Imagine that you borrowed money and then suddenly couldn't pay it back. What happens next? Well, except for trouble from the lender. Can you imagine? Scary, isn't it? It can be compared to default - a situation when a country or company cannot fulfill its financial obligations to creditors. But why does this happen and, most importantly, how to stay calm and protect your finances in such conditions?
What is a default?
Default is the term used when a country or company declares that it cannot meet its debt obligations. This can happen for any reason: economic difficulties, poor financial management, or unexpected external factors such as wars or natural disasters. If a country or company cannot pay its debts or other obligations, it has serious consequences for them and for their citizens or investors.
Types of default risks and their causes
There are different types of default risks for banks, companies, and investors. The most important ones include:
- Credit risk and creditworthiness risk for lenders
- Credit risk and country risk for companies (corporate)
- Default risk for investors
Risk for creditors
With every loan, the lender assumes the risk that the borrower will repay the loan amount and interest late, not in full, or not at all. The most common reasons for default are:
- Borrower's illness or unemployment
- Failed attempt at self-employment
- Excessive debt
To protect themselves from the risk of default, banks verify the creditworthiness of applicants by conducting a credit check. Banks also require collateral for the loan, such as salary transfers, transfer of vehicle ownership, or a guarantor.
Corporate risk
Not only banks, but also companies check the creditworthiness of their customers. This is especially important if the manufacturer sells its products on deferred payment terms. If the buyer's credit rating deteriorates, its liquidity suffers, and the invoice is not paid on time. In the case of customers with a low credit rating, the seller can refuse to defer payment or use factoring to hedge a possible default by selling the receivables.
Country risk
Companies that have business partners abroad run the risk with every order that the political or economic situation in the country may change. The foreign customer is ready to pay, but cannot transfer the invoice amount due to existing restrictions on the transfer of funds. If the invoice is issued in a foreign currency, there is also a currency risk. Manufacturers may choose to sell receivables under export factoring as a hedge.
Risks for investors
Anyone who invests part of their savings in stocks, bonds, or other securities risks losing their value. The company may become insolvent, and the bonds or certificates may suffer price losses. This is especially true of speculative securities such as warrants or derivatives.
Default risk affects the terms
Banks and savings banks make lending conditions dependent on various factors:
- Equity: For certain loans, such as construction financing, lenders require a portion of equity. This reduces the amount and term of the loan, resulting in better terms.
- Assets: Existing assets can serve as collateral for a loan. Real estate can be encumbered by a mortgage or ground rent, or a deposit can be made.
- Banks provide better lending conditions due to the availability of collateral.
- Credit rating: A good credit rating ensures that the loan will be repaid as agreed and provides better terms.
How to minimize default risks and effectively prevent them
If you experience payment delays or don't receive payment at all, it may be too late to prevent bad debt. Therefore, we recommend taking preventative measures to protect yourself from default. You can take the following preventative measures now:
1. Collect business information
Data is becoming increasingly important in business and is a success factor that cannot be underestimated. The best way to hedge your business risks is to collect detailed information about potential target groups and new customers early on. Ideally, before you start your business in the acquisition phase. This also includes keeping your customer data up to date. The most important company data includes your name, address, contact information and company status. Even for existing customers, this data can change from time to time. Delayed payments due to incorrect billing addresses can be easily prevented if your customer data is kept up to date.
You can get this key company data from the following organizations:
- Chamber of Commerce and Industry
- Commercial register maintained by local courts
- Register of debtors or portal for enforcement of decisions
- Credit agencies that offer additional information beyond data from state registers and verify solvency.
2. Credit check
In addition to general company information, it is important to know the financial situation of your business partners. Therefore, before concluding a contract, especially for large transactions, a credit check should be carried out. To do this, you can instruct credit agencies to check your solvency.
Advantage: The credit rating is based on current, valid data and can be obtained directly through the credit report form. The probability of default is clearly displayed, which allows you to better evaluate your counterparty. It is advisable not only to check new customers, but also to check the solvency of existing ones at least once a year.
By the way: do you have both business clients and end consumers? Also, check the solvency of consumers before concluding a deal.
3. Track your business partners over long periods of time
Monitoring is the key word when it comes to long-term business relationship monitoring. Integrate a process into your company that allows you to document your customers’ own payment experiences.
The advantage: you can see exactly how business relationships with individual customers have developed to date and can draw conclusions for the future. Were the invoices paid quickly and on time, or were payments rather slow? And here too, you can outsource the monitoring process to an external service provider. This service provider will monitor all of your business partners' creditworthiness data for you over a certain period of time and inform you immediately of any changes. This means that you are always up to date and can take action in good time.
4. Review external payment information
Payment histories are an important source of information for assessing creditworthiness. But what if a customer always pays you on time, while other suppliers are waiting in vain for their money? This important additional information is provided by databases of companies' payment experience with their business customers. By regularly analyzing your customer base, they serve as an early warning system for future payment behavior. You receive information about the payment terms that the business partner receives from other suppliers, whether they pay their invoices on time, and what status your company has as a supplier to your customer.
What to do if a country declares default?
Historically, almost every country has defaulted at least once. Spain, for example, has defaulted up to thirteen times, and Greece experienced a sovereign default during the post-2008 financial crisis. Over the past forty years, the world has seen dozens of sovereign defaults. The largest of these (over $1 trillion) have involved Mexico (1982), Brazil (1987), Russia (1998), Ecuador (1999), Argentina (2001), Greece (2012, 2015), Ukraine (2016), Venezuela (2017), and Lebanon (2020).
Causes of government default
When examining the causes of sovereign default, several key factors are recognized that contribute to this economic phenomenon. A deep understanding of these causes helps to take preventive measures and develop possible solutions.
- Excessive government spending and budget deficit
- Economic recessions and their consequences
- External shocks and their financial consequences
Possible consequences for the population
The consequences are profound and complex, especially for the population. Such an event can have a significant impact on daily life due to the immediate need to reduce government spending. These cuts often affect essential services such as healthcare, education and public safety. Below is a list of possible direct and indirect consequences of a sovereign default for citizens:
- Raising taxes to cover government deficits can increase the financial burden on individuals and families.
- Public sector cuts often result in job losses, which increases unemployment and reduces the incomes of many households.
- Inflation leads to a depreciation of savings and income, which further reduces the standard of living.
- A general loss of confidence in the state's economic policy can lead to political unrest, which puts a strain on the social structure.
The consequences of a sovereign default go far beyond the immediate financial crisis and can have profound effects on the socio-economic fabric of a country. The population suffers both from the immediate impact and the long-term consequences of such an event.
State default - difference from corporate default
Sovereign default and corporate insolvency have fundamentally different consequences and are governed by different legal frameworks. In our brief overview of sovereign insolvency, we highlight the features that distinguish this event from corporate insolvency proceedings. One thing is clear: while companies go through clearly regulated legal processes in the event of insolvency, there is no such clear legislation for states.
What are the possible ways to avoid state bankruptcy?
To avoid national bankruptcy, states must have a sustainable budget, that is, balance expenditures and revenues, promote economic growth, fight corruption and create reserves in case of economic shocks. And people… People become hostages of the state in the country. This requires significant savings (safety cushion), patience and finding opportunities to earn money.
Conclusion
Default is a serious situation that can affect the financial stability of a country or company, but it is not always the end of the world. It is important to understand the risks, monitor economic processes and find ways to protect your finances. Yes, the situation may be difficult, but with a smart approach, you can maintain stability and even benefit from these changes.
