small scale industries.

They should be able to identify the untapped potential clientele, especially in various SME industry sectors, and create awareness on how the higher cost of factoring vis--vis the traditional finance is justifiable and cost effective for the businesses in the long run. Factoring companies should also constantly endeavour to upgrade their expertise on both the technological front as also on the operational level for offering cost effective services to their clientele.

The author is deputy governor, RBI(Excerpted from his address at the annual conference of International Factors Group, in New Delhi )