Industry
Banking
Banking Services Transformation: Unlocking Exponential Value
Highlights
- Deficiencies in covenant management have increased risk in commercial banks’ credit portfolios and compromised regulatory compliance leading to heavy penalties.
- The key reason for these shortcomings is a severe lack of digitization in the covenant management space.
- Banks must deploy AI-backed tools and develop covenant management into a centralized capability to enhance credit risk management and avoid regulatory penalties.
Introduction
Credit is the lifeline of economic development and modern economies depend heavily on different types of loans to fund various activities.
These arrangements can range from retail loans such as credit cards and mortgages to large commercial credit lines to enable businesses to finance day to day operations as well as capitalize on new growth opportunities.
In the commercial lending space, banks have to contend with competitive pressures from alternative lenders, compressed profits due to stress in lending portfolios, and colossal penalties imposed by regulators. All these three dynamics have touched covenant monitoring and management, key to effective risk management in the commercial lending value chain. Credit facilities extended to commercial banking clients are subject to certain covenants or conditions that are designed to help lenders better manage risk by monitoring borrowers’ financial stability. Borrowers are required to comply with such covenants and a failure to do so can result in lenders penalizing them which can take the form of increased interest rates or even termination of the loan, among others.
Additionally, regulatory scrutiny of lending processes in general, and covenant management in particular, has increased in recent times. Coupled with the rise of alternative lenders, this is putting pressure on incumbent banks to revamp covenant management processes by leveraging digital technologies to introduce innovations and enhance efficiencies.
Regulatory and competitive pressures
Regulators and central banks are increasing focus on various processes and policies followed by banks in their commercial lending operations.
One key area of regulatory interest is covenant management, spanning covenant stipulation, in-life monitoring, and actions taken in the event of breaches. Deficiencies in banks’ covenant monitoring processes have resulted in regulators imposing curbs, especially with regard to new business. Covenant audits by regulators and central banks have exposed critical shortcomings that have led to penalties for banks. They include:
- Testing: In many instances, banks have missed testing covenants at the stipulated frequency or as per the stipulated benchmark values. In some cases, testing of certain covenants has been missed out entirely.
- Non-submission of covenant certificates: Banks have failed to take penal action when borrowers have not submitted the covenant certificate—customers have been allowed to delay submissions, further compounded by a lack of follow-up by banks. Banks tend to treat non-submission of data less severely than a covenant breach, which is a cause for concern.
- Covenant breaches: Banks have fallen short of taking penal action on covenant breaches, even in the event of severe breaches, such as on covenants with stipulations mandating follow-up action including recall of the loan. In especially egregious cases, clients have even managed to get their facilities further enhanced, thus resulting in the bank disbursing additional funds, and consequently increasing risk.
- Records: Banks have been unsuccessful in maintaining adequate records of periodic covenant monitoring activities such as names of staff who performed a particular check, date and time of the check, feedback captured, remedial action stipulated, and action taken.
Another factor at play is the dramatic emergence of private equity funds and other institutions with large pools of capital. These players lend from a corpus raised from sophisticated investors rather than depositors, which has disrupted the commercial lending market. Such private lenders are not only subject to less stringent regulations but are also far more nimble compared with traditional banks. As a result, they approve loans faster and offer a great deal of flexibility in the terms that govern financing deals, especially in covenant compliance. This has put pressure on incumbent banks to reduce their approval cycles or time-to-yes. To achieve this, some banks now prescribe pre-packaged covenant libraries that can be stipulated in bulk. Needless to say, this leads to extra covenants which may not be necessary for every loan under consideration, thus increasing the compliance burden for both clients and banks.
Competitive pressure from such alternative lenders has compelled banks to reduce the stringency of covenants governing financial deals. In addition, clients often demand exceptions to policy terms and covenants that are hard to comply with. As a result, bank relationship managers frequently resort to credit policy deviations. Insufficient guardrails around approvals for such exceptions lead to unacceptable risks in the credit portfolios of banks, exposing them to higher bad loans and future losses.
In our view, with alternative lenders disrupting the commercial lending space, banks must build covenant management into an independent competency rather than considering it an aspect of the overall credit process.
The case for digital
Our interactions with global banks reveal a severe lack of digitization in covenant management.
Many banks are reliant on legacy paper and spreadsheet based compliance processes. Covenant monitoring staff are left to maintain their own individual calendars for upcoming tests without any system-driven alerts that can automatically create tasks in advance of due dates. Monitoring staff are buffeted by excessive workloads. For example, assuming a conservative figure of five clients per associate, each with two credit facilities and 10 covenants per facility, the workload comes to 100 covenants to be monitored in every reporting period. Over-reliance on manual effort for tasks such as data entry from covenant certificates, calculation, and testing of ratios, leads to errors which may result in both false positive and false negative compliance statuses.
In our view, rather than treating covenant management as a component of the larger commercial loan origination and administration system, banks must create a standalone capability that can be integrated with other credit platforms. To achieve this, incumbent banks must adopt a comprehensive digitization strategy addressing all areas of covenant policies, stipulations, in-life testing, and post-testing follow-up actions.
We believe that banks must focus on four main pillars—process, data, portfolio, and guidance—to transform covenant management.
Banks must consider stitching together the entire covenant lifecycle into a single end-to-end solution by leveraging business process management (BPM) platforms. This will brings all the stakeholders including relationship managers, credit officers, credit monitoring teams, and senior management executives on a single platform. The BPM platform can digitize several email and paper based processes like policy exceptions, approvals for deviations, and so on. Banks must configure the solution to automatically create tasks for credit monitoring staff based on the testing frequency of each covenant, thus removing the need to monitor an ever-changing testing workload. In addition, the solution must integrate with upstream applications like financial spreading to automatically test financial covenants and include a repository to facilitate reporting. Implementing this platform with a composable architecture can enable integration into credit origination workflows, offering front line staff a single interface, eliminating the need to repeatedly switch between multiple applications.
With recent advances in artificial intelligence (AI), it has now become possible to significantly reduce the workload of credit monitoring staff. AI tools can be used to automatically ingest compliance covenant documents submitted by clients, which can include rent rolls, covenant certificates, quarterly financial statements, management information, and stock exchange filings. In addition to transcribing data from PDFs and images into the bank’s covenant compliance solution, AI tools can help validate the authenticity of certificates, dates, and signatories and signatures. Tasks like verification with publicly available financial documents, analysis of financial ratios relative to financial spreads, and validation of ratios through the prescribed formulae can be taken over by AI tools. Most importantly, AI tools can be employed to identify fraudulent statement and calculate costs.
Banks continuously monitor their lending portfolios to identify signs of stress that may be an indication of potential default or even bad debts. We believe covenants are an overlooked arrow in the quiver of monitoring tools available to banks. While many banks monitor external news, account conduct, and external credit ratings among others, they haven’t paid much attention to drawing insights from covenant monitoring. This can be attributed to siloed and manual processes and the absence of a single repository that stores data generated across the covenant lifecycle. With an enterprise covenant management capability in place, rich covenant data will become available for analytics and can yield valuable insights such as:
- Rising instances of breach of a particular financial covenant across borrowers in a specific industry sector – this may signal emerging financial stress.
- Frequent recourse to policy exceptions for a particular client or sector – this may imply either that the policy is too stringent or that it is out of tune with existing sector dynamics.
Chief risk officers of banks can use these insights to detect emerging hotspots in the portfolio and initiate corrective steps at a credit policy level as well as proactively adjust risk appetite. Based on these insights, business leaders can tweak strategy to reduce exposure to sectors or areas that show signs of stress.
Banks lack guidance on the most appropriate covenants for financial deals. While guidelines exist in credit policy documents, in practice banks go over and beyond them as they consider customer and deal specific information. Banks must build and deploy a cognitive model trained in credit policy provisions and historical credit information with the ability to combine insights from both and recommend a list of covenants. Banks can override these recommendations and add or subtract from the list. These changes can be fed back into the model for retraining.
In summary
Incumbent lenders have to contend with ever-evolving, complex forces that continually disrupt the landscape.
Increasing competition from non-traditional lenders, customer demand for flexible terms similar to those offered by alternative players, and intense regulatory scrutiny have created a challenging and dynamic business environment. Macro-economic tensions and geo-political stress are adding to the mix—all of which have significantly heightened risk underscoring the importance of efficient covenant monitoring and management.
To successfully navigate the prevailing industry environment, banks must build covenant management into a centralized capability rather than treating it as a minor component of the overall lending process. This will help ensure regulatory compliance, simplify the monitoring process, and strengthen control mechanisms, ultimately resulting in covenant management becoming a key enabler in providing smart and tailored credit products to customers.
