Collateral. The liquidation of collateral – typically accounts receivable, inventory, and property, plant, and equipment – is the primary source of principal repayment if the borrower defaults. Therefore, the institution should develop policies that encourage the proper monitoring and valuation of collateral and should also establish acceptable loan-to-value ratios based on the type of collateral. As many CI lenders have learned, there can be a high risk of fraud with these types of collateral. For example, inventory and equipment can be easily moved and accounts receivable can become uncollectible. CI lenders should understand the nuances of accepting this type of collateral and have the experience to appropriately evaluate its worth and secure the banks priority lien position in the event of default.
Covenants. Loan covenants can provide an early warning system for emerging problems. A complete discussion of covenants is beyond the scope of this article, but some highlights are worthy of consideration.
While loan covenants should be aligned with the borrowers financial condition and projections, the loan policies should require certain covenants for all CI loans and provide optional covenants to be applied at the lenders discretion, with a mechanism for prior review of exceptions when warranted. Further, because of the protective nature of covenants, community bank CI lenders are strongly discouraged from making «covenant-lite» loans, as those loans increase the banks longer-term risk despite the current creditworthiness of the borrower.
Covenants can take various forms, but most relate to either the operation of the business or the maintenance of financial measures. Some covenants may require a borrower to take certain steps (affirmative covenants), while other covenants may prohibit a borrower from taking particular actions (negative covenants). When the lender drafts the covenants, it is important to ensure each one meets a defined objective. Nonfinancial, or operational, covenants are generally designed to (i) require full and timely disclosure about the borrowers operations and financial position; (ii) maintain management commitment and quality, which could include personal guarantees by key members of management; and (iii) ensure the continued viability of the borrowers operations.
However, despite the value of covenants, they are no substitute for a CI lenders ongoing monitoring, analysis, and anticipation of emerging problems.
Remediation. Despite a banks best efforts, borrowers may experience financial difficulties. Lending policies and individual loan documents should establish a remediation framework that permits certain actions in the event of a covenant violation or any other event of default. A well-structured remediation framework should provide the bank with the flexibility to ensure that its interests are protected. Consequently, one focus of credit administration should be on enforcing covenants through default letters and imposition of default interest rates. While covenant forbearance (which is temporary) or covenant waivers (which are permanent) may be appropriate in certain circumstances to both protect the banks interests and ensure the viability of the business, granting forbearance should be considered carefully, and granting covenant waivers should be the exception rather than the payday loans in Georgia norm. The banks response to any covenant violation, whether enforcing the covenant or granting forbearance or waiver, should be communicated promptly to the borrower in writing to preserve the banks rights under the loan agreements.
Pricing. Setting an appropriate interest rate and appropriate fees for CI loans is both an art and a science. Yet, it must also be a science to ensure that the institution receives an appropriate risk-adjusted return for its shareholders. Without consistently applied interest rate and fee pricing parameters and centralized monitoring of all CI loan proposals, individual lenders could make inconsistent pricing decisions, often to the detriment of the borrower and the bank.