Credit risk

Faced by lenders

Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

* limit the borrower's ability to weaken his balance sheet voluntarily, e.g. by buying back shares, or paying dividends, or borrowing further.
* allow for monitoring the debt by requiring audits, and monthly reports
* allow the lender to decide when he can call back the loan according to specific events or when financial ratios like debt/equity, or interest coverage deteriorate.

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.

Faced by business

Almost all companies carry some credit risk, because they 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.

Significant resources are devoted to managing the risk by large companies with many customers (whether they are businesses or individuals). There may even be a credit risk department whose job 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 fewer products 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.

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).

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