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Loan covenants refresher: What, when, why & how

Mary Ellen Biery

November 12, 2023

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Understanding loan covenants, when financial institutions should use them, and how to monitor them supports strong lending portfolios and credit risk management best practices.

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The what, when, why and how

Loan covenants are critical to banks and credit unions as they manage credit risk. They become especially important when business borrowers face stressors that could affect their ability to repay the loan or run their business.

Notably, many banks recently reported having tightened standards and terms on C&I loans to large, middle-market, and small firms due to the less favorable or more uncertain economic outlook. Two-thirds of Senior Lending Officers said covenants remained basically unchanged, but almost a third reported having tightened them in the second quarter.

Understanding what loan covenants are, when financial institutions should use them in business lending, and how to monitor them can support strong lending portfolios and credit risk management best practices.

This refresher on loan covenants may be helpful as commercial lenders, credit managers, credit risk managers, and others navigate the institution’s push-me-pull-you goals of growing balance sheet liabilities while mitigating rising pressures on credit quality.

Abrigo Director of Advisory Services Kent Kirby and Abrigo Senior Advisor Rob Newberry recently provided guidance on covenants during the webinar “Demystifying covenants: Who needs them and why.”

Protecting the lender's investment

Loan covenants are agreements between the lender and borrower that outline the behaviors in which the borrower must or must not engage as it relates to the operations of the company receiving a loan. They are designed to help maintain the financial health of borrowers throughout the loan term. Ultimately, covenants are aimed at protecting the bank or credit union from the financial risk of a loss on its investment and expected return on the loan.

Covenants, Kirby said, are designed to “compensate for the increased risk in the transaction -- either the inherent risk in the transaction or the time that's outstanding.” They also give the lender tools to monitor and manage the situation.

“The greater the risk profile of the transaction, the more the financial institution has an incentive to motivate the borrower's behavior related to business risk so that they can ensure their financial risk is covered,” he said.

In other words, the greater the risk, the more covenants matter.

Where are loan covenants found?

Loan covenants can be included in either the note or the loan agreement (or credit agreement), Kirby says.

The note outlines the terms and conditions for the extension of credit and its repayment, including penalties that might apply if the borrower doesn’t pay it back on time.

The loan agreement, typically used for a larger or more complicated deal, provides more detail about the note. Details in a loan agreement generally include terms and conditions of the loan, representations and warranties, and default provisions and remedies. Those default provisions can describe financial default, such as a borrower failing to make a payment, and technical default, such as failing to send financials to the institution. Loan agreements also include provisions describing financial default and technical default.

The loan agreement also might be where some institutions include covenants, although others might include them in the note. “There’s no law that says you have to put them in the loan agreement,” said Kirby. “You can put them in a note.”

Regardless of where they are, loan covenants are considered independent agreements. They exist independently of any other type of risk (such as late payments) and provide some kind of remedy if violated, he added.

Capital, performance, administrative

Three types of covenants are common with business loans. The first two types are sometimes called “financial covenants.”

Capital (incurrence) covenants: Capital covenants are designed to shape behavior related to capital structure, or the physical and financial resources available for the company to convert to cash. This category includes behavior related to the company’s equipment, receivables, and debt. Examples of capital covenants include limitations on additional debt and requirements for equipment-replacement escrows.
Performance covenants: Performance covenants are intended to shape behavior related to running the business well. They, therefore, serve as “trip wires” related to the company’s operating efficiency and are the covenants credit analysts and lenders are most familiar with. They include leverage ratios, debt-service coverage ratios, and liquidity ratios.
Administrative covenants: Administrative covenants are requests for information aimed at helping the lender understand how the business is operating. They help the financial institution monitor the risk and are “no brainers” as covenants lenders should use, Kirby said. Common administrative covenants include requirements for financials, requirements for ancillary information, receivable agings, and inventory listings. “If you don’t get a financial statement and there’s a covenant requirement for a financial statement, that is technical default, and you have remedy,” he added.

Sometimes credit professionals will hear the terms “positive covenant” or “negative covenant.” Those simply refer to the tone of the covenant, whichever type it is. A positive covenant would use wording like “thou shall,” while a negative covenant would use “thou shall not.”

Stay up to date on loan covenant best practices.

Motivating the borrower

According to Kirby and Newberry, loan covenants are appropriate when the lender needs a path to return the borrower to the “original state” (or better) than it was when the loan was approved. One example is if the financing will result in a credit risk rating that would be at least a double downgrade from the current risk rating. Another might be when the borrower has a 2-to-1 leverage ratio for the transaction, but it increases to 5-to-1 afterward. In either case, a covenant would be aimed at motivating the borrower sufficiently that they return to the original state.

A lender might also want a covenant when the bank or credit union needs control related to a short-term facility. Loans to some businesses in specific industries, such as car dealerships or those in the oil industry, are more likely to need covenants than others, regardless of the loan structure, said Newberry. Covenants are warranted in commodity financing and floor-plan lending deals, Kirby added.

“The key element is that a covenant is not a one-size-fits-all” situation, Kirby said.

In the above situation involving a risk rating downgrade, for example, a stair-step approach to encouraging the borrower to return to the original state is more effective than an unrealistic deadline. “Make sure that the covenants are appropriate to the transaction.”

For examples of loan covenants and situations where they can be beneficial, listen to the full webinar on covenants.

To build covenants for a specific deal, lenders should obtain whatever information is needed, which can include more than financial statements alone. Lenders need to know the pro forma condition of the borrower immediately after the financing to help build any covenants. Pro forma projections, provided by the borrower, not the lender, help the borrower (and lender) understand how they’ll repay the loan.

'As appropriate' is key

“What you're really trying to do is to make sure that you have protections in place, and that if those projections are not met, then you have the ability to manage the situation, to try to get it back on track,” Kirby said.

Newberry noted that lenders should always balance the desire to mitigate risk and motivate borrower behavior as they create covenants that describe specific actions and consequences.

In an Abrigo survey of more than 200 bankers, 57% said their institution has a policy or guidance that requires a covenant or agreement on term loans. Thirty percent said their institution does not have such a policy or guidance, and another 13% were unsure.

Some lenders insist that any term loan or a loan over a certain amount must have performance or capital covenants. However, a blanket policy isn’t ideal. “There are times when you have a term loan that can be paid back well within the current financial capacity of the company, and you don’t really need covenants in the loan agreement,” Kirby said.

A policy requiring covenants on all loans can also create problems (such as one covenant offsetting another) or result in exceptions that aren’t constructive. “You can have too few covenants, but you can also have too many.”

The Abrigo advisors recommend including the term “as appropriate” in any loan covenant policy. “You don't want to have a situation where you're just sitting there hanging out to dry for five years and hope you get paid back,” he said. “At the same time, you don't want to have [covenants] so tight that every quarter you're having to deal with a breach.”

Businesses often use accounting software like QuickBooks to help track and develop their financials, and this can allow the lender to require more frequent data than is available via annual audited financial statements. Getting data quarterly enables quarterly covenant tests for an appropriate situation. It also provides opportunities for the banker to check in with and provide advice to help borrowers improve the business’s financial performance.

Tracking covenants is one of the common challenges of a credit officer, but loan administration software can ease this pain point and better help manage ticklers and provide exception reporting.

Engage and correct

What should happen when a borrower violates (or blows) a covenant?

About 3 out of every 4 bankers in the Abrigo survey said they actively follow up on and enforce covenants at their financial institution, but many of those agreed they could follow up more. Only 1 in 4 said their institution is strict on enforcement.

A blown covenant is an opportunity for engagement and correction. As a result, lenders need to understand why a borrower violated a covenant before building the remedy or agreeing to a waiver. The breach could be due to an accounting change (as happened when lease accounting changed) or something more impactful, such as the loss of a big customer.

A covenant waiver is a separate legal agreement from the credit agreement that essentially outlines how long the waiver will supersede the loan agreement (the next 90 days, for example) and what must happen in the meantime. Waivers should include a plan for the borrower to fix the situation, typically before the next test of covenants. They also include an incentive, such as charging them a higher interest rate until the borrower satisfies the terms of the waiver.

Waiving covenants may be OK in certain situations, but repeated waivers are a red flag from both a policy and an examiner's perspective. They send a mixed message to borrowers. “Waivers are fine, but they need to be time-bound and need to be very specific,” Kirby said.

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About the Author

Mary Ellen Biery

Senior Strategist & Content Manager

Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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Loan covenants refresher: What, when, why & how

Support credit risk management

Review the 2023 Loan Review Survey results with experts and get their take on emerging trends and best practices

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