For any financial institution, it is crucial to monitor who is following the covenants and who is not. Covenants are rules a borrower agrees to comply with while entering a loan contract. If lenders create these covenants to prevent violations, the net effects will include a lower risk of default, timely repayments, and easy loan management. 

What’s the key to successful covenant compliance management? Strategies. Without correct techniques, lenders may find more borrowers missing repayments, defaulting on loans, and ultimately financial loss. With the five critical strategies mentioned below, lenders may close the gap with their borrowers and ensure better management.

  1. Giving Orientation to New Borrowers

One effective strategy is to reach out to new borrowers and give them a chance to discuss covenants with the covenant compliance committee. An orientation like this will serve as a welcome gesture to the borrower. Besides that, it allows the lenders to tell new borrowers everything they must know about the lending and borrowing policies. 

With complete and clear information, borrowers can also take full advantage of their loans. Therefore, orientation is an excellent way to benefit the borrowers and avoid common violations to safeguard the lenders.

  1. Creating Easily Comprehensible Documents

People are busy, and reading through each line of the loan document is often not a priority for borrowers. However, lenders may help them understand critical information by condensing it into a booklet or brochure written in layman’s terms. It is conducive to financial covenants. A maintenance matrix is another essential document that can save stress for both lenders and borrowers. It is a simple chart that clearly indicates the tasks, timelines, penalties, etc. By taking ambiguity out of the equation, this document is highly helpful in preventing violations.

The lender must run these documents by an attorney to ensure they have not missed anything. After finalizing them, the lender may add them to their borrower’s welcome packet, hand them out during orientation, and post them on their website so that they are easily accessible always. 

  1. Proactive Communication 

These days, financial institutions can communicate with borrowers more quickly using different media other than mailers, including social media, email, websites, etc. Proactive communication is ideal for sending reminders to prospective defaulters and reducing the chances of violation. For instance, sending EMI reminders to borrowers a couple of days before the due date will encourage them to act fast and prevent missing the payment. With proactive communication, the lender makes covenant compliance easier and increases borrowers’ chance to repay their loans on time.

  1. Taking Warning Signs Seriously

Lenders must keep an eye on warning signs pointing to borrowers’ problems. Such signs include declining revenue, reducing cash balances, excessive leverage, and increasing input costs. Supplier issues, a backlog of payments, and losing key customers are other indications of prospective loan default. 

If the lender notices any of these warning signs with the borrower, they likely face operational and financial challenges. Therefore, it’s the right time to communicate and warn the borrowers proactively. When the borrower gets an alert from the lender, they become active to manage their issues and sending positive signals to the lender.

  1. Using a Covenant Monitoring and Validation Tool

Using an automated covenant monitoring and validation tool to understand a borrower’s covenant performance is highly essential for a contemporary financial institution. These tools aim to monitor covenant compliance in a deal and deliver warning signs whenever it notices a violation. Many financial institutions use these tools to create covenants according to the loan documents while following practices relevant to the financial industry. 

The tools use accessible data to monitor credit behavior and identify compliance breaches in time. Creditors can act proactively and make better credit decisions with early warning signs and alerts. Consequently, they minimize risk and keep their finances safe by ensuring compliance.

Despite all the best efforts, violations do happen. However, proper communication can resolve a violation and preserve the relationship even under such situations. Instead of taking legal action, why not leave an alert explaining the non-compliance and the next steps in a friendly way? It can help maintain a friendly demeanor while saving the finances. These covenant compliance strategies help reduce violations and improve the relationship between lenders and borrowers.

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