Re-thinking the Lender Borrower Relationship: Using Financial Covenants as an Effective Management Tool

Analysis

Many aspects of the future banking landscape will certainly be different from before, but in the “old banking toolbox”, there remains at least one tried and tested methodology for managing lending risk, namely the effective use of financial covenants by lenders and borrowers. In the new world, if effectively used as a management tool by both parties, financial covenants will arguably have even higher importance than before. Tim Travers reports

In brief:

• Using financial covenants as an effective management tool provides the glue which binds a lender and borrower closely together in managing their respective risks during their relationship

• Lenders, borrowers and their professional advisers should endeavour to ensure that the financial covenants are drafted with absolute clarity, but equally with sufficient elasticity, to nurture and safeguard the overall health of their relationship

• To this end, lenders and borrowers should consider two or three tiers of financial covenants, with increasing levels of sanction for breach, but not every breach automatically triggering an event of default

• Financial covenants are not just for large corporates. The principles behind using them apply equally to small- and medium-sized businesses.