Trade credit contracting under asymmetric credit default risk: Screening, checking or insurance

Trade credit has grown rapidly and become an effective tool to incentivize suppliers to increase sales and profits in supply chain management. However, granting trade credit also increases the suppliers’ default risks, especially when they face retailers privileged with private information concerning their credit status. In this paper, we consider three common mechanisms that suppliers use to address credit default problems: the screening, checking and insurance mechanisms. Under these mechanisms, based on two-level trade credit, we model a supplier–retailer–customers supply chain, in which the retailer’s credit level, either high or low, is the retailer’s private information. We find that the high credit type retailer’s consumption is always limited by reducing the credit period under all three mechanisms. In contrast, for the low credit type retailer, the supplier manages the default risk by directly forgoing some profits from the retailer under the screening mechanism, encouraging the retailer to consume under the checking mechanism, and restricting the retailer’s consumption under the insurance mechanism. Additionally, contrary to intuition, we show that a low credit type retailer consistently obtains a longer credit period from the supplier since the corresponding risk of a longer credit period can be gradually decreased through an increased initial payment due to the regulating effect of trade credit. Finally, our results reveal that the supplier prefers to use the insurance mechanism only when the retailer’s credit state is relatively poor and employs either the screening or checking mechanism based on the default risk gap effect otherwise.