What Is Credit Risk?

Credit Risk, What Is It?

Credit risk is the risk of loss due to a counterparty defaulting on a contract, or more generally the risk of loss due to some "credit event". Traditionally this applied to bonds where debt holders were concerned that the counterparty to whom they've made a loan might default on a payment (coupon or principal). For that reason, credit risk is sometimes also called default risk.

In business, almost all companies carry some credit risk, because most companies do not demand up-front cash payment for all products delivered and services rendered. Instead, most companies deliver the product or service, and then bill the customer, often specifying net 30 payment, in which payment is supposed to be complete on the 30th day after delivery. Credit risk is carried during that time.

Managing Credit Risk

Managing credit risk is important for any company, and significant resources are devoted to the task by large companies with many customers (whether they be businesses or individuals). For large companies, there may even be a credit risk department whose job it is to assess the financial health of their customers, and extend credit (or not) accordingly. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by tightening payment terms to "net 15", or by actually selling less product on credit to the retailer, or even cutting off credit entirely, and demanding payment in advance. These strategies will probably impact the distributor's potential sales, and cause friction in the relationship with the retailer, but the distributor will end up better off if the retailer is late paying its bills, or, especially, if it defaults and declares bankruptcy.

A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.

Credit risk is not really manageable for very small companies (i.e. those with only one or two customers). This makes these companies very vulnerable to defaults, or even payment delays by their customers.

The use of a collection agency is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).

Source: Wikipedia