We are not sure when the first signs of a credit shock will appear, but it is coming. When it does, it will be the presence of commercial loan covenants that give banks a competitive advantage of using covenant violations to pressure borrowers so that banks can improve their risk position. During late 2007 and early 2008, the ability to workout loans before other banks proved to be a material competitive advantage as those first movers were able to better extract concessions and better protect their capital. Given the increase in loan competition and our potential proximity to the next downturn, loan covenants are now more important than ever. To better manage credit risk, we present our data on some basic covenants that proved valuable.
The Role of Covenants
Covenants help partially solve the asymmetrical information problem that results in the borrower having better information than the bank. A proper set of loan covenants, we have found, can reduce the probability of default, the loss given default and the net exposure at default by a significant amount for commercial borrowers. The net result is an expected loss rate of almost 20% less with a set of strong covenants than without. A large part of this expected loss reduction is the fact that covenants give the lender an average of seven or more months of early warning between the time the covenants are tripped and the time delinquency occurs.
We looked at research covering more than 7,200 loans (all three years or longer in remaining maturity) from more than 2,800 unique borrowers from 1995 to 2013. While covenant sets vary by borrower and bank, here is our recommendation (internally called the “Six-Pack”), in order of impact on expected loss that we would always attempt to get:
- Timely financial information (monthly preferred, quarterly at worst) – for small business borrowers, insistence (and an adjustment to loan pricing) of timely financial data or reports is the biggest thing a lender can do to establish early warning thresholds and covenant monitoring;
- Cash flow (debt service ratio);
- Leverage (senior and total debt/EBITDA (EBITDA if often adjusted for Capital Expenditures), debt-to-equity or debt-to-assets);
- Liquidity (current ratio);
- Collateral value (loan-to-value or net worth); and,
- Cash control - the ability to use proceeds from asset sale/debt issuance and the ability to control cash out in the form of a bonus, dividend restrictions (dividend payout ratio) or similar are important.
In addition to the Six-Pack, there are a variety of restrictive and negative covenants that are important, but we don’t have quantitative evidence as of yet. Items like insurance are obviously mandatory, while covenants like key man insurance are a little murkier. Further, negative covenants also play an important role but are equally hard to quantify.
Since borrowers tend to be more price-sensitive than covenant sensitive, if you have to compete on price, then including important loan covenants can not only offset the lower pricing but can actually result in a higher risk-adjusted return by reducing losses and potentially lowering reserves. If you have to lower your loan pricing, insisting on some of the above-mentioned covenants will help relieve some of the current lending anxiety that is going around.
Submitted by Chris Nichols on August 11, 2019