Credit Netting

What Is Credit Netting?

Credit netting is a practice common among large financial firms. It consists of consolidating a series of financial transactions and agreeing to carry out a single credit check that relates to the entire bundle of transactions. In this sense, the transactions are effectively combined, or "netted together."

This practice is common among large banks and other financial institutions who wish to avoid carrying out numerous and redundant credit checks on repeat transactions.

Key Takeaways

  • Credit netting is the practice of bundling together numerous transactions and performing a single credit check on that combination.
  • It is used by large financial firms to avoid conducting several redundant credit checks.
  • Credit netting can help reduce administrative overheads and delays for both parties to a credit transaction.

Understanding Credit Netting

Credit netting is a system whereby the number of credit checks on financial transactions is reduced by entering into agreements that simply net all transactions. These agreements are made between large banks and other financial institutions and place all current and future transactions into one agreement, thereby removing the need for credit checks on each transaction.

The need for credit netting arises from the fact that financial institutions are often required to conduct credit checks on their customers before approving particular transactions. Checking the borrowing party's credit lowers counterparty risk, or the risk that the counterparty, or borrowing party, will default on the loan.

When dealing with repeat customers, however, the constant checking and rechecking of credit is not only time-consuming, but it also has the potential to create missed opportunities. Entering into a large-scale credit netting agreement can therefore be beneficial for all parties involved. From the lender's perspective, credit netting can reduce administrative costs and permit a greater number of transactions to be processed in a given length of time. From the borrower's perspective, credit netting can make it easier for large-scale borrowers to obtain credit in a timely fashion.

Real World Example of Credit Netting

Credit netting is one of a number of common methods used by banks to reduce their counterparty risk while also increasing administrative efficiency. Other examples include close-out netting and netting by novation.

Close-out netting is a form of credit netting used when a counterparty has entered into bankruptcy. Its purpose is to prevent liquidators from cherry-picking which contracts they wish to enforce. In close-out netting, all transactions with the defaulting counterparty are netted together, either at their current market value, or at an amount equal to the non-defaulting party's financial loss.

Similarly, netting by novation is a form of credit netting whereby one or more related transactions are canceled in order to create a new payment obligation. The new obligation would be based on the sum of all the outstanding transactions. In this manner, the counterparties can settle all of their outstanding obligations by way of a single payment.