Loss-averse retailers’ financial offerings to capital-constrained suppliers: loan vs. investment

Abstract

Suppliers' insufficient capital can disrupt the normal operations of other participants in the supply chain. To alleviate suppliers' capital constraints, retailers have the option of providing financing. However, when addressing the risks of default, retailers should behave conservatively and sensitively, which results in loss-averse behaviors. Using a game theoretical approach, this study examines and compares two financing schemes available to loss-averse retailers: loan and investment. We find that both schemes bring additional value to the loss-averse retailer and the capital-constrained supplier, providing a win–win situation. An appropriate interest rate or proportional dividend is the prerequisite for both participants to adopt a loan or an investment scheme, respectively. For the loan scheme, the retailer's higher loss aversion causes him to reduce the wholesale price. In the investment scheme, a higher loss aversion reduces production quantity. We locate the Pareto improvement regions of the two schemes for both participants using comparative analysis. The retailer's higher loss aversion causes both participants to have lower chances of achieving Pareto improvements from supply chain financing. When the retailer is more loss averse and the supplier is highly capital constrained, both participants prefer an investment rather than the loan scheme. This study provides implications for participants adopting particular financing schemes to enhance profits and reduce risk.

Introduction

Small and medium-sized enterprises (SMEs) are the backbone of a country's economy and are the key to economic growth, innovation, and job creation. In the U.S., in 2018, 30.2 million SMEs occupied 99.9% of businesses, created 1.9 million net new jobs, and employed 58.9 million workers, which is nearly half of the total U.S. workforce (US Small Business Administration, 2018). However, some of the greatest challenges faced by SME suppliers include high production costs and lack of sufficient capital (Deng et al., 2018, Tang et al., 2018, Tunca and Zhu, 2018, Yang et al., 2019). Exacerbating the situation is the limited financial access to commercial banks, owing to their SME status, low credit score, high operational and default risk, and large information asymmetry (Deng et al., 2018). For example, only 20% of all SMEs in China were granted credits from commercial banks in 2016 (Shi, 2017). After the financial crisis of 2008–2009, 22 of the largest banks in the United States significantly reduced loan amounts to SMEs (Wu et al., 2014). Only an extremely limited number of banks offer or accept loan applications from SMEs, and this trend is still decreasing, as shown by a reduction in the number of banks from 6058 in June 2016 to 5787 in June 2017 in the United States (FDIC, 2018). Even worse, most of the loans offered have been limited. Statistics show that 5.7 million loans under $100,000 (valued at $82.6 billion) were issued by financial institutions in the United States in 2016 (FFIEC, 2017). Even today, the financial institutions still refuse and fear providing loans to SMEs due to their low creditworthiness and high bankruptcy risk (Zhu et al., 2019), which means that financial services typically offered by banks to SMEs are often unavailable (Jia et al., 2020). In the upstream of the supply chain, suppliers' lack of sufficient production capital can significantly disrupt the normal operations of other participants. When external funding is not feasible, it is time to turn to internal supply chain participants for financial access (Xu et al., 2018b). However, most supply chain finance (SCF) studies (Chen et al., 2018, Huang et al., 2019) have focused on large manufacturers financing SME retailers. Only a few (e.g., Kouvelis and Zhao, 2018, Tunca and Zhu, 2018) have examined how SME suppliers' capital constraints can be alleviated.

Suppliers often have capital constraints for their enough production (Tunca and Zhu, 2018). Suppliers often experience a long delay in payment after delivering products to retailers, causing them to have extremely limited working capital and making them greatly in need of cash and financing to support their operations (Esty et al., 2016). In addition, small suppliers often have severely limited or even no access to a fair-priced capital market (Deng et al., 2018). Suppliers, as the upstream participants in the supply chain, often experience production disruption as a result of limited capital, which can cause disruption of continuous operations of the whole supply chain. This motivates downstream participants such as giant retailers and third-party financing institutions to offer various financing programs to those capital-constrained suppliers. From the perspective of larger retailers, the traditional profit source is the retailing channel. When facing SME-supplier capital constraints, expanding traditional retail services and initiating financing new services are urgent issues faced by retailers. Many retailers in various industries, such as auto, aviation, fast-moving consumer goods, and beverage industries, have already provided positive answers to alleviate suppliers' capital constraints. In detail, in the auto industry, in the United States, Ford offers loans to its suppliers, and Porsche offers financing programs for suppliers' production tooling. In Europe, BMW and PSA pay suppliers in advance for parts (Bolduc, 2008). Also in the aviation industry, Boeing paid $590 million to its fuselage supplier Vought Aircraft Industries to ensure normal supply for the Boeing 787 in 2009 (Deng et al., 2018). Moreover, in the fast-moving consumer goods industry, the suppliers of Procter & Gamble Company also have opportunities to receive similar early payments to alleviate their financial constraints (Esty et al., 2016). Further, in the beverage industry, Coca Cola Beverages South Africa provided a $20 million fund to boost SME suppliers' development and procurement annuals from 2019 to 2024 (Ngalonkulu, 2019). In the e-commerce era, in North America, Amazon.com offered the Amazon Lending program to financially constrained suppliers (Guinan, 2019). And in China, Suning.com and JD.com offered various financial programs, such as “FinanceSN,” “Jingbaobei,” and “Jingxiaodai” (Hong, 2013). These all show the commonality of suppliers’ capital constraints and the worldwide common financing practices to alleviate those constraints.

When a retailer decides to finance suppliers, two key issues should be considered. First, a financing scheme should be chosen. Second, irrespective of the scheme, retailers must mitigate the financial risks. Thus, the question remains, “how can they deal with those risks and the associated loss?”

Two financing schemes are currently common. One involves loans, where the retailer provides loans to the supplier, and the supplier pays back the principle and interest after sales. For example, Suning Commerce Group Co. Ltd., one of the largest retailers in China, launched a suite of financial products to help finance its upstream suppliers via their Suning Finance program (e.g., credit-quick financing, ticket-quick financing, and account-quick financing). During the first 10 months of 2018, approximately $8 billion in loans were extended to more than 5000 SME suppliers for production purposes (PR Newswire, 2018). Although retailers’ loans have relatively shorter audit periods, longer loan periods, and larger financing amounts compared with commercial loans, suppliers still face repayment pressure and interest charges. This can certainly increase their operational and financial cost burdens.

The other scheme involves retailers' investments, which can overcome the above negative effects. With retailers’ investments, downstream retailers finance suppliers via direct investments. The retailers do not need to repay the principal and interest. Instead, both parties share the dividends from the profits earned at the end of the sales season. For example, in 2011, Airbus purchased a 51% share of PFW aerospace to ensure the normal supply of key aircraft components (Deng et al., 2018). Mengniu Dairy Company Ltd., one of the largest dairy companies in China, purchased a 26.9% stake in its upstream supplier, Modern Farming Group Co., Ltd., for $0.41 billion and became its largest single shareholder (Xingzhou Finance, 2013). Thus, Mengniu was ensured a steady quality and quantity of raw milk sources. However, its supplier Modern Farming has to lose some flexibility of self-control.

Regarding the risk-control issue, although funding suppliers provides the aforementioned benefits, the default risks of suppliers caused by sales drops, underpayments, and other unexpected issues cause retailers to adopt a high level of hesitation (Kouvelis and Zhao, 2018). In 2018, multiple well-known suppliers and manufacturers filed bankruptcy worldwide across various industries, including the Again womenswear company, Hobbico hobby products, and J. Mendel clothes (Klein, 2018). Prior to that, there were a multitude of bankruptcies during the financial crisis of 2008–2009 (Duarte et al., 2018). Thus, many companies lending money behave conservatively when facing these financial risks (Yan et al., 2019). They prefer to avoid losses to acquire the equivalent gains, and they view potential losses more seriously while perceiving potential gains less enticingly (Chen et al., 2014). Thus, instead of loss-neutral behaviors assumed in many previous SCF studies (e.g., Chen et al., 2018, Deng et al., 2018), many financing lenders tend to be loss averse (Li et al., 2016, Yan et al., 2019). The loss aversion can cause decision bias, leading to participants behaving differently than loss neutral (Schweitzer and Cachon, 2000).

This study examines and compares the two financing schemes offered by loss-averse retailers: loans and investments. We first compare the profits of supplier and retailer when they do and do not adopt SCF. Thus, we reach the first research question: “what values can loan and investment schemes bring to supply chain participants?” Second, we examine the retailer's behavior factors affecting operational and financial decisions. Thus, the second question is, “how does the retailer's loss aversion affect wholesale price, production quantity, and finance-scheme choice?” Third, we examine participants' preferences between the two financing schemes and their Pareto improvement regions using comparative analysis. Accordingly, the third research question is, “under what conditions will both retailers and suppliers adopt loans or investments?”

The main contributions of this study involve the following aspects. First, this study extends the few extant studies about buyer finance (Deng et al., 2018, Tunca and Zhu, 2018) by examining and comparing the loan and investment financing schemes. The conditions under which participants adopt either of the two schemes are analyzed. Second, we dismiss prior SCF studies' assumptions about participants’ loss-neutral attitudes (Chen et al., 2018, Deng et al., 2018) by factoring the operational behavior of retailer loss aversion into the models. We also examine the impact of loss aversion on operational and financial decisions.

The rest of the paper is organized as follows. Section two reviews the relevant literature, followed by a description of the model framework in section three. We then analyze participants’ optimal decisions under loan and investment schemes in section four and section five, respectively. Section six provides a comparative analysis of the two schemes, and section seven concludes this study. All proofs are found in the Appendices.