Loan Covenant Monitoring Essential to Loan Review Process
When performing loan review one of the first things a loan review specialist looks for is how loan covenants are handled. Many times specific loan covenants are spelled out in the loan agreement, but quite often forgotten or ignored during the term of the loan. Loan covenants by definition are clauses that spell out what a borrower may do and must do in order to satisfy the terms of the note. They are contractual restrictions placed on the borrower. Covenants became more popular during this financial crisis and are used more frequently now, since, in an event of violation, they could accelerate the maturity of the loan.
There are two different types of covenants: affirmative and negative covenants. Affirmative covenants require the borrower to provide the lender with certain information, pay taxes, as well as comply with the terms of the note. Negative covenants are prohibitions to the borrower such as, not allowing them to pay dividends, acquiring new inventory or incurring additional liabilities.
Depending on the type of borrower, different covenants may apply. When dealing with a strong borrower, most banks will only require a few standard covenants like annual financial reporting. But the tables turn when dealing with a highly-leveraged borrower. In that case more specific monitoring could apply, such as having a minimum debt service coverage ratio (DSCR) or sufficient working capital.
One of the main issues loan review analysts come across is that, often times, loan officers include specific loan covenants in the credit presentations, but then these covenants don’t make it into the actual loan agreement. Also, the covenants will be included in the loan agreement, but the loan officer does not enforce them. An example would be receiving monthly borrowing base certificates and/or aging reports. When taking business assets as collateral, it is crucial to monitor them on at least a quarterly basis; however, this often isn’t the case. Problems arise when the borrower stops making payments and when the bank decides to go after the collateral only to realize that the collateral is worth half of what was once reported. This could have been avoided if, on a monthly or quarterly basis, the loan officer received and reviewed updated collateral values.
Another example would be monitoring debt service coverage ratio. It has become a common practice in the commercial lending world to include as a loan covenant the requirement for a specific DSCR to be tested annually. This requirement may be for the borrowing entity only or sometimes it may be on a global basis. Sometimes banks fail to address these values, either because they don’t perform annual reviews (including complete financial analysis), or because they simply forget to spell it out throughout the analysis. If they are requiring the customer to maintain a certain level of profitability, wouldn’t it be prudent to make sure the company is in compliance?
Loan covenants should be detailed in the loan presentation, included in the loan agreement and regularly monitored. That is the only way these can be beneficial for all parties involved.