Financing Suppliers under Performance Risk

Abstract

This chapter focuses on the relative efficiency of two innovation pre-shipment financing schemes that enable suppliers to obtain financing for production: purchase order financing (POF, under which financial institutions offer loans to suppliers by considering the value of purchase orders) and buyer direct financing (BDF, under which manufacturers lend directly to suppliers). Both schemes are closely related to suppliers’ performance risk (whether the supplier can deliver the order successfully). When the manufacturer and the bank have symmetric information regarding the supplier’s operational capabilitiy, we find that even though POF and BDF yield the same payoffs, BDF allows more flexibility in contract terms. However, when the manufacturer has superior information, BDF leads to higher payoffs when the supplier is severely financially constrained. The relative benefit of BDF is more pronounced when the supply market contains a larger fraction of inefficient suppliers, when efficiency gaps between suppliers are greater, or when the manufacturer’s alternative sourcing option is more expensive.