Credit insurance trap for UK retailers
Robert Peston discusses the difficulties that retailers (or their suppliers) are having getting trade credit insurance.
Fundamentally, information asymmetry combined with efficient use of capital causes this problem. The reason suppliers want insurance is because the economy is shrinking and a (small but significant) percentage of retailers and wholesalers are going to go under. Even though the number is small (I'd estimate 3 to 5 per cent), the problem is that nobody knows which ones. Therefore unless suppliers stop trading altogether, they want to be covered for the risk.
I read a nice analogy recently: if someone gave you ten bottles of water and you knew one was poisoned, you probably wouldn't drink any of them. Even if you were really thirsty.
This combines with the (quite correct) desire of retailers to minimise the amount of working capital tied up in their supply chain in order to be price competitive and profitable. Therefore they extend payment terms to the degree that suppliers have a substantial risk of not getting paid at all.
Suppliers therefore want insurance. Insurers are certainly going to ramp up rates in a recession - to the 3-5% level that will cover them for failures. This is a big extra cost which will ultimately passed onto the retailer (though suppliers might need to absorb some in the short term).
Unfortunately there is a well-known problem of adverse selection in insurance markets - if the insured parties know more about their circumstances than the insurers, which is definitely true in this case. It works like this:
Solid retailers, who are much less likely to go bust, will not want to pay a 3-5% premium on all goods they buy. Therefore, if someone (let's say Marks and Spencer, or Tesco) can demonstrate their stability to the extent either that insurers offer a lower rate, or that suppliers are willing to be uninsured, they will effectively withdraw from the risk pool.
This forces the retailers who remain to bear a higher premium - let's say 10%, and incentivising the next tier of mid-stable retailers to somehow prove their solvency - at least to the degree where they can get cheaper insurance.
Finally, you will be left with a group of companies who cannot or will not be transparent enough to prove their stability, and will become uninsurable. They will be forced to pay upfront to suppliers, which with their likely financing costs, is likely to put them under - as it did with Woolworths and Zavvi. Sadly, the group who can't prove their solvency is likely to be bigger than the group who actually are insolvent. So we may end up with the 3-5% level being amplified to 6, 10 or 20%. Essentially all the risk in the system will get funneled onto the least stable companies who can afford it least.
There are only two ways out of this:
Perhaps we will end up with two classes of retailer: those (M&S) who choose to provide full transparency to prove their creditworthiness, and those (whoever is the next Zavvi) who choose instead to participate in a risk pooling arrangement where extra capital is provided in return for insurance premiums payable to the government, or higher taxes on future profits.
Would these conditions make the "risky" retailers uncompetitive and therefore more likely to collapse? Maybe. It does seem inevitable - both due to the recession, and due to the continuing substitution of online shopping for retail - that more retailers are going to go under. I believe a solution like this can be engineered to make sure the number that does collapse is not artificially increased by this trap.
Fundamentally, information asymmetry combined with efficient use of capital causes this problem. The reason suppliers want insurance is because the economy is shrinking and a (small but significant) percentage of retailers and wholesalers are going to go under. Even though the number is small (I'd estimate 3 to 5 per cent), the problem is that nobody knows which ones. Therefore unless suppliers stop trading altogether, they want to be covered for the risk.
I read a nice analogy recently: if someone gave you ten bottles of water and you knew one was poisoned, you probably wouldn't drink any of them. Even if you were really thirsty.
This combines with the (quite correct) desire of retailers to minimise the amount of working capital tied up in their supply chain in order to be price competitive and profitable. Therefore they extend payment terms to the degree that suppliers have a substantial risk of not getting paid at all.
Suppliers therefore want insurance. Insurers are certainly going to ramp up rates in a recession - to the 3-5% level that will cover them for failures. This is a big extra cost which will ultimately passed onto the retailer (though suppliers might need to absorb some in the short term).
Unfortunately there is a well-known problem of adverse selection in insurance markets - if the insured parties know more about their circumstances than the insurers, which is definitely true in this case. It works like this:
Solid retailers, who are much less likely to go bust, will not want to pay a 3-5% premium on all goods they buy. Therefore, if someone (let's say Marks and Spencer, or Tesco) can demonstrate their stability to the extent either that insurers offer a lower rate, or that suppliers are willing to be uninsured, they will effectively withdraw from the risk pool.
This forces the retailers who remain to bear a higher premium - let's say 10%, and incentivising the next tier of mid-stable retailers to somehow prove their solvency - at least to the degree where they can get cheaper insurance.
Finally, you will be left with a group of companies who cannot or will not be transparent enough to prove their stability, and will become uninsurable. They will be forced to pay upfront to suppliers, which with their likely financing costs, is likely to put them under - as it did with Woolworths and Zavvi. Sadly, the group who can't prove their solvency is likely to be bigger than the group who actually are insolvent. So we may end up with the 3-5% level being amplified to 6, 10 or 20%. Essentially all the risk in the system will get funneled onto the least stable companies who can afford it least.
There are only two ways out of this:
- We accept the collapse of lots of retailers
- The retail sector is required to increase its capitalisation across the board to increase working capital in the supply chain - probably with a corresponding increase in transparency of corporate books, or possibly as an alternative to that
Perhaps we will end up with two classes of retailer: those (M&S) who choose to provide full transparency to prove their creditworthiness, and those (whoever is the next Zavvi) who choose instead to participate in a risk pooling arrangement where extra capital is provided in return for insurance premiums payable to the government, or higher taxes on future profits.
Would these conditions make the "risky" retailers uncompetitive and therefore more likely to collapse? Maybe. It does seem inevitable - both due to the recession, and due to the continuing substitution of online shopping for retail - that more retailers are going to go under. I believe a solution like this can be engineered to make sure the number that does collapse is not artificially increased by this trap.
Update: Land of Leather has asked the stock exchange to suspend its shares and has gone into administration.
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