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

A bank lends USD 10 million to a mid-sized manufacturer under a term loan. The credit officer wants a covenant that gives the bank an early opportunity to renegotiate terms before the borrower's financial condition deteriorates to the point of payment default. Which type of covenant best serves this purpose?

Regularly tested financial maintenance covenants, such as minimum interest coverage, combined with negative covenants limiting extra debt and dividends, trip before payment default occurs. This gives the bank an early chance to renegotiate or tighten terms, unlike fixed pricing or trivial affirmative covenants.

  1. AA negative covenant restricting additional debt and dividend payments, together with a financial maintenance covenant such as a minimum interest coverage ratio tested quarterlyCorrect
  2. BA cosmetic covenant requiring the borrower to send an annual greeting letter to the bank
  3. CAn affirmative covenant requiring only that the borrower exist as a legal entity
  4. DA pricing clause that fixes the loan margin for the full term regardless of credit quality

Explanation

Maintenance covenants tested regularly, such as minimum interest coverage, are breached while the borrower is still paying, giving the lender a seat at the table and renegotiation leverage. Negative covenants restrict value leakage to other claimants. Fixed pricing and trivial affirmative covenants give no early trigger.

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