The revival of covenants in the credit crisis gtnews 30 mar 2010
The Revival of Covenants in the Credit CrisisGrzegorz Hansen, BRE Bank - 30 Mar 2010The Polish banking sector has seen an increasing use of covenants as a result of the creditcrisis. This article looks at why this has come about, and how banks are using covenantsstrategically in their corporate relationships.During times of credit shortage, lenders want to make the most of the financing they provide. Banks attemptnot only to reduce the risk of lending but also to become their borrowers’ strategic financial serviceproviders. This points to the spread and the increasing sophistication of covenants in credit agreements.Poland was hit by the financial crisis in mid-September 2008 with the sudden devaluation of its domesticcurrency, Polish zloty (PLN). The crisis brought an immediate drying out of market liquidity and substantiallyincreased corporate credit risk. Such an environment has raised the importance, as well as the frequency,of covenants included in credit agreements concluded between banks and companies. Within the space ofseveral months, covenants spread from structured, large-scale financing agreements to small, plain vanillaloans. They also became more specific and detailed.As professor Joel Bassis put it: “Covenants are obligations for borrowers and options for lenders. Covenantbreaches trigger prompt repayment of outstanding debt, making it mandatory for the borrower to renegotiatewith the lender for continuing operations. The borrower needs a waiver to continue operations”. 1Credit risk management during the time of the agreement typically turns out to involve a frequent review ofthe credit, the condition of the borrower and status of the possible collateral. The lender should thereforeensure the right to perform these reviews by the respective provisions of the credit agreement. Moreover,the lender usually adds additional, associated requirements - covenants - concerning: • Actions that the borrower should either perform or enable. • Activities from which the borrower should refrain and situations it should prevent.A covenant therefore becomes one of the conditions of credit being granted. The agreement may requirethe borrower, for example, to present to the bank the newest financial statements as soon as possible, or itmay prohibit the borrower to undertake certain new obligations. In case the borrower defaults under theseconditions, the credit may be declared immediately due, and the borrower may be obliged to sell certainassets or to present new assets as additional collateral.Legislation: Minimum RequirementsLegally, the Polish Banking Act established the right of a bank to monitor its borrower’s behaviour. Article 74of the Act obliges the borrower to present - during the life of the loan agreement, at the banks request -“such information and documents as are necessary to assess its financial and economic standing and toenable monitoring of the loan use and repayment”. Granting a loan is always conditional. In particular, thebank shall condition loan extension upon a borrower’s creditworthiness, which “shall be understood as thecapacity to repay the loan taken, together with interest, at the dates specified in the agreement” (Article 70paragraph 1). In order to enable the bank to execute this condition, Article 70 paragraph 3 requires theborrower to “facilitate measures taken by the bank to assess the financial and economic situation and tomonitor loan use and repayment”. Finally: “where the terms of the loan have not been observed by theborrower or the borrower has lost its creditworthiness, the bank may reduce the amount of loan granted orgive notice of termination of the loan agreement” (Article 75 paragraph 1).However, the Banking Act is not the only regulation that requires the bank to monitor the condition of theborrower, the status and value of collateral and the punctuality of credit servicing. The key supplementaryregulation is the Ordinance of the Minister of Finance concerning the creation of reserves covering bankingactivity risks. The Ordinance assumes, inter alia, that the inspection of the financial-economic situation ofthe borrower considers such financial ratios as: return on equity (ROE), financial liquidity, debt-equity ratio,etc. Moreover, banks are obliged to appraise their borrowers qualitatively with respect to: managing quality,
market dependence, dependence on government donations, bids, dependence on few large suppliers orbuyers and the extent of dependence from other group members, if any. The appraisal usually occurs at theend of each quarter and, in some specific cases, annually.Standard Functions of CovenantsTraditionally, covenants address three areas: 1. Financial performance. 2. Provision of information. 3. Protection of assets.2Financial performance covenants are based on the assessment of a borrower’s economic condition(members of its group, guarantors, etc). They use the indicators of liquidity, profitability, market indicators,capital management and debt coverage, and refer to general risk, the sector in which the borrower is active,company management, etc. These covenants often define acceptable limits of capital (acceptableminimum) or the level of financing (maximum value of debt).Information covenants usually refer to such key points as the availability of updated financial informationand insurance agreements, as well as documents referring to ownership, transfer of share or toproceedings.Covenants referring to the protection of assets are usually divided between so-called ‘positive’ (requiring theborrower to undertake certain action) or ‘negative’ ones (prohibiting some borrower actions or requiring it toprotect the company, its assets or the lender’s situation and claims under the credit agreement againstdeteriorating changes). Positive covenants frequently require the borrower to inform the lender of theoccurrence of certain critical events, e.g. on any actual or possible default of the borrower versus otherlenders. They require the borrower or their assets to be properly insured, to hold the relevant authorisationsand necessary licenses, etc. Negative covenants include: negative pledge, pari passu (equal) treatment (i.e.no discrimination) of lenders, the borrower’s undertaking regarding disposals and acquisitions, lending,issuing shares, distribution of dividends, and choice of auditors.The Use of CovenantsCovenants are typically used under one of two strategies: 1. ‘Exit’: in case of a borrower’s default under a covenant, a lender has the right to exit the credit relationship early, calling on the borrower to repay the loan as soon as possible. If the requested repayment is not possible, the loan is declared due and proceedings towards clearing the debt are started. 2. ‘Hardening’: in case of borrower default or serious considerations concerning their situation, the lender has the power to demand fulfillment of particular requests. These can include refraining from certain decisions that the borrower could consider, presenting additional collateral, undertaking particular actions and partial repayment or reduction of the loan granted, etc.Both strategies can be used by the same institution in different cases. Sometimes, the exit strategy isapplied after the hardening strategy has been unsuccessful.However, considering differences in the banking credits marketplace, the quicker exit option is mostfrequently and commonly applied by lenders that concentrate their offer on small- to medium-sizedenterprises (SMEs) and have developed scoring engines to define the initial credit limit on the basis oflimited, standardised, primarily publicly available information on potential borrowers. This mechanismenables these banks to offer credits on a mass scale (to thousands of SMEs at once). However, in the caseof such rapid lending expansion (not uncommon before the credit crisis), these banks often have too manycredit relationships to renegotiate or to restructure them quickly. Therefore, their main strategy in almostany default is the exit option. As these banks are usually neither the main nor the only lenders for many ofthe borrowers, they try to receive repayment or at least additional collateral as early as possible, i.e. beforeother lenders would claim the same. Here, loyalty is definitely not implicit in the credit policy, as it is notexpected from borrowers.
The hardening option, assuming renegotiation, and often restructuring, is typical for strategic lenders,cannot be easily repaid on demand. Therefore, these banks usually demand additional collateral to bepresented, and pari passu treatment i.e. no repayments of other loans before their debt would be repaid.New Functions of Covenants in the Credit CrisisThese corporate banks which - due to their market position and strategy - consider themselves the strategiclenders, logically imply the element of loyalty in their policies. They do not want to be credit shops only, butthey consider financing as an investment in the borrower’s business and primarily into broader relationshipwith the borrower. Therefore, these lenders are determined to finance selected companies with creditmargins lower than their standard expectations. They are motivated to attract the loyalty of their customers.This loyalty is measured by the share of all operations (turnover) of the client that are effected via the bankthat finances the activity of the company. There are two systems that come together here: 1. Current monitoring of credit usage and the economic condition of the enterprise. That is the reason why the bank requires the borrower’s financial operations to be effected wholly or at least mostly through the financing bank. 2. The increase of profitability from the customer relationship, resulting from the scope and volume of operations of an entity in the financing bank. Therefore, banks tend also to negotiate the prices of non-credit services with the borrower in order to facilitate for the customer to shift its operations to the bank. Covenants of this type indicate not only the minimum turnover (of foreign exchange (FX) transactions, cash operations), but also the minimum number of payments (domestic, cross-border) that the debtor expects to effect over a given period.Due to such conditions, the lending bank is not only able to closely monitor the situation of its borrower, butalso receives the expected return from the capital invested in the financing relationship. This dimension ofcovenants is particularly important during the financial crisis, especially as banks effectively use it toincrease their non-credit income, related to extended financing. These covenants force banking experts tocooperate actively with their clients to fulfill the discussed provisions of the agreement. The fact that a clientdoes not fulfill the turnover covenant (specifying the number of payment transactions or a volume ofoperations) cannot be substituted with anything else (not by requesting collateral, or by increase of the priceof the credit) as it poses key doubts regarding borrower’s business performance. Even if the bankrelinquished additional, associated income, it should definitely not neglect the monitoring of its clientsturnover, thereby especially insisting on fulfillment of cash management related covenants.2010 and BeyondAlthough 2010 will be a difficult time of recovery for the Polish economy, the banking market is graduallyunfreezing in terms of credit policies, risk appetites, lending conditions and, finally, interbank competition. Inthis environment, three questions arise regarding the future scope, importance and purposes of covenantsin corporate credit agreements: 1. Will the banks step back from their policies of introducing various types of covenants into virtually all corporate credit agreements and will they sacrifice security to boost short-term results and to achieve rapid expansion of the market share? 2. In case the banks decide to retain their often rapidly-developed new competences in structuring and customised phrasing credit agreements, will they continue to negotiate detailed covenants regarding daily treasury operations of their clients (such as the minimum number of payments and minimum volumes of specific operations, etc.) or will they only stick to basic ratios and the most obvious information covenants? 3. Considering the different target segments and different approaches of banks to corporate lending, will we also see the two main trends in terms of the purpose of covenants: • In one scenario, will banks that do not have long-term orientation towards corporate banking and treat covenants as purely early warning alerts, exit sooner from a particular exposure (borrower), group of clients (e.g. enterprises engaged in a certain sector of economy) or the whole corporate portfolio? • In another scenario, will banks with long-term corporate banking strategies, where covenants allow the bank to negotiate the future actions of the customer and impose measures that should secure the loan and borrower’s performance under it, impose stronger relationships and bonds of mutual loyalty on the lender and the borrower?
If this last scenario emerges, that would mean that the financial crisis helped the banks to set up theirstrategic direction and that the local corporate banking market is ready for a gradual consolidation, witharound five or six banks forming the stable nucleus of strategic lenders, with the remaining dozens of banksplaying the role of exchangeable, less stable, credit shops.1 Bessis, Joel, “Risk Management in Banking”, J Wiley & Sons, 2nd ed., 2002, page 514.2 David Adams, “Corporate Finance: Banking and Capital Markets”, Jordan Publishing Ltd., 1998, page 82.