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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank lends to a mid-sized manufacturer and wants to reduce its exposure to a deterioration in the borrower's financial condition before an actual default occurs. Which feature of the loan agreement is best suited to this purpose?

A financial covenant such as a minimum interest coverage ratio is best, because a breach gives the lender early rights to renegotiate, add security or accelerate before default. Pricing, longer maturity and a floating charge do not give an early intervention trigger.

  1. AA financial covenant requiring a minimum interest coverage ratio, with a breach acting as an event of defaultCorrect
  2. BA floating charge over the borrower's future inventory
  3. CA higher interest margin set at origination
  4. DA longer final maturity to ease the borrower's repayment profile

Explanation

Financial covenants such as a minimum interest coverage ratio act as early warning triggers. A breach lets the lender renegotiate, demand collateral or accelerate repayment before the borrower actually defaults. A higher margin only compensates for risk and does not give an intervention right. A longer maturity increases exposure duration. A floating charge improves recovery after default but does not give an early trigger.

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