Role of Technology in Covenant Analysis

Technology influence things around us, from education to business to almost all our communications, even financial covenants. A financial covenant is a set of obligations that a borrower upholds during the course of the loan. It demonstrates to the lender that they are still creditworthy. These covenants are used by lenders to safeguard their interests. Let’s take a look at how it influences covenants analysis and how it contributes to better credit risk governance.

What is the Traditional Approach to Covenant Analysis?

Numerous covenants are frequently incorporated in various contract types in the retail, business, and capital sectors. A back-of-the-envelope calculation is typically used in the old method of covenant analysis. This helps to certify covenant adherence. 

However, there were several drawbacks to employing this strategy. They were as follows:

• A back-of-the-envelope calculation cannot guarantee that covenants are computed accurately, and the statistics may not match the financials disclosed by the firm
• Excel or other spreadsheets are often decentralized, and banks would fail to discover early signs of these covenants at the portfolio level if they were not kept in a data lake
• Outlook is typically clogged with meetings and reminders, and a covenant due warning may be overlooked
• Manual enforcement of compliance issues
• Errors in loan servicing

Covenant Analysis with Technology

Now that we understand –

• What is a covenant? 
• How did we use to evaluate it conventionally? 
• What the issues were with the old technique? 

Now we can readily recognize the role of technology, namely Distributed Ledger Technology, aka DLTs Covenant Analysis. 

Distributed Ledger Technology

DLT is a technique that allows a digital data database to be copied, saved, shared, and synchronized across several participants. And all this is done without the need for a centralized administrator.

Since it is a digital database, the DLT is utilized to make sure that no assets are duplicated. If more than one security is established against the same asset, this may be traced to that specific asset and the Debenture Trustees (DTs) take the appropriate remedial action.

How does it work?

According to the DLT Circular, issuers need to enter important facts about various types of assets submitted as security for non-convertible securities. The issuer is required to register each asset on the DLT, subject to DT inspection and verification.

Each asset documented on the Platform will be allocated with a 12-digit alphanumeric unique identification (“Asset Identifier”) created by the system.

If the Platform detects duplicate/near duplicate entries for an asset, it will notify the issuer and the DT. The Issuer and DT then cross-check and validate the information submitted into the system for asset creation.

How AI and Automation are used in Covenant Analysis?

Below are the steps for using AI to interpret covenants:

1. Charge the relevant team with investigating the covenant
2. Make a timetable and a list of actions for your tasks
3. Keep track of all paperwork that the counterparty must provide
4. Uphold the validity following the norms set forth
5. Ascertain that all financial demands are within approved limitations

Benefits of the AI and Automation Approach

• Enhance covenant monitoring and compliance reporting by streamlining processes
• Reduce the cost of regulatory compliance and data mistake rates
• Boost the efficiency of your company’s credit decision-making and the performance of its commercial portfolio

Benefits of Technology for Covenant Analysis

The use of technology makes it easier to comprehend the contract’s financial and non-financial covenants. The following are some factors that enable technology to gain an advantage over conventional approaches and make monitoring easier.

• The covenant analysis procedure is automated by technology. Technology concentrates on gathering the necessary data, while analysts concentrate on the area of judgment.
• By reusing the spreads that were already produced for risk-rating reasons, it prevents unnecessary duplication
• Produces an alert once a covenant is about to become due to prevent any misses
• In only a few clicks, machine learning-based covenant extraction from loan agreements may be completed
• Banks may recognize broken covenants with the use of smart contracts, and the contracts’ costs can then be applied
• Using technology, banks can make sure that each borrower has the best possible covenant levels
• It assists in attaining consistency, transparency, and prompt action to safeguard investors’ interests concerning Issuers’ assets

This is how technology contributes to Covenant Analysis.

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