Financing Inventory under Bank Capital Regulation and Seller Orchestration

Abstract

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). This paper analyzes how bank capital regulation affects supply chain decisions such as inventory and pricing, and how the seller should orchestrate a joint finance scheme in the presence of such regulatory requirement. Despite its prevalence and importance, the implications of bank capital regulation and seller-orchestrated joint finance programs, and the interaction of these two, on supply chain decisions and performance is not well understood. We consider a game-theoretic model consisting of a manufacturer and multiple capital-constrained newsvendor-type dealers, who obtain financing from banks who are subject to capital regulation. The manufacturer sets the wholesale price and decides whether or not 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. Under this model, dealers with low initial assets prefer financing through banks under the standardized approach, while those with high initial assets prefer IRB banks. The relative benefit of the IRB approach is further enhanced by risk pooling among dealers. The manufacturer could orchestrate a joint finance program with an IRB bank when dealers' initial assets are reasonably high, their demand correlation is low, and there is a large number of dealers. 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 manufacturers on how to orchestrate a joint finance scheme, and to small dealers on their corresponding optimal operational decisions.

Keywords: operations-finance interface, inventory, bank capital regulation, risk pooling, joint-financing, distributor financing