The Revival
of Covenants in the Credit Crisis
The Polish banking
sector has seen an increasing use of covenants as a result of the credit crisis.
This article looks at why this has come about, and how banks are using
covenants strategically in their corporate relationships.
During
times of credit shortage, lenders want to make the most of the financing they
provide. Banks attempt not only to reduce the risk of lending but also to
become their borrowers’ strategic financial service providers. 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 domestic currency,
Polish zloty (PLN). The crisis brought an immediate drying out of market
liquidity and substantially increased 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 of several months, covenants spread from structured, large-scale
financing agreements to small, plain vanilla loans. They also became more
specific and detailed.
As
professor Joel Bassis put it: “Covenants are obligations for borrowers
and options for lenders. Covenant breaches trigger prompt repayment of
outstanding debt, making it mandatory for the borrower to renegotiate with
the lender for continuing operations. The borrower needs a waiver to continue
operations”.1
Credit
risk management during the time of the agreement typically turns out to
involve a frequent review of the credit, the condition of the borrower and
status of the possible collateral. The lender should therefore ensure 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 refrrain and situations it should prevent.
A
covenant therefore becomes one of the conditions of credit being granted. The
agreement may require the borrower, for example, to present to the bank the
newest financial statements as soon as possible, or it may prohibit the
borrower to undertake certain new obligations. In case the borrower defaults
under these conditions, the credit may be declared immediately due, and the
borrower may be obliged to sell certain assets or to present new assets as
additional collateral.
Legislation: Minimum Requirements
Legally,
the Polish Banking Act established the right of a bank to monitor its borrower’s
behaviour. Article 74 of the Act obliges the borrower to present - during the
life of the loan agreement, at the bank's request - “such information
and documents as are necessary to assess its financial and economic standing
and to enable monitoring of the loan use and repayment”. Granting a
loan is always conditional. In particular, the bank shall condition loan
extension upon a borrower’s creditworthiness, which “shall be
understood as the capacity to repay the loan taken, together with interest,
at the dates specified in the agreement” (Article 70 paragraph 1). In
order to enable the bank to execute this condition, Article 70 paragraph 3
requires the borrower to “facilitate measures taken by the bank to
assess the financial and economic situation and to monitor loan use and
repayment”. Finally: “where the terms of the loan have not been
observed by the borrower or the borrower has lost its creditworthiness, the
bank may reduce the amount of loan granted or give 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 the borrower, the status and value of collateral and the
punctuality of credit servicing. The key supplementary regulation is the
Ordinance of the Minister of Finance concerning the creation of reserves
covering banking activity risks. The Ordinance assumes, inter alia, that the
inspection of the financial-economic situation of the 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
or buyers and the extent of dependence from other group members, if any. The
appraisal usually occurs at the end of each quarter and, in some specific
cases, annually.
Standard Functions of Covenants
Traditionally,
covenants address three areas:
1. Financial performance.
2. Provision of information.
3. Protection of assets.2
Financial
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 (acceptable minimum) or the level of financing (maximum
value of debt).
Information
covenants usually refer to such key points as the availability of updated
financial information and insurance agreements, as well as documents
referring to ownership, transfer of share or to proceedings.
Covenants
referring to the protection of assets are usually divided between so-called
‘positive’ (requiring the borrower to undertake certain action)
or ‘negative’ ones (prohibiting some borrower actions or
requiring it to protect the company, its assets or the lender’s
situation and claims under the credit agreement against deteriorating
changes). Positive covenants frequently require the borrower to inform the
lender of the occurrence of certain critical events, e.g. on any actual or
possible default of the borrower versus other lenders. They require the
borrower or their assets to be properly insured, to hold the relevant
authorisations and 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 Covenants
Covenants
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 is applied after the hardening strategy has been
unsuccessful.
However,
considering differences in the banking credits marketplace, the quicker exit
option is most frequently and commonly applied by lenders that concentrate
their offer on small- to medium-sized enterprises (SMEs) and have developed
scoring engines to define the initial credit limit on the basis of limited,
standardised, primarily publicly available information on potential
borrowers. This mechanism enables these banks to offer credits on a mass
scale (to thousands of SMEs at once). However, in the case of such rapid
lending expansion (not uncommon before the credit crisis), these banks often
have too many credit relationships to renegotiate or to restructure them
quickly. Therefore, their main strategy in almost any default is the exit
option. As these banks are usually neither the main nor the only lenders for
many of the borrowers, they try to receive repayment or at least additional
collateral as early as possible, i.e. before other lenders would claim the
same. Here, loyalty is definitely not implicit in the credit policy, as it is
not expected 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 be presented, and pari passu
treatment i.e. no repayments of other loans before their debt would be
repaid.
New Functions of Covenants in the Credit Crisis
These
corporate banks which - due to their market position and strategy - consider
themselves the strategic lenders, logically imply the element of loyalty in
their policies. They do not want to be credit shops only, but they consider
financing as an investment in the borrower’s business and primarily
into broader relationship with the borrower. Therefore, these lenders are
determined to finance selected companies with credit margins 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 bank that 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, but also receives the expected return from the
capital invested in the financing relationship. This dimension of covenants
is particularly important during the financial crisis, especially as banks
effectively use it to increase their non-credit income, related to extended
financing. These covenants force banking experts to cooperate actively with
their clients to fulfill the discussed provisions of the agreement. The fact
that a client does not fulfill the turnover covenant (specifying the number
of payment transactions or a volume of operations) cannot be substituted with
anything else (not by requesting collateral, or by increase of the price of
the credit) as it poses key doubts regarding borrower’s business
performance. Even if the bank relinquished additional, associated income, it
should definitely not neglect the monitoring of its client's turnover, thereby
especially insisting on fulfillment of cash management related covenants.
2010 and Beyond
Although
2010 will be a difficult time of recovery for the Polish economy, the banking
market is gradually unfreezing in terms of credit policies, risk appetites,
lending conditions and, finally, interbank competition. In this environment,
three questions arise regarding the future scope, importance and purposes of
covenants in 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 their strategic direction and that the local corporate
banking market is ready for a gradual consolidation, with around five or six
banks forming the stable nucleus of strategic lenders, with the remaining
dozens of banks playing the role of exchangeable, less stable, credit shops.
Article
by Grzegorz Hansen has been working in the Polish banking sector since
1994. He worked for dedicated programmes, Polish affiliates or local branches
of the World Bank, Credit Lyonnais,
Banca Commerciale Italiana, SEB and ING Bank N.V. He was also the head of
transactional banking departments in Bank BPH and Bank Millennium. Hansen
joined BRE Bank in 2009. He graduated with M.Sc. Eng. in Applied Mechanics and
with M.A. in Philosophy. He received his Ph.D. in Political Philosophy from Warsaw University in 1995.
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