9 Indicators For When Your Bank Should Tighten Loan Covenants

Loan Covenant Performance

If you think your bank has tough employees, consider a bank that brought in a motivational consultant that had the employees walk on a 6 ft. wide path of hot coals. This trick has been popular with corporations for decades and is supposed to result in more confident and more bonded employees – the kind of employees that can tackle any banking problem. Usually, the hot coal walk does wonders except when it doesn’t, like in this bank’s case. Unfortunately, several people burned their feet. If one employee burned their feet, we could write that off as an accident. However, with multiple employees burning their feet, it brings up a bunch of questions like – what was that third employee thinking?

 

Now, if for a second you think that a retreat to honor your employees ended up injuring those employees was anything less than “successful,” we can tell you that you may not be bank CEO material. This bank’s CEO went on record as saying the retreat was a “total success” and while he regrets the minor injuries, they resulted from employees’ “tender feet and not moving fast enough.” Of course, the counter-argument is, and we are just thinking out loud here – THEY WERE FORCED TO WALK ON HOT COALS.

 

Loan Covenants – Two Schools of Thought 

 

Regardless of what you think, there are arguments for and against strong loan covenants. Like coming up with the idea to have your employees walk on hot coals, the acceptance by a borrower of a robust set of covenants tends to say something about the borrower.

 

One school of thought is that only a desperate, more risk-prone borrower accepts a strong covenant set because they have little alternative. The other school of thought is that only the confident, fire-walking, risk-averse, borrower would tend to accept multiple and tightly set covenants. So which is it?

 

Loan Covenants Help Performance

 

It turns out, that after looking at the empirical performance of more than eleven thousand loans spanning six years - riskier borrowers are more likely to agree to loans with robust and tight covenants. In other words, tighter loan covenants are a predictor of lower credit quality which makes sense since that is when bankers mostly insist on them.

 

A derivation of this trend is the fact that tighter covenants produce more than 3x the number of covenant violations when compared to borrowers with fewer, and looser, covenants. While all this sounds self-evident, there is more here than meets the eye. 

 

The research indicates that after adjusting for credit quality, those borrowers that accept tight covenants tend to do better than those borrowers with fewer and looser covenants. In particular, we can trace back to the fact that borrowers with a strong set of tight covenants tend to reduce their capital expenditures during the period of the loan and tend to limit their indebtedness - both factors that lower the risk for the lending bank.

 

The net result is, despite requiring more credit management (or because of it), tight loan covenants reduce the exposure at default, the probability of loss and reduce the expected amount of loss for a loan. 

 

Defining Tight Covenants  

 

We define tight covenants as those covenants that are in the top two quartiles of their industry. Thus, for the current ratio, the median for community bank borrowers is approximately 1.45x. Thus, a covenant here at 1.75x would be considered “tight.”  To hone this, it pays to understand the industry and the borrower, as it all comes down to the volatility of cash flows, balance sheet levels, and valuations.

 

The greater the volatility, the wider the covenants should be set. In analyzing the data, a debt service covenant around a country club or a wheat farmer is tight in excess of 2.2x (because of the higher volatility of earnings) than compared to a dentist that might be considered tight at about 1.6x. Understanding a five or more year history of the borrower and/or understanding industry benchmarks can aid bank lenders in setting covenants.

 

Not All Covenants Have The Same Impact

 

We should clarify that we looked at more than 17 different types of covenants to include not only financial covenants but covenants around the borrower’s net worth and collateral.  Some covenants like debt-to-cash flow, current ratio, EBITDA-to-sales, and others have a material impact, while other covenants such as those around capital expenditures have less of an impact.

 

Another interesting fact is that while three or four covenants covering debt, cash flow, collateral and use of excess cash flow tend to be ideal, increasing the number of financial covenants beyond that had little impact on loan performance. Adding more financial covenants above five just produced more violations, requiring more management time with very little increase in credit performance.

 

Finally, we will conclude probably the most important point for community bankers – there is a positive risk-adjusted return correlation between pricing, covenants, and performance.

 

The 9 Indicators

 

While this is not an all-inclusive list, below is a graphic that breaks down nine metrics that have historically statistically indicated when a borrower would benefit from tighter loan covenants. In general, the more uncertainty you have around the borrower’s performance and the more historical volatility there has been in both earnings or cash flow, the more your bank should insist on tighter covenants. 

 

9 Indicators When To Tighten Loan Covenants

 

 

Putting This Into Action

 

If the borrower is high quality and demands tight pricing, putting a variety of tight loan covenants in place only serves to increase performance, not hurt it. While the borrower might go elsewhere, borrowers are less sensitive to covenants than pricing. As a result, most borrowers will stay as they will believe (and is statistically true) that they will not violate the covenants. In other words, it usually pays to get tighter covenants in exchange for more aggressive pricing.

 

The net result is the right covenants, set at the proper levels, increase a bank’s risk-adjusted return by reducing losses. Through use and setting of covenants, banks can gain greater control/oversight of credit and detect problems earlier. This tactic should result in better long-run loan performance and in the process, say something positive about the quality of your banking.