How To Craft Loan Covenants That Balance Risk and Flexibility

Loan covenants are crucial tools in managing credit risk. They set expectations between a borrower and a bank, helping identify potential risks early. However, overly stringent covenants can drive borrowers to competitors, while loose requirements can expose the bank to undue risk. Based on a recent RMA Journal article by lending veteran Hooi Lim, here’s a practical guide to crafting effective covenants that strike the right balance: 

Understand the Two Types of Covenants 

• Reporting Covenants: These require borrowers to provide essential financial documentation, such as tax returns and financial statements. Reporting covenants are the foundation for assessing performance and maintaining transparency. 
• Performance Covenants: These include financial metrics borrowers must meet, like minimum debt service coverage ratio (DSCR) or total liabilities-to-tangible net worth (TNW). Performance covenants ensure borrowers maintain financial health. 

Design Balanced Covenants 

• Be Realistic With Triggers: Set performance thresholds that reflect the borrower’s financial position at loan origination. For example, if a borrower’s TNW is $2.2 million, don’t set the minimum at $2.5 million—keep it slightly below their current standing to avoid violations. 
• Customize for Loan Types: In commercial and industrial (C&I) lending, three key performance covenants—TNW, liabilities-to-TNW, and DSCR—are often sufficient. For owner-occupied real estate loans, a consolidated DSCR may be enough. 

Avoid Overloading Covenants 

Excessive covenants can make loans harder to monitor and less appealing to borrowers. One case cited involved a $2 million real estate loan saddled with unnecessary quarterly requirements. Simplifying the covenants reduced borrower burden while still protecting the bank. 

Test and Enforce Covenants Regularly 

Monitor covenants on schedule and address violations promptly. Options include waiving the violation, renegotiating terms, or declaring default. Consistent enforcement preserves the integrity of the agreement. 

Encourage LOC Discipline 

For revolving lines of credit (LOCs), including a clean-up period ensures borrowers use funds as intended—revolving them for seasonal needs rather than as permanent financing. 

By designing covenants that are fair, clear, and tailored to the borrower’s financial realities, banks can protect their interests without stifling borrower relationships. As Lim notes, “Having more covenants does not make the loan safer.” Balancing risk and flexibility is the key to effective covenant writing. 

RMA Journal subscribers can read the article in its entirety.