is the risk of loss due to a debtor's non-payment of a loan
or other line of credit (either the principal or interest (coupon)
by lenders to consumers
employ their own models (Credit Scorecards) to rank potential
and existing customers according to risk, and then apply appropriate
strategies. With products such as unsecured personal loans or
mortgages, lenders charge a higher price for higher risk customers
and vice versa. With revolving products such as credit cards
and overdrafts, risk is controlled through careful setting of
credit limits. Some products also require security, most commonly
in the form of property.
by lenders to business
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:
the borrower's ability to weaken his balance sheet voluntarily
e.g., by buying back shares, or paying dividends, or borrowing
for monitoring the debt requiring audits, and monthly reports
the lender to decide when he can recall the loan based on
specific events or when financial ratios like debt/equity,
or interest coverage deteriorate.
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")
carry credit risk when, for example, they do not demand
up-front cash payment for products or services.
By delivering the product or service first and billing the customer
later - if it's a business customer the terms may be quoted
as net 30 - the company is carrying a risk between the delivery
resources and sophisticated programs are used to analyze and
manage risk. Some companies run a credit risk department whose
job is to assess the financial health of their customers, and
extend credit (or not) accordingly. They may use in house programs
to advise on avoiding, reducing and transferring risk. They
also use third party provided intelligence. Companies like Moody's
and Dun and Bradstreet provide such information for a fee.
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. Such strategies impact sales volume but
reduce exposure to credit risk and subsequent payment defaults.
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
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
may face credit risk in a direct form as depositors at banks
or as investors/lenders. They may also face credit risk when
entering into standard commercial transactions by providing
a deposit to their counterparty, e.g. for a large purchase or
a real estate rental. Employees of any firm also depend on the
firm's ability to pay wages, and are exposed to the credit risk
of their employer.
cases, governments recognize that an individual's capacity to
evaluate credit risk may be limited, and the risk may reduce
economic efficiency; governments may enact various legal measures
or mechanisms with the intention of protecting consumers against
some of these risks. Bank deposits, notably, are insured in
many countries (to some maximum amount) for individuals, effectively
limiting their credit risk to banks and increasing their willingness
to use the banking system.
- Principles for the management
of credit risk from the Bank for International Settlement
Christian, Ludger Overbeck, and Christoph Wagner (2002). An
Introduction to Credit Risk Modeling. Chapman & Hall/CRC.
Servigny, Arnaud and Olivier Renault (2004). The Standard
& Poor's Guide to Measuring and Managing Credit Risk.
McGraw-Hill. ISBN13 978-0071417556.
- Darrell Duffie and Kenneth J. Singleton
(2003). Credit Risk: Pricing, Measurement, and Management.
Princeton University Press. ISBN13 978-0691090467.