The banking sector in the United Kingdom is the third largest reserves in the world after the United States and Japan. In addition to having one of the largest banking industries, United Kingdom is also a major international canter for investment and private banking services. The UK banking sector's strong international orientation is reflected in the significant foreign existence and substantial assets of foreign banks in London. UK banking sector being a highly developed banking system with large number of domestic and multinational corporations offer far more advanced corporate banking services. UK banking comprises Bank of England as central bank and many other UK and foreign owned banks.
2.1.1 Bank of England:
Bank of England serves as a central bank for the UK. One of the most important responsibilities of the Bank of England is to maintain overall stability of the financial system as a whole. Since its responsibilities for supervising individual banks were transferred to the Financial Services Authority (FSA). "The financial stability role of the Bank has been to focus on identifying and limiting systemic financial risk. This involves close monitoring of the financial system infrastructure, particularly payment systems. The Bank also keep an eye on economic and financial market development, as part of an overview of the system as a whole. Since May 6th 1997 the Bank of England has had operational independence over monetary policy, and its role as the Government's agent for debt management and cash management was transferred to the Debt Management Office". (www.ifsl.gov.uk )
Decisions on interest rate policy are made by the Monetary Policy Committee, chaired by the Governor of the Bank of England and composed of top Bank officials and outside members. There is a Memorandum of Understanding between the FSA, HM Treasury and the Bank of England which explains how the three authorities will work together towards the common objective of financial stability. The Memorandum established, among other things, a Standing Committee which meets monthly to discuss individual cases of significance and other developments relevant to financial stability and banking industry.
2.1.2 Banks in UK:
The number of authorized banks in the UK totalled 686 in September 2010 (www.ifsl.gov.uk). Although the number of UK incorporated banks declined over the past decade there was a significant increase in their average size and financial strength. The total number of authorized banks increased largely due to the growing presence of European Economic Area (EEA) banks. Many of these do not have a physical presence in the UK but can accept deposits on a cross-border basis. Table below shows details of banks in UK.
TABLE 2.1 BANKS IN UK
1995
2000
2005
2010
Incorporated in UK (1)
224
200
184
185
UK owned
142
121
94
95
Foreign OWNED
82
79
90
90
Incorporated outside UK (2)
301
449
490
501
EAIs with UK branches
102
109
93
94
Other EAIs
44
205
284
304
Outside EEA
155
135
113
103
Total authorized banks in UK (1 + 2)
525
610
674
686
Source: International Financial Services London
UK incorporated banks consist of both UK and foreign owned banks authorized by the Financial Services Authority (FSA) under the Financial Services and Markets Act 2000 (FSMA). These primarily include commercial banks, investment banks, foreign owned banks and banks operated by retail companies. The number of UK incorporated banks cut down between 1995 and 2003 from 224 to 185 due to a fall in the number of UK owned banks. Foreign owned banks incorporated in the UK increased slightly during this period.
The fall in the total number of UK incorporated banks was mainly a result of mergers and the surrender of licenses by small institutions in response to changing market conditions.
During this period there was a considerable increase in the average size and financial strength of these banks. London is one of the most important centres for international banking and a lot of foreign banks have positioned branches and representative offices there. Foreign banks in the UK are authorized by the Financial Services Authority (FSA) or their home country within the EEA. In 2003 there were 501 banks incorporated outside the UK that were authorized to carry out business in the UK. A large number of these were European Authorized Institutions (EAIs) without a physical presence in the UK but permitted to accept deposits on a cross-border basis. In total, 287 foreign banks were physically located in the UK, with the majority of these located in the City of London.
The UK has one of the most competitive, efficient and secure banking systems in the world. Banking represents about half of UK based financial services' GDP and employment and just over a half of tax paid. UK banks operate 150 million current, deposit and savings accounts worth nearly £7 trillion, safeguarding money for individuals and companies. Bank customers increasingly use their accounts without visiting a branch: 46 million customers have registered for telephone banking and 33 million for online banking. The outstanding value of UK banks' domestic lending totalled £4.9bn at the end of 2009. (International Financial Services London).
2.1.3 UK Banks Used For Research:
The Major British Banking Groups (MBBG) have shown a better progress compare to last period in profitability and capitalization. According to financial stability review August 2010 of Bank of England the MBBG are Abbey National bank, Alliance & Leicester bank, Bank of Scotland, Barclays, Halifax, Lloyds TSB, Royal Bank of Scotland, NatWest and Woolwich. As there are large number of banks working in the UK and it is not possible to include all these banks for the research purpose. Only four major banks out of Major British Banking Groups (MBBG) will be used to compare corporate services, which are Barclays, Nat west, HSBC and The Royal Bank of Scotland.
Barclays is a UK based financial service group involved in banking for over 300 years and operates in over 60 countries with more than 78,800 permanent employees allover the world out of which 40,700 are alone working in UK banking. It is primarily engaged in commercial banking, investment banking and investment management. In terms of market capitalization Barclays is one of the largest financial services companies in the world. In terms of profits for half year ended 30th June 2010, group achieved a pre tax profit of £3.95 billion, which is 9% more than same period in 2009. UK corporate/business banking provides services to nearly 182,000 large and medium sized businesses through network of relationship and industry sector specialist managers.
NatWest Bank (National Westminster) came into existence as a result of merger of National Provincial Bank and Westminster Bank in 1968. In 2000 NatWest was acquired by The Royal Bank of Scotland Group for £21 billion, which is the largest take over in British history. NatWest bank offer full range of business services to over 850,000 business customers through 1,640 branches all over UK. In term of profit NatWest earned pre tax profit of £211 million for first half of 2010, which is an increase of 11 percent from the year 2009.
HSBC is one of the largest banking and financial services organizations with 9,800 branches in 77 countries of Europe, Asia, America, Middle East and Africa. HSBC shares are listed on major stock exchanges like London, New York, Hong Kong, Paris, etc. Shares in HSBC are held by over 200,000 shareholders in over 100 countries. In terms of profit HSBC made £7.1 billionpre tax profit for first half of 2010 which is almost a double from the year 2009.
The Royal bank of Scotland is one of the oldest banks of UK, founded in Edinburgh in 1727. The Royal Bank of Scotland offer full range of banking and related financial services to 3.5 million personal and business customers through 650 branches all around Great Britain. In terms of profit RBS made £1,157 million pre tax profit for first half of 2010.
2.2 PAKISTANI BANKING SECTOR:
Pakistani banking system is one of the world's fast developing banking system in the world. The overall macroeconomic environment of Pakistan is continuously improving, which provide the crucial support to the Pakistani banking system to perform outstandingly.
Due to the positive developments in numbers and activities of domestic and multinational corporations in the preceding years, the economic growth is gaining a strong momentum.
The economy witnessed a GDP growth of 1.2% for the first half of 2010, much higher than the growth target of 0.5% for year 2010. A number of factors contributed to put the economy in the top gear. Important one is the fast growth in the service sector, which is the largest contributor to the Pakistani economy. Service sector showed the growth at 0.8% during first half of year 2010. Growing activities in telecommunication sector coupled with significant growth in the financial institutions has given a boost to the services sector performance. Figure below shows the sector-wise percentage share in GDP.
Source: Banking System Review 2010
The consistent performance and strength of corporate sector holds special importance for the banking system as corporate sector is largest destination of bank loans. Pakistani banking sector comprises the State Bank of Pakistan as the central bank and many other Pakistani and foreign owned banks.
2.2.1 State Bank of Pakistan:
The encouragement of financial stability has been the most important theme governing operations of central banks in recent times. State Bank of Pakistan (SBP) is a statutory body formed under the State Bank of Pakistan Act 1956. In its capacity as the guardian of monetary and financial stability, the State Bank of Pakistan is completely aware of the importance of this issue and its possible consequences for the overall economy. As central bank of the country, the State Bank of Pakistan has a number of policies, regulatory and fiduciary responsibilities aimed at strengthening the financial system of the country and providing a framework for the financial industry that fosters economic growth. These responsibilities include regulation of the domestic monetary and credit system through an efficient monetary policy, securing monetary and exchange rate stability and ensuring financial stability through effective regulation and supervision of the banking sector in particular and the financial industry in general.
Over the years, State Bank of Pakistan has evolved through the stages of being an organization owned partly by the private banks, to be state-owned in 1974 and then to have seen gradually more independence since 1994. However, with the recent approval of an Ordinance by the Federal Cabinet, which provides for amendments in the State Bank Act of 1956 relating to grant of enhanced autonomy for the institution, State Bank of Pakistan has now accomplished far superior administrative and functional independence than at any stage since it was established.
Like a central bank in any developing country, State Bank of Pakistan performs primary, secondary as well as developmental functions. Primary functions are normally performed by almost all central banks which include issuance of notes, formulation of monetary policy, regulation and supervision of the financial system, acting as a bankers. bank, lender of the last resort, and banker to the Government. Secondary functions include agency functions such as supervision of public debt and foreign exchange reserves, advising the Government on policy matters and maintaining close relationships with international financial institutions. In addition to these, the State Bank also carry out important developmental functions such as the provision of frameworks for the institutionalization of savings and investment in the economy, creating an environment offering capacity building opportunities to the banking sector in association with the Institute of Bankers Pakistan and the National Institute for Banking and Finance to support the Government in promoting the growth of sectors such as SMEs, Housing and IT. State Bank has also been actively involved in the promotion of the agriculture sector and encouraging consumption of locally manufactured machinery in industrial undertakings through policy framework.
Furthermore, it is focusing on the development of an Islamic banking system and financial instruments toward compliance of the Supreme Court's ruling for gradual introduction of an alternative financial system in Pakistan that accommodates the needs of this market.
(Annual performance review 2008-2009)
2.2.2 Banks in Pakistan:
Commercial banks in Pakistan represent the heart of the financial system, holding about 90% of deposits and providing more than two thirds of total financing. At present, there are 25 domestic commercial banks (with 8,718 branches), 1 micro finance bank, 17 foreign banks (with 78 sub branches) and 13 investment banks. Table below shows the details of these:
TABLE 2.2 BANKS IN PAKISTAN
Nationalized Banks 2
Denationalized Banks 4
Specialized Schedule banks 4
Private Banks 13
Provincial Banks 2
Micro Finance Bank 1
Foreign Banks 17
Investment banks 13
Total Banks 56
Source: State Bank of Pakistan
In 1975, the banking system was nationalized, with a number of private banks merged into a few larger state owned institutions. Since the early 1990s, the Government has under taken banking sector reforms and sought private sector participation in the banking system through the privatization of the state owned commercial banks and the establishment of new privately owned banks. The IMF and the World Bank who are not always very generous in their praise had this to say about the Banking sector in Pakistan after carrying out a comprehensive and through review in early 2006, .The far reaching reforms have resulted in more efficient and competitive banking system. In particular, the pre dominantly state owned banking system has been transformed into one that is predominantly under the control of private sector. The legislative framework and state bank of Pakistan's supervisory capacity has been improved substantially. As a result financial sector is sounder and exhibits an increased reliance to shocks. (Husain 2007)
Pakistan has introduced Islamic banking system to operate in correspondence with the conventional banking providing a choice to the consumers. A large number of Pakistanis have remained withdrawn from commercial banking because of their strong Islamic beliefs against riba-based (interest) banking. These individuals and firms are mostly middle and low class, who will have the chance to invest in trade and businesses by availing loans from Islamic banks and thus enlarge economic activities and employment. A complete Islamic bank has already opened the doors for business and quite a few commercial banks have branches solely dedicated to Islamic banking products and services. The State Bank of Pakistan has set up a completely separate Islamic Banking Department and a Shariah Advisory Board to help it in the promotion of Islamic banking in the country.
There is immense surge amongst the banks including state-owned commercial banks to improve their technology and on-line banking services. During the last three years there has been a great development in the ATMs and at present about 700 ATMs are working throughout the Pakistan. Development in creating automated or on-line branches of banks has been quite significant until now and it is predictable that in 2010 almost all the bank branches will be on-line or automated. Utility bills payment and remittances would be handled through ATMs and personal computers reducing both time and cost.
2.2.3 Pakistani Banks Used For Research:
Although there are a large number of domestic and foreign banks operating in Pakistan, due to time and word constraints only four will be used to compare current corporate banking services, which are Muslim commercial bank limited, Habib bank limited, Union bank and Bank Alfalah limited.
Muslim Commercial Bank Limited (MCB) has a solid foundation of over 50 years in
Pakistan and was the first privatized bank of Pakistan. Now after ten years of privatization MCB have a network of over 900 branches, 225 ATMs in 41 cities and a network of 12 banks on the MNET ATM switch all over the Pakistan. MCB is the only bank to receive Euromoney award and Best Bank in Pakistan for fourth time in last five years. In the area of financial products and advice, MCB offer full range for personal and corporate customers. In terms of profit for half year ended 30th June 2010, MCB made a pre tax profit of Pakistani rupees Rs. 4,227 million, which is Rs 2,538 million more than the profit for same period in year 2009.
Habib Bank Limited (HBL) is a major player of Pakistan's services industry with extensive branch network of 1480 (1425 domestic and 55 international branches) and employing over 18,625 qualified professional bankers. In terms of profit HBL earned a pre tax profit of Pakistani rupees Rs. 4,883 million during first half of 2010, which is Rs. 2,671 million more than the profit for the same period in year 2009.
Union Bank was established in 1991 and is backed by a major Middle Eastern Group. Union bank is one of the fast growing private banks with 42 branches in 19 cities all over Pakistan and a network of over 300 banks in 85 countries. In terms of profit it is showing fast growing trends as pre tax profit for 2009 was Pakistani rupees Rs. 1,410 million, which was Rs. 845 million more than for year 2008.
Bank Alfalah Limited (BAL) was incorporated on June 21st, 1997 as public limited company and commenced its operation on November 1st, 1997. BAL is currently operating through 104 commercial banking branches and 15 Islamic banking branches in 36 cities throughout Pakistan. During the half year ended 30th June 2010 bank's pre tax profit stood at Pakistani rupees Rs. 1,275 million, which is Rs. 422 million more than profit for same period in 2009.
2.3 RECENT TRENDS AND MARKET DEVELOPMENTS IN BANKING:
The banking sector in UK and Pakistan is undergoing rapid transformation during the last decade or so. Some of the important issues that might affect the banking sector in future are: Restructuring of bank business, which is becoming more global and is helped by reduction in barriers to enter the international trade and technological advancements.
Distinction between the banks and other financial service providers has fallen considerably in the recent years. Competition level has increased due to the entry of other players like internet banks and provision of banking services by institutions whose primary business is not banking.
Off shoring or remote business processing is a growing trend in the international business in the recent time. Technological advancement and reduction in telecommunication costs have allowed more independence of operations in terms of location. Most popular destinations for off shoring are India, China, Sri Lanka, Philippines, Malaysia, etc. and this market is projected to grow at 30% to 40% annually. In terms of distribution channels, it is widely believed that because of technological advancements internet, mobile telephone banking and TV banking will be some of the most important form in the future UK banking. In spite of these predictions, branch banking will continue to have an important role in the provision of banking services. Liberalization of banking and other financial services is one of the popular global trends especially in the developing countries.
Chapter - 3
CORPORATE BANKING SERVICES 1: FINANCIAL SERVICES
Every company requires at least one bank, but recent studies reveal that only 8% of companies use just one bank. Large-scale business may deal with hundreds of banks. The number of banks dealt with depends on the business size, complexity and geographical spread. Whilst it makes sense to have more than one bank, too many can make it difficult to promote strong relationships. Turnbull (1983) was among the first researchers who studied the perceptions of corporate customers towards their banks. He examined the relationship between 44 corporate customers in UK and their bankers and found that size of the corporate customer played an important role in maintaining multi banking practices.
Another important finding of Turnbull (1983) was that larger corporations tend to prefer foreign banks than the local banks. Turnbull and Gibbs (1989) carried out a study using lager and very large companies in South Africa. The objectives of their study were to find factors that were considered significant among corporate customers in selecting their bank and to find information weather companies have banking relationship with one bank or more. The finding generally showed that the corporate customers perceived that quality of service was the most significant factor in establishing a banking relationship. Other significant factors were quality of staff, bank manager's attitude and service charges. Although very large companies considered quality of service as the most important factor, both price and quality of staff were equally important. Multi banking relationship practice was common among the corporate customers and physically appearance of the banks had no impact on their selection process.
The real significance of good banking relationship is discovered when things get tough and when continued bank support is required. A healthy banking relationship requires the company to deal openly, honestly and regularly with the bank, keeping it informed of development and ensuring there are no nasty surprises. Many Banks had made numerous efforts to develop relations with the business community, yet despite their efforts, banks are often criticised for their lack of support in difficult times. Regardless of such problems, banks remain the most important source of external finance for the businesses, providing roughly 60% of their external finance. In this chapter we will examine the nature and characteristics of financial services generally provided by banks in both UK and Pakistan to their corporate clients.
3.1 BANK CREDIT FACILITIES:
Banks in UK and Pakistan offer wide variety of credit facilities, ranging from short term overdrafts to long term loans of varying terms. The interest rate generally rises with the term of the loan, the actual rate being linked with the bank's base rate, which in turn depends on the base rate set by Monetary Policy Committee in UK and State Bank of Pakistan in Pakistan.
Over a one third of UK bank lending was targeted towards overseas customers and two third towards domestic customers in 2009. This is not surprising given the significant presence of foreign banks in the UK. Total lending or advances reached £2,608 billion at the end of 2009, which is 6% more than the previous year 2008. Figure below shows the division of bank lending to domestic customer and foreign customers as a percentage of total lending by UK banks in respective years.
Figure 3.1 Destination of UK Lending
Percentage of Total Lending
Source: City Business Series Feb, 2010.
Corporate lending has doubled over the past decade. This was paralleled by a varying pattern in bank lending to companies both in the direction and maturity of lending. Financial services increased its share of bank lending typically at the expense of manufacturing, wholesale and retail trade. Bank borrowing is the major source of external finance for all businesses and especially for small firms, which have less capacity to issue bonds or to attract equity finance. Between 2000 and 2005 bank borrowing amounted to 52% of external finance for UK SMEs (Small and Medium Enterprises), ahead of leasing at 25%, factoring and shareholders both around 6%, and venture capital 3%.
Over the past decade the ratio of medium to long term lending to businesses has improved slightly while during the same period there has been a substantial decrease in the use of overdrafts. The overall ratio of lending to businesses for terms of at least one year, increased from 33% in 1999 to 35% in 2009, mainly due to increase in loans with a maturity period of over five years. Most lending however remains short term reflecting the primary requirements of customers in managing cash flow, working capital and other short term financing requirements. During the same period the ratio of business lending on overdrafts decreased from 28% to 16% of total lending while other short term lending unto 1 year rose from 39% to 49%.Diagram below shows the details of financing type and its percentage of total lending.
Figure 3.2 Type of Loan and Percentage Share
Source: City Business Series Feb, 2010.
In Pakistan the corporate sector (including big corporations, small and medium enterprises) is the biggest destination of bank lending. During the past year 2009 the corporate sector took the majority of the total advances made by the schedule banks of Pakistan, which is about 71.4% of the total loans (big corporation 53.90% and SME.s 17.5%). Figure below shows the details of the advances made by schedule banks of Pakistan by type of borrowers for year 2009.
Figure 3.3 Percentage of Advances by Type of Borrowers
Source: Banking System Review Feb, 2010
Advances made by schedule banks of Pakistan up to the month of June in 2010 were Pakistani (rupees) Rs. 1,752,074 million, which were 36.77% more than in May 2009 i.e. Rs.1,281,062 million. Table below shows the details of the monthly advances made by schedule banks in Pakistan.
TABLE 3.1 TOTAL ADVANCES BY SCHEDULE BANKS IN PAKISTAN
TOTAL ADVANCES BY SCHEDULE BANKS IN PAKISTAN
Million Rupees
As on last week of
2007
2008
2009
2010
March
960,988
1,002,414
1,211,241
1,688,464
June
970,112
1,069,259
1,324,522
1,759,566
September
930,871
1,051,184
1,396,430
--
December
1,000,331
1,169,986
1,589,870
--
Source: Economic Data
Banks exist to lend money at interest for making profit. Both personal and corporate customers require financial assistance from time to time. This assistance is usually given in the form of bank credit facility. Following are few credit facilities usually offered by banks to their corporate customers in both UK and Pakistan:
3.1.1 Overdrafts:
The most excellent known form of short term bank credit in both UK and Pakistan is the overdraft facility offered to corporate customers for period such as six months or a year. There is no pre-determined minimum or maximum level of borrowing on an overdraft and is determined by Bank's relationship manager. Overdraft limit and provision of security depends upon the corporate customer's business nature and association with the bank.
Interest rate varies with the banks base rate and only payable on the negative balance or amount used at any time rather than the maximum agreed limit.
As pointed out in Bank of England quarterly bulletin summer 2010, the overdraft finance was once again quoted as the most common form of debt instrument used, with 62% of small companies acknowledging they have an overdraft facility. According to British Banker's Association, overdraft borrowing made by small companies alone amount £9.652 billion up to second quarter of 2010.
Figure 3.4 Overdraft According to Size of Company
Source: Bank of England Quarterly Bulletin Summer 2010.
Figure above shows the relationship between the sizes of the company and usage rate of overdraft facility as mentioned in a survey conducted by Bank of England that the bigger the size of the company in term of number of employees employed the more it uses overdrafts to finance its short term financial needs.
3.1.2 Term Loans:
Business loans with maturity longer than one year are called term loans. Term loans could be for short (1- 5 years), medium (6-10 years) and long term (more than 10 years).These loans are structured on the basis of primary project characteristics and cash flows of the business. Like previous studies current survey by Bank of England finds much greater usage of short term bank loans than medium and especially long term. Short-term and medium-term loans are more likely amongst bigger, profitable and more established companies. Long-term loans seem to be uniformly rare amongst all types of businesses, even though they are most common at old-established companies. This can be seen in the diagram below:
Figure 3.5 Term Loans According to Size of Company
Source: Bank of England Quarterly Bulletin Summer 2010.
As evident from above figure that popularity of term loan decreases with the increase of duration of the loan i.e. short term loans are most popular among the business community as compared to medium and loan term loans.
3.1.3 Revolving Credit Facility:
Revolving credit facility permits the borrower to borrow, repay and re-borrow during the period of loan provision. It is often protected on the borrower's working capital e.g. using stock as security. However, big companies having good relationship with bank may not be required to furnish any form of security for loan.
3.1.4 Credit Cards:
Credit cards are an important method of lending money used by banks all over the world. The main ones offered by banks are those carrying Visa and MasterCard symbols. Credit cards are normally aimed at individuals and are charged with very high interest rate. However, company cards are the credit cards given to the employees of the company typically commercial travellers, managerial staff to pay for travel expenses etc. and cost is charged to the company. Biggest advantage is the control over the expenses made by company's employees. In recent years credit cards have become the single most significant mode of payments in the daily life both for individuals and corporate employees. Diagram below shows the prevalence of credit cards in the UK market and that significant proportion of customers hold multiple credit cards:
Figure 3.6 Prevalence of Credit Cards in UK
Source: Financial Stability Review June 2010
3.1.5 Mortgages:
In the word of Clark (1999) .mortgage is a transfer of legal document to a property as a form of protection for the settlement of a debt.. As the loan is secured against the property and risk associated with the loan is less, the bank generally charges low interest on mortgages. Corporate customers are generally offered commercial mortgages against commercial properties. Table below list down the top 10 banks issuing mortgages to the UK customers in 2010:
TABLE 3.2 TOP 10 MORTGAGE LENDERS FOR 2010 IN UK
TOP 10 MORTGAGE LENDERS FOR 2010 IN UK
Rank
Name of Bank
£ in billions
Estimated market share
1
Abbey
193.0
28.0%
2
Halifax
90.9
21.0%
3
Nationwide
80.1
20.0%
4
Northern Rock
78.2
15.0%
5
Woolwich
64.5
11.0%
6
Bradford and Bingley
57.5
8.0%
7
HSBC
49.0
5.6%
8
Royal Bank of Scotland
32.4
3.7%
9
Lloyds TSB
27.9
3.2%
10
Alliance & Leicester
23.6
2.7%
Source: Council of Mortgage Lenders (www.mortgageguideuk.co.uk)
State bank of Pakistan permitted schedule banks of Pakistan to advance residential housing loans in 1998 in its circular no. 10, in which it made changes in credit policy of housing finance and permitted schedule banks to forward mortgage loans keeping in view the regulations for lending set by state bank of Pakistan. Since then majority of schedule banks of Pakistan are forwarding mortgage loans to the citizens of Pakistan.
3.2 FACTORING AND INVOICE DISCOUNTING:
Factoring and invoice discounting, together known as invoice finance, are mainly used as a form of short-term working capital finance. Both invoice discounting and factoring involve the assignment by a vendor to its financier of the proceeds due on outstanding invoices (receivables), in return for an instant payment of up to around 85% of the invoices. Face values and the remainder (less fees and finance charges) upon payment of the debts by the vendor's customers. Thus, the finance is extended for the length of the trade debt. The main difference between factoring and invoice discounting is that in the latter the vendor retains control of its sales ledger and remains responsible for collecting debts, whereas factoring involves the transfer of this function to the financier (banker). For this reason, bigger companies tend to use invoice discounting, whereas factoring is more suitable for smaller companies. This relationship is discussed in bank of England quarterly bulletin summer 2010, where it argues that as the size of the company increases it tends to favours the use of invoice discounting as shown in the figure below:
Figure 3.7 Invoice Discounting and Size of Company
Source: Bank of England Quarterly Bulletin Summer 2010.
3.3 LEASING AND HIRE PURCHASE:
Leasing and hire purchase are financial facilities that permit a business to utilize an asset over a fixed period, in return for regular payments. The business chooses the equipment it requires and the bank buys it on behalf of the business. Most business equipment may be obtained this way. There are fundamentally two forms of lease in both the United Kingdom and Pakistan: the finance lease and the operating lease. Finance leases confer upon the lessee all the economic risks and rewards of ownership of the asset, because the lessee repays mostly the entire asset's cost to the lessor. At the end of the lease, the lessor may sell the asset and pay to the lessee most of the proceeds. On the other hand, the lessee may continue to lease the asset at a nominal rental. Under an operating lease, the lessor keeps some or all of the economic risks and rewards of ownership. This is generally because the economic life of the asset is expected to be longer than the length of the lease.
When an operating lease terminates, the asset is simply returned to the lessor, who may lease it out again. Assets subject to hire purchase arrangements are recorded on the lessee.s balance sheet in almost the same way as if it were a finance lease, provided that the cost to the lessee of exercising the option to purchase the asset is insignificant. The vast majority of cases in the United Kingdom are of this nature. According to bank of England quarterly bulletin 2010 lease and hire purchase are much more heavily used by businesses than invoice discounting. Diagram below shows the fact that with the increase in the size of the business use of lease and hire purchase also increases.
Figure 3.8 Lease & Hire Purchase and Size of Conpany
Source: Bank of England Quarterly Bulletin Summer 2010.
3.4 INTERNATIONAL TRADE FINANCING:
Banks both domestic and foreign play an important role in the smooth execution of the international deal between to parties generally known as exporter and importer. When dealing with less reliable or new customers based in other parts of the world more formal procedures are required to over come the fear of nonpayment by a customer in a foreign country, the exporter enlists the help of a well respected bank to act as intermediary. Banks offer different services to finance the foreign trade which are as follows:
3.4.1 Letter of Credit:
Letter of credit is an undertaking by an issuing bank to the beneficiary to make payment within a specified time, against the presentation of documents which comply strictly with the terms of the credit. Therefore, the risk to the seller, of non-payment by the buyer is transferred to the issuing bank (and the confirming bank if the letter of credit is confirmed) as long as the exporter presents the documents in strict compliance with the credit. It is imperative to keep in mind that all parties in the letter of credit transaction deal with documents, not goods. Letter of credit makes possible for the exporter to receive the payment for goods in its country of origin once the shipment has taken place.
Valdez (2000) has identified following few types of letter of credit. A revocable letter of credit can be amended or cancelled at any time without the beneficiary's agreement (unless documents have been taken up by the nominated bank). Little protection is offered to the beneficiary with a revocable credit and they are rarely seen. An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. An unconfirmed letter of credit is forwarded by the advising bank directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity. A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This promise holds even if the issuing bank or the buyer fails to make payment.
A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. If the exporter fails to receive payment from the buyer he can claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit. The revolving letter of credit is used for regular shipments of the same commodity to the same buyer. It can revolve in relation to time or value. If the credit is time revolving once utilized it is re-instated for further regular shipments until the credit is fully drawn. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit. A transferable letter of credit is one in which the beneficiary has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of letter of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers. A back-toback letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favor of his supplier. Many banks are hesitant to issue back-to-back letters of credit due to the level of risk to which they are exposed.
3.4.2 Bill of Exchange:
Bill of exchange is a form of commercial credit instrument used in international trade. In Britain, a bill of exchange is defined by the Bills of Exchange Act 1882 as an unconditional order in writing addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a certain sum of money to or to the order of a specified person, or to the bearer.
3.4.3 Forfaiting:
Forfaiting is a form of fixed-rate trade finance, which involves the purchase of an exporter.s debt by a financial institution or banks- the forfaiter. These debts are usually in the shape of bank bills of exchange or promissory notes and have been accepted by the exporter as deferred payment for goods sold to foreign buyers. The exporter sells the bills or notes at a discount, for cash, and passes all commercial and political risks and responsibilities for collection to the forfaiter. The exporter protects himself by including the words 'without recourse' in endorsing the bill. Forfaiting is commonly used in Europe, Latin America, North Africa and the Far East.
3.4.4 Factoring:
Valdez (2000) defines export factoring as .buying export trade on a non-recourse basis to assist cash flow.. Export factoring is similar in essence to domestic factoring, with the added benefit that the factor usually assumes the foreign exchange risk and therefore may be expensive.
