The current global environment demands close monitoring of high-risk loans as the number of global corporate defaults almost doubled in 2023¹ to 153 from 85 in 2022.

In 2024, slowing economies and higher financing costs could further contribute to a rise in defaults.

In such a scenario, stringent monitoring of covenants will help minimize credit losses, while alerting lenders on weakening credit quality. For instance, waive-off requests, delayed furnishing of financials/covenant certificates or covenant headroom contraction to below 5%, can act as early warning indicators, prompting account officers to investigate further. For covenants to be truly effective, timely monitoring is crucial, as any lapse could impact the ability of lenders to restructure credits, adjust pricing and improve recovery outcomes.

Regulatory background

Recent guidelines by regulators stress comprehensive monitoring of covenants as well as regular follow-ups. Guidelines by the European Banking Authority (EBA) on loan origination and monitoring² focus on “monitoring the borrowers’ adherence to the covenants agreed in the credit agreements”, utilise them as early-warning tools and emphasize the importance of early detection of deviations.

Notably, the EBA expects close engagement between the relationship managers of banks and borrowers. “Institutions should also monitor non-financial covenants, not only by collecting the covenant certificate, where applicable, but also by other means; for instance, through close contact with the borrower by the client executive,” the EBA said. Frequent connects with the borrower are likely to yield valuable insights, which the usual documentation might fail to capture adequately or timely. Personal interaction with the management and officials of the borrower could prove to be far more effective in certain circumstances; especially because it involves two-way communication and behavioural signals that go beyond the numbers.

Ongoing issues in covenant monitoring

Despite the critical nature of debt covenants, implementing and operating an effective covenant monitoring system is fraught with challenges: 

Source: CRISIL

Embracing technology can provide real-time, actionable insights

For most banks, MS Excel or MS Access sheets have been the de facto tools of choice to compute and manage loan covenants. The process is rudimentary, laborious and prone to human errors. Further, the capabilities are largely limited, especially in terms of accessing real-time information and generating actionable insights. Consequently, over the past few years, some banks have adopted covenant monitoring tools to minimize manual tracking on centralized/shared databases. Nonetheless, capabilities are still limited to updating financial covenants on the application.

Interestingly, at the same time, data extraction and analytical capabilities, in general, have evolved over the past few years. Progress in the ability to handle unstructured data has been especially impressive. Most of the challenges stated above can be resolved through a technology-enabled covenant monitoring tool, augmented with an intuitive interface and data visualisation features. However, only a few large global banks have embraced such sophisticated covenant monitoring mechanisms/tools, which include features, such as document sharing, auto-alerts and dashboarding.

Technology adoption will pay high dividends

Technology-enabled covenant monitoring tools will allow banks to automate manual routine tasks, reduce transaction costs and strengthen the audit function.

Adoption of a holistic covenant monitoring application with capabilities, such as data extraction, storage, analysis and reporting, and workflow management will enable banks to:

• Improve the accuracy of covenant monitoring by minimising manual intervention 
• Update covenants on the application faster through data extraction and ensuing analysis
• Monitor and analyze covenant headroom and deviations
• Create audit trails and access historical records and documentation from a centralized repository
• Provide a bird’s-eye view of the portfolio, including breach by sector, delayed reporting and covenant history by the obligor
• Generate alerts for the account owners/credit officers on overdue actions and headroom contraction
• Generate customized reports, graphs and tables to slice and dice data and spot trends or outliers
  

As such tools evolve, they will also facilitate collaboration between the relationship managers and borrowers, ensuring that insights obtained by the former are duly captured by the system, analyzed, and acted upon. Enabling close contact with the borrowers is also one of the complex regulatory asks, and we believe such capabilities are the hallmarks of an ideal monitoring solution.

A robust tech-enabled covenant monitoring application will reassure regulators and significantly enhance the quality of a bank’s portfolio through timely identification and analysis of breaches.

What the future holds

As covenant monitoring applications mature, they could be leveraged by banks to identify appropriate covenants based on the borrower’s risk profile. Machine learning (ML) models could optimize accumulated information in the underlying databases to suggest suitable covenants and thresholds, by product and industry, to improve the effectiveness of covenants in the deal-origination process. 

New-age ML models, such as Random Forest and XG Boost can effectively combine traditional variables with data points in the covenant database to arrive at a more accurate credit score. For instance, trends in covenant structuring, history of waivers and amendments and the presence of qualitative and restrictive covenants can serve as inputs/independent variables.

Covenants are extremely useful risk management tools. Bringing them and modern technology together can create a highly effective system to take timely action and minimize losses.

There’s no point in closing the stable door after the horses have bolted.

¹Sources: S&P Global Ratings Research and S&P Global MarketIntelligenceCreditPro®
²Guidelines on loan origination and monitoring

To learn more, contact us at: Contact.CLS@crisil.com