Anna Costello, What Are You Thinking About?



Q: What are you thinking about?

A: Trade Credit Exposure

Bank credit gets a lot of time and attention from policymakers and the business press, but there’s another type of financial risk that dwarfs short-term bank financing and is less understood. Anna Costello, Arthur Andersen Faculty Fellow and assistant professor of accounting, is trying to help businesses, accountants, and policymakers get a better handle on the credit risk that comes from everyday supplier relationships. Doing so will help them find better ways to hedge the risk, understand its sources, and quantify the potential exposure.

What are you thinking about?

I’m thinking about how firms become exposed to credit risk when they transact with supply-chain partners. In particular, when a company enters into a transaction to buy goods and services from suppliers or sell goods and services to customers, they often do so on credit. This is called trade credit, and it’s more than three times as large as bank financing as a source of short-term borrowing for companies in the United States. Furthermore, a large portion of this credit risk remains largely unhedged. That means firms in the United States may face large financial risks if their customer base defaults on trade credit loans. My research focuses on understanding the magnitude of these risks for individual firms as well as for the economy as a whole. I also study how managers can use information — either public financial statements or soft, relationship-specific data — to assess and minimize credit risk when they enter into a trade transaction.

Why is this interesting to you?

We live in a global economy, and most companies are highly exposed to a variety of industries and countries through their supply chain links. While this diversity creates many benefits, it also carries costs in terms of exposure to negative events.

We saw many of these spillover effects during the recent financial crisis. It’s also difficult for managers to understand the scope of their financial exposure due to the complexity of the supply chain and the opaque nature of many suppliers and customers. What’s fascinating is how large trade credit exposures are, yet how little is understood about how to mitigate risk.

What are the implications for industry?

My research helps to inform both managers and the trade credit industry on how to assess the risk that a customer might default on a trade credit loan. One of my papers was recently used to aid a credit bureau in building their credit scoring model for trade creditors. My hope is that if we improve our understanding of the sources and consequences of trade credit risk, managers will become more efficient in making trade credit decisions. My research can also aid industries that serve to hedge trade credit risk. In this way, businesses may be better prepared to cope with cross-industry and cross-country credit spillovers during times of economic distress.

To illustrate, consider the damage that businesses incur during a hurricane. Severe weather often causes damage to local businesses, shutting them down for weeks or even indefinitely. Businesses most affected by Hurricane Sandy during the fall of 2012 delayed or even defaulted on payments to their own suppliers, causing an economic spillover effect that stretched far beyond the northeast region.

Similarly, banking crises can wreak tremendous havoc on the corporate economy. My research provides strong evidence that firms that had strong ties to the financial sector during the 2007-2008 U.S. financial crisis passed their liquidity problems on to their supply chain partners through trade credit claims; this exacerbated employment losses on Main Street.