A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs.
There are several ways to manage this risk. Sometimes, companies assess the creditworthiness of customers in advance, in order to avoid non-payment. Companies also commonly purchase credit insurance, where the insurer pays if the customer does not. Sometimes, companies simply ask the customer to pay in advance, which is known as “prepayment”. When large amounts of goods are traded directly between two parties, credit risk is always an issue. There is an entire field of banking, called Trade Finance, which is designed to mitigate this risk. Most commonly, banks issue a letter for credit, which is a form of assurance to the seller that the buyer possesses the funds needed to purchase the goods. In addition, banks may also offer payment guarantees.