The Loan That No Longer Fits the Policy
A credit officer is reviewing an existing £400,000 term loan to a bakery business. The business has traded for nine years and has always repaid on time. However, the latest management accounts show that the interest cover ratio has fallen from 3.1x to 1.4x, and the current ratio has dropped from 1.5 to 0.9. The owner explains that a large supermarket contract was lost six months ago and that a new contract with a regional chain starts in four months. The loan covenant requires interest cover of at least 2.0x. The officer's lending mandate allows them to approve new facilities up to £250,000; the existing loan is above that limit. The business has asked for a three-month payment holiday. The officer's annual bonus is partly linked to the proportion of the loan book classified as non-performing.
1. Has a covenant breach occurred, and what are the officer's options?
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Yes - on the figures given, the interest cover covenant of 2.0x is breached at 1.4x. The current ratio of 0.9 also signals a liquidity squeeze. The breach should be recorded as a covenant breach under the loan agreement, whatever the cause.
Options include:
- Do nothing and hope - not acceptable; it conceals a breach and misstates the loan's status.
- Formal waiver - the bank may waive the breach for a defined period, typically with conditions (reporting, milestones, fees).
- Restructure - extend tenor, capitalise arrears, or grant a payment holiday with a revised covenant package.
- Forbearance classification - the loan should be assessed for forbearance and likely moved to a watchlist, with any impairment considered under the bank's provisioning policy.
- Enforcement - premature here given nine years of clean repayment and a credible recovery plan, but must remain an option if milestones are missed.
Mandate point: the officer cannot approve a restructure above their £250,000 limit alone; it must go to the appropriate credit committee. The bonus link creates a conflict that should be disclosed or the decision escalated.
2. How should the officer handle the conflict between the bonus incentive and the credit decision?
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The officer should recognise and manage the conflict explicitly:
- Disclose the incentive link to the approving committee and, where policy requires, recuse from the final decision.
- Base the recommendation on evidence, not on the classification outcome: the numbers, the contract pipeline, and the recovery plan.
- Do not delay classification to protect the bonus - a delayed non-performing classification is a misstatement of the loan book and a governance failure.
- Escalate because the facility exceeds the officer's mandate in any event; the decision is not theirs alone.
The key principle is that incentives must not drive the credit judgement. A bank that lets bonus pressure suppress watchlist classification builds up hidden losses. The correct sequence is: assess honestly, classify per policy, then let the committee decide on forbearance.
3. What conditions should accompany any payment holiday, and what monitoring is needed?
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Conditions:
- A defined holiday period (three months as requested) with a clear end date, not open-ended.
- Revised covenants reflecting the temporary position, with a step-back to the original level by an agreed date.
- Monthly management information - cash flow, sales, and the status of the new contract.
- Evidence of the new contract - signed or at least a letter of intent, with start date and value.
- No further drawings without approval.
- A milestone review at the end of the holiday, with pre-agreed consequences if missed.
Monitoring:
- Monthly covenant and liquidity reporting.
- Watchlist status with regular review.
- Impairment assessment at each reporting date.
- Early warning triggers (e.g. missed contract start, further ratio deterioration) that force escalation.
A holiday is forbearance, not a fix; the bank must be able to show it monitored and acted on the conditions.