Financial Pooling in a Supply Chain

Abstract

Trade credit is often extended by suppliers to buyers who often have easier access to external financing. Moreover, many buyers also delay paying their suppliers beyond the agreed due day. Prior literature attributes this phenomenon to quality assurance or buyer's abuse of market power. In this paper, we show that pooling could be another reason behind this practice. Using a game-theoretic model that explicitly captures the liquidity shocks faced by different supply chain partners, we analyze the total financing cost of the supply chain under endogenous supply contract and working capital policies. We show that the embedded stretching option of trade credit allows supply chain partners to pool their liquidity buffers. Due to this pooling effect, even if the supplier's financing costs are strictly higher than the buyer's, the buyer may still demand trade credit from the supplier in order to lower the total financing cost. The model reveals that trade credit is more efficient than cash on delivery when the supplier's cost for collecting trade credit is low (e.g., when the retailer trusts the supplier) or when the supplier does not have access to a low-cost financing channel when facing liquidity shocks. This pooling effect also dictates that variabilities of firms' liquidity shocks have asymmetric impact on the efficiency of trade credit: while trade credit can only be more efficient than cash on delivery when the supplier's liquidity shock has a sufficiently large variability, it could benefit the supply chain even when the buyer's liquidity shock is deterministic (e.g., an investment opportunity). The benefit of financial pooling increases as the buyer's supplier portfolio becomes more diversified. As an innovative financing scheme, reverse factoring further enhances the efficiency of this pooling effect and, as a result, reduces the overall supply chain financing cost.