Seller-Orchestrated Inventory Financing under Bank Capital Regulation

Abstract

To help small firms obtain bank financing, large sellers often orchestrate joint finance programs. Under such a program, a large seller connects its small dealers to a large bank, who lends to all participating dealers based on the comprehensive information the seller provides. In this paper, we examine the supply chain pricing and inventory decisions, and the lending term under such seller-orchestrated financing programs. In loan pricing, we focus on a form of financial friction that is of particular importance under such schemes — bank capital regulation. Banks worldwide are required to hold a certain amount of regulatory capital to cushion against loans’ unexpected losses. Currently, there are two widely adopted approaches in calculating regulatory capital: the standardized approach (the amount of regulatory capital equals to a certain percentage of the amount of the loan) and the internal rating-based (IRB) approach (the amount of regulatory capital is contingent on the Value-at-Risk (VaR) of the underlying loan). We consider a game-theoretic model consisting of a large seller and multiple capital-constrained newsvendor-type dealers, who obtain financing from banks who are subject to capital regulation. The seller sets the wholesale price and decides whether to orchestrate a joint finance program for its dealers by collaborating with a bank, and the dealers choose their inventory level and the financing channel. We find that a seller should only orchestrate the joint financing program when the bank adopts the IRB approach and the dealers are of low risk. The relative benefit of this program is further enhanced by risk pooling among dealers, thus are more profitable when the demand correlation among dealers is low, and there is a large number of dealers. Such a seller-orchestrated joint finance program will always benefit the seller and the entire supply chain, but may hurt dealers of intermediate risk-level. Facing dealers with various initial assets, the terms under the joint finance program should be designed as if the financially strong dealers subsidize the weak ones. Our results provide guidance to large sellers on how to orchestrate a joint finance scheme, and to small dealers on their corresponding optimal operational decisions.

Keywords: supply chain management, inventory, operations-finance interface, bank capital regulation, joint finance program, seller-orchestrated financing, risk pooling