Perspectives

Mitigating Risks with AI-Led Covenant Management

Mahadevan Janardhanan
Principal Consultant - Commercial Lending
Article

Loan covenants are much like the rumble strips on the side of a highway. A set of covenants can help banks offset some of the risks that threaten them. A study by CenterState – Correspondent Division suggests that a well-adhered covenant set can reduce the default risk of the borrower by more than 20%.

On the contrary, it seems that this is an area many banks still need to improve on.

Poor Covenant Management Increases Credit Risk

Lenders put in considerable effort to define covenant terms. However, banks tend to undermine its significance, especially in monitoring. Most banks continue to use outdated, manual methods, such as Excel spreadsheets and physical paper to manage covenants and refrain from investing in technology that can make the process accurate and efficient. Due to the lack of vigilance and importance given to covenants (created during the loan appraisal process) banks may not notice compliance violation, which can have dire consequences such as a breach of agreements or a loan default.

Simply put, an unmonitored covenant can increase the credit risk and jeopardize banks’ financial health.

Improve Covenant Monitoring with Artificial Intelligence

To safeguard financial health, banks need a systematic approach to track and monitor the covenants of their loans. An integrated covenant management approach can infuse an augmented level of transparency and seamlessness in a loan transaction process.

Emerging technologies, such as machine learning (ML) and blockchain can be the bedrock for banks to define, classify, and monitor covenants, and take real-time action that do not meet the agreed standards. The sooner banks realize the potential of the two technological building blocks and weave them in the fabric of their lending approach, the better it will be in mitigating risks and defaults.

ML algorithms can identify covenants from loan contracts and classify them under various buckets – such as financial, non-financial, affirmative, negative, tax – by creating summary checklists of covenants and attaching them to specific entities such as documents, standards, or financial requirements.

This can further help in defining a set of relevant covenants that otherwise requires staff expertise to manually extract it from contracts that is a highly time-consuming, expensive, and labor-intensive process.

Furthermore, Blockchain can help keep a check on the debt in real time once covenants are classified. Particularly smart contracts can help in monitoring the covenants and applying borrower penalties and charges for not maintaining it. While this can give banks more control of the process, it can also allow borrowers to be more informed so that they can avoid penal interest and charges.

With diligent monitoring, banks can read the early warning signs and make informed decision around investing and managing risks. The immense potential of emerging technologies to help banks maintain their stability underscores the importance of its adoption among banks.

Covenant management must be a priority for all banks – big or small

Lenders should be meticulous in formulating and testing covenants during the underwriting process. Monitoring and reporting of covenants safeguard the stability of banks and ensure a higher risk-adjusted return by reducing losses and potentially lowering reserves.

It’s time banks treat covenants like its next-best safeguard. Being cautious at every step of the loan lifecycle is the way forward to avoid being crushed by a ‘tripped’ covenant, and to create a win-win situation for both lenders and borrowers.

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