Application of financial covenants in credit risk management at commercial banks a case on construction enterprises in vietnam

STATE BANK OF VIETNAM MINISTRY OF EDUCATION AND TRAINING BANKING UNIVERSITY OF HO CHI MINH CITY --- BACHELOR THESIS Major: Financial - Banking APPLICATION OF FINANCIAL COVENANTS IN CR

STATE BANK OF VIETNAM MINISTRY OF EDUCATION AND TRAINING

BANKING UNIVERSITY OF HO CHI MINH CITY

-

BACHELOR THESIS Major: Financial - Banking

APPLICATION OF FINANCIAL COVENANTS

IN CREDIT RISK MANAGEMENT AT COMMERCIAL BANKS: A CASE ON CONSTRUCTION ENTERPRISES

ABSTRACT

The research has focused on the application of financial covenants into the Viet Nam market with the objects are construction enterprises The author choose the a non-parametric model called Decision Tree model to measure the thresholds for selected indicators from 100 listed construction companies in the period of time from

2014 to 2017 The detailed process has been demonstrated, from preparing data, selecting variables to building a model and finally obtaining result The performance figures of the obtained model are all reasonable, which proves its capability to apply into covenants Despite providing numerous beneficial contribution, there are still some shortcomings, mainly due to the lack of time and information, have been withdrawn Recommendations for improvement and further studies have also been proposed Based on the results of the study, the paper provides not only the idea about

a new mechanism for credit risk management in Viet Nam market but also the suitable thresholds to apply it into construction companies

DECLARATION OF AUTHENTICITY

I hereby confirm that I am the sole author of the written these here enclosed and

I have compiled it in my own words

With my signature, I confirm that this dissertation is my original work, gathered and utilized especially to fulfill the purposes and objectives of this study I have mentioned all people who were significant facilitators of the work

I declare that all statements and information contained herein are true, correct and accurate to the best of my knowledge

Ho Chi Minh City, December 26th, 2018

Nguyen Hoang Thuy Tien

ACKNOWLEGEMENTS

Firstly, I would like to express my gratitude towards MSc Nguyen Minh Nhat for his dedication, patience and support me with useful recommendations and guidance

in the process of this study

Secondly, I would like to thank all Banking University's lecturers who have provided me with valuable knowledge as well as experience to help me obtain a solid academic foundation for the future research, career practice and workflow

Finally, I would like to thank my friends for the sharing and support throughout

my Bachelor program

However, due to the limitation of experience and time, the study cannot avoid some certain drawbacks All the comments and advice contributed by members in the committee are gratefully welcomed and appreciated

Ho Chi Minh City, December 26th 2018

Nguyen Hoang Thuy Tien

TABLE OF CONTENTS

ABSTRACT i DECLARATION OF AUTHENTICITY _ ii ACKNOWLEGEMENTS iii LIST OF ABBREVIATIONS _ vi LIST OF TABLES vii CHAPTER 1: INTRODUCTION vii

1.1 Motivation 1 1.2 Research goal _ 2 1.3 Research questions _ 3 1.4 Research subject and range 3 1.5 Research method 3 1.6 Research contribution 3 1.7 Research Outline 4

CHAPTER 2: LITERATURE REVIEW _ 5

2.1 Review about Construction Industry in Viet Nam _ 5 2.2 Credit risk 5

2.2.1 The importance of credit risk management in commercial banks 6 2.2.2 Credit risk management models 7

2.3 Loan covenants _ 10

2.3.1 Covenant types 12 2.3.2 Basic financial covenant structure 16 2.3.3 Prior study on the application of financial covenants _ 22

2.4 Decision Tree Model _ 27

2.4.1 Introduction _ 27 2.4.2 Previous application of Decision tree model 29

CHAPTER 3: RESEARCH METHOD AND DATA _ 33

3.1 Data Sources _ 33 3.2 Data Preparing _ 33 3.3 Variables selection 34

CHAPTER 4: EMPIRICAL RESULTS _ 37

4.1 Obtained Results 37 4.2 Discussion about research results 39

CHAPTER 5: CONCLUSION AND SUGGESTIONS _ 41

5.1 Limitation _ 41 5.2 Recommendations _ 42 5.3 Proposal for further research _ 42

REFERENCES _ viii APPENDIX _ xi

LIST OF ABBREVIATIONS

Depreciation and Amortization

LIST OF TABLES

Table 1 Types of Loan Covenants

Table 2 Input ratios of RiskCalc™ for Japanese private company models Table 3 Selected input ratios by Engelmann and Rauhmeier

Table 4 The separation of Default and Non-default firms

Table 5 Selection of input variables

Table 6 Descriptive Statistics table

Table 7 Correlation matrix

CHAPTER 1: INTRODUCTION

1.1 Motivation

In a project financed transaction, the lenders will want to ensure that the revenue stream is protected and the project performs as it is supposed to with no default on the loan However, credit risk is an inevitable but controllable factor that every bank has to consider when accepting a company loan With traditional methods of risk management such as credit risk measurement models, banks will only capable of controlling risk after the loan is disbursed but not before Loan covenant is a method with practical control mechanism which will give banks the right to create limitations on what the project company can do without bank‟s approval and the ability to step into management of the investment decisions made

by the company Specifically, this forecast mechanism will help the bank control the company‟s developing direction by keeping financial ratios in thresholds which will benefit the bank more than the company

Banks will also seek to have trigger events, which allow them additional rights and powers in the event of their occurrence (for instance, if certain ratios such as debt to equity ratios or debt service cover rations are breached by the company) Given the priority of banks to ensuring security of the project revenue stream, a number of financial ratios will be key to the analysis of a project financed transaction Financial ratios can quantify different aspects of the project company‟s business and operations and are an integral part of analyzing its financial position During due diligence, before financial close, banks will run these ratios using various sensitivities, for example testing the financial ratios in the event construction costs increase by 20%, or revenues fall by 10% After financial close, the banks will use these ratios as part of the project monitoring and control functions Where ratios do not achieve the levels required, they will have a series of possible interventions including blocking dividend distribution, sweeping cash from existing accounts, applying reserve account money to debt service, taking control of additional rights of the borrower or its shareholder If these breaches persist, eventually, such breaches will amount to events of default permitting the

lenders to accelerate, cancel outstanding loan amounts or suspended existing loans

It may also permit them to increase the interest margin, require compensation of the lenders for additional investigation costs and other fees and fines

Jing Wang (2017) stated that loan covenants are designed to assist creditors‟ preferred mechanisms to control and protect loan values in contracting environments with corporations They can give banks a more active role in corporate governance through either the experience or the forecast mechanisms When the covenant is designed with the forecast mechanisms, they either make sure shareholder‟s actions are consistent with the bank‟s preference or incorporate positive prospect of the borrowers, so that future creditor intervention is not necessary; when the covenant is designed with the experience mechanisms, they can reduce moral hazard problems through creditor intervention after the lending relationship is underway A proper set of loan covenants can reduce the probability

of default, the loss given default and the net exposure at default by a significant amount for commercial borrowers The net result is an expected loss rate of almost 20% less with a set of strong covenants than without A large part of this expected loss reduction is the fact that covenants give the lender an average of seven or more months of early warning between the time the covenants are tripped and the time a delinquency occurs

The construction market in 2018 may continue to be optimistic, thereby enabling businesses in the industry to expand their business and consolidate solid resources This results in the raising need of loans from construction companies, but it also leads to a bigger problem in bank lending – risk management

The issue that creditors are most concerned about will be categorizing the kind of risk they are facing and choose the corresponding types of covenants In Viet Nam, loan covenants haven‟t been considered a strategy for risk management

in banks Therefore, this thesis will help creditors – commercial banks in this situation, build a suitable covenant model that can apply to Viet Nam‟s financial market, typically with construction companies

1.2 Research goal

The purpose of this study is to focus on how to use loan covenants in credit

risk governance in Viet Nam commercial banks by researching theories about the impact of loan covenants to credit risk management in banking system The main approach of the study will be exploring thresholds for selected indicators of a loan covenant sample that fits in bank lending in commercial banks in Viet Nam This research will also include suggestions on suitable covenant thresholds to apply in bank loans between commercial banks and construction enterprises

1.4 Research subject and range

Research subject: Construction Enterprises

Research range:

- Space: Construction enterprises listed on the stock market in Viet Nam

- Time: This thesis uses financial information from 2014 - 2017

- Companies selected in this study are required to be majored in construction industry and have full information in selected indicators of the same period

Academically, this thesis provides evidence of application of loan covenants

in previous studies, giving related researches viewpoints about the effect of applying debt covenants to construction enterprises in bank lending of commercial banks in Viet Nam and how to design them Moreover, this thesis‟ results can open

up other research ways for the advancement of loans covenants in the future,

Experimentally, this thesis provides a specific opinion about the application

of loan covenants in commercial banks Viet Nam In addition, it can give suggestions to risk managers in banks on how to design a tight covenant that can recognize and govern credit risks well

1.7 Research Outline

Chapter 1: Introduction

Chapter 2: Literature review

Chapter 3: Research method and research data

Chapter 4: Empirical results

Chapter 5: Conclusion and suggestions

CHAPTER 2: LITERATURE REVIEW

2.1 Review about Construction Industry in Viet Nam

Construction is a process of design and construction so the infrastructure or construction, housing Construction activity differs from manufacturing activities in place to produce a large amount of products with the same details, while building to target products at the locations for each individual customer In developed countries, the construction industry contributes 6-9% of the gross domestic growth

In Viet Nam, civil and industrial construction is a mainly about design, consultancy, constructing as well as management and supervision civil and industrial construction works Civil and industrial construction projects may include: houses, commercial centers, hospitals, schools, hotels, restaurants

In basic construction activities, the construction time is often prolonged, the acceptance and handover is done separately in parts, and normally the disbursement time is slow The process of completing construction documents as well as agreeing

to approve the final settlement between investors and contractors often takes a long time Therefore, there is a significant impact on the financial situation of construction companies, especially the value of receivables, payables and operating cash flows

2.2 Credit risk

Bank management is generally acknowledged to involve the management of four major risks: liquidity risk, interest rate risk, capital risk and credit risk (Hempel et al, 1989) Of these, credit risk has been identified as the key risk in terms of its influence on bank performance (Sinkey, 1992) and bank failure (Spadaford, 1988)

In the operation process of commercial banks in the world and in Viet Nam, credit loans play a very important role, in terms of both the scale of capital use and the ability to make a profit In terms of scale of capital use, they accounts for 70%

of total assets and thus is also the most high-yield item of commercial banks

Servigny and Renault (2004) supposed that a default event is not always defined in the same way by all stakeholders The market definition for credit

default is related to financial instruments which corresponds to principal or interest past due

The Basel II (2004) definition considers a default event based on various alternative options such as past due 90 days on financial instruments or provisioning It can also be based on a judgmental assessment of a firm by the bank

However, credit risk of commercial banks are often referred to the risk that borrowers fail to repay a loan or meet contractual obligations, resulting in creditor‟s loss in principal or interest, disruption to cash flows, and an increase in collection costs, completely or partially Credit risk mainly arises when borrowers are unable

to pay due willingly or unwillingly

Derived from the importance as well as potential risks in credit activities mentioned above and considering the actual operation of commercial banks shows that the demand for loans of companies, especially construction companies are constantly increasing, investment objects more and more, the bank also encountered many difficulties in managing credit risks

Although it is impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of loss Interest payments from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk In this research, we will concentrate on managing credit risk in corporate loans, construction companies in particular

2.2.1 The importance of credit risk management in commercial banks

In banking activities, lending generates most of the profit, however, it also contains great potential risks It can be said that lending and deposit-taking credit are also lending and taking risks The basic characteristic of a bank is to pursuit benefits with acceptable and measurable risks As it is mentioned previously, credit risk happens when customers could not repay their loans and can be predicted and mitigated

Credit risk management is known as the process of identifying, analyzing risk factors, measuring the level of risk, on the basis of which the option of implementing measures and managing credit activities to limit and eliminate risk in

the credit granting process

For commercial banks, credit risk management is essential, because:

Firstly, credit risk is one of the most prominent problems that all commercial

banks have to deal with but not avoidable Credit risk always goes along with debts, and at the same time is very complex Bad credit risk governance will result

in loss of capital and income of the bank

Secondly, if credit risk prevention is well implemented, it will bring benefits

to the bank such as: reduce costs, improve income, preserve capital for commercial banks; create trust for depositors and investors; create a premise to expand the market and increase prestige, position, image and market share for the bank

Thirdly, good credit risk mitigation will benefit the whole domestic

economy In financial markets, the relationships between institutions are comparatively close, if a commercial bank malfunctions, it will immediately cause chain reactions to other banks Therefore, credit risk management brings safety and stability to the market

Finally, because the bank's equity over total assets is small, even if there are

a tiny percentage of problem loans will still cause bankruptcy Especially corporate loans because they are often of great value, losses that occur when the loan is not repaid will cause severe damage to the bank

In short, credit risk management is crucial because it causes financial losses, reduces the market value of bank capital, in a more serious case, it may make the bank's operations become unprofitable, even cause bankruptcy Measures to prevent and limit credit risks need to be researched in accordance with the characteristics of business operations of each bank

2.2.2 Credit risk management models

In recent years, after facing big risks, especially credit risks with high frequency and high value, the commercial banks of Vietnam has focused more on credit risk management in business and gradually approaching risk management standards under the Basel II international treaty on risk management

Credit risk measurement was fully recognized with the 1975 and 1976 Equal Opportunity Acts (implemented by the Federal Reserve Board‟s Regulation B)

These acts stated that any discrimination in the granting of credit was outlawed except if it was based on statistical assessments Historically credit risk measurement methods were assumed to include external ratings services like Moody‟s, Standard & Poor‟s (S&P) or Fitch, and financial statement analysis models (which provide a rating based on the analysis of financial statements of individual borrowers, such as the Altman‟s Z score and Moody‟s RiskCalc) (Allen and Powell, 2011) In terms of methodology, since 1960s serious improvements were brought out with the introduction of various methods in credit risk forecast

Duffee’s research

Duffee (1995) reviews the techniques used to measure the credit risks associated with derivative instruments over the lives of these instruments He stated that there were two views of credit risk measurement, from academics and practitioners The former focused on using contingent-claim techniques to price the credit risk associated with derivative instruments, pioneered by Black and Scholes (1973) and first applied by Merton (1974) The latter including financial institutions preferring the estimation of distribution of credit exposure as generated

by Muffet (1987), Bank of England and Federal Reserve Board Staff (1987) which determined capital requirement; and distribution of credit losses, as demonstrated

by Hull (1989b) and Belton (1987), which reflected the likelihood that credit losses could affect firms „probability of survival

Duffee and Zhou’s research

Duffee and Zhou (1999) constructed a model of a bank that has an opportunity to make loans and sell any fraction of the loan in order to reduce its expected costs of distress, but because the bank has superior information about loan quality, the loan-sale market is affected by an asymmetric-information problem

KMV model

Merton‟s model (1974) implied that a creditworthiness of a firm (level of credit risk related to its obligations), can be displayed with credit spread for its debt which is defined as difference between the yield on the risky debt and the risk – free rate This ratio is obtained by reducing the yield rate with the risk – free rate and dependent on three important ingredients: leverage ratio, assets volatility and

the time to repayment T (Debt maturity)

KMV model is based on the structural approach to calculate EDF (credit risk

is driven by the firm value process) The market information contained in the firm‟s stock price and balance sheet are translated into an implied risk of default This model has the ability to adjust to the credit cycle and ability to quickly reflect any deterioration in credit quality It was a modified version of the Merton‟s concept, varied from the original with a few aspects However, the KMV model is only confident of predicting 1-year EDF and admits difficulty to use even 3-year EDF in real application

VAR (value at risk) measurement

For investors, risk is about the odds of losing money, and VAR is based on that common-sense fact By assuming investors care about the odds of a really big loss, VAR answers the question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?" by Harper (2018) This measurement based on models provided a measurement of expected losses over a given time period at a given tolerance level These included the JP Morgan Credit Metrics model which used a Transition Matrix, and the Credit Portfolio View model which incorporated macroeconomic factors into a Transition approach

In conclusion, through prior researches mentioned above, we can get the

general idea about credit risk and how to measure it As time go by, these measuring methods might become regular with the growth of the economic and technology Different from other evaluations‟ operation mechanism, loan covenants have a distinct approach on managing credit risk KMV and VAR measurements are used after the loan have been disbursed; they are used to calculate credit risk but not to prevent them from happening like loan covenants The ex-ante mechanism allows creditors to predict and control the risk before the loan is taken out, which will give more protection to the creditors such as banks than traditional methods

The advent of loan covenants give banks the more variable choices on credit risk management tools as a means of monitoring a borrower‟s operations to assure that the basis upon which a loan was made continues throughout the term of the loan which will be detailed at the next part

2.3 Loan covenants

A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions, or forbid the borrower from undertaking certain actions, or possibly encourage certain actions when other conditions are met It can require a certain level of performance by borrowers, including limitations on new debt beyond current borrowings, changes in business strategies or senior management, and various financial compliance requirements, often as measured by standard ratios in such categories as liquidity, leverage, activity and profitability Financial covenants are provisions in debt contracts that require the borrower to maintain a threshold level of a financial ratio or measure If the borrower fails to maintain the threshold, the loan enters technical default and the creditor has the option to take action, such as renegotiating or terminating the loan Use of financial covenants of various types is pervasive in private debt contracts Despite this, there is little research examining the specific purpose that financial covenants serve

Typically, violation of a covenant may result in a default on the loan being declared, penalties being applied, or the loan being called This will be designed by the creditor when composing a covenant

Covenants may also be waived, either temporarily or permanently, usually at the sole discretion of the lender According to Peter (2010), before a loan

is issued, the lender evaluates the credit risk of the borrower To the extent that the lender is not sure about the borrower‟s ability to repay the loan (and in most cases there will be at least some degree of uncertainty), the lender will demand compensation, such as a higher interest rate If the loan can be renegotiated prior to maturity, the cost of uncertainty can be limited Financial covenants provide a trigger for renegotiation If the covenant is indexed to a financial measure that is informative about the borrower‟s ability to pay in future, and this covenant is triggered, it suggests the lender needs to re-evaluate the credit worthiness of the borrower In cases where the lender determines the borrower presents higher risk than was originally priced in the contract, the loan can be renegotiated at a higher interest rate or even terminated If the covenant violation is not deemed serious (i.e

it does not indicate an increase in credit risk), the lender can waive the violation and the loan can continue This view of financial covenants suggests two things First, the use of financial covenants should be increasing in the uncertainty of the borrower Second, the financial measure of the covenant should provide information about the future value and cash flows of the borrower

In short, loan covenants are designed to protect the lenders – banks, from the borrower‟s substantially weakening of the latter‟s financial position It can help the lender from facing situations like insolvency of the borrower and non-repayment of

an amount of loan by the borrower by giving a closer look into the financial status

of the company and also the right to make important decisions on the company‟s investment decisions Thus, the contract conditions are composed by the lender so that the lender can ensure the repayment of the loan and protect themselves from the borrower‟s substantially weakening of the latter‟s financial position In short, loan covenants‟ ex-ante mechanism allows better protection to the banks because of the prediction

A well-designed loan covenant can help banks take a closer look into the financial status of the company and be more active on how to prevent credit risk from happening by building a more suitable covenant depends on the company‟s financial status

Peter (2010) found out that when a loan is made to a borrower, there is uncertainty about the borrower‟s ability to repay that loan And by examine the inclusion and selection of financial ratio covenants in debt contracts find that both the likelihood of inclusion of and the number of financial covenants is increasing in the uncertainty of the borrower He also examines the selection of financial measures for use in covenants The results show that leverage plays a role in the selection of financial covenants, with high leverage being associated with income statement covenants and low leverage being associated with balance sheet covenants Following the literature on firm performance and value relevance of earnings and book values, I find that income statement covenants are used when borrower performance is strong and balance sheet covenants are used when performance is not as good Overall, these results support the view that financial covenants serve to limit the costs associated with borrower uncertainty

Chris (2014) stated that covenants help partially solve the asymmetrical information problem that results in the borrower having better information than the bank A proper set of loan covenants can reduce the probability of default, the loss given default and the net exposure at default by a significant amount for commercial borrowers The net result is an expected loss rate of almost 20% less with a set of strong covenants than without A large part of this expected loss reduction is the fact that covenants give the lender an average of seven or more months of early warning between the time the covenants are tripped and the time a delinquency occurs

Since exposure to credit risk continues to be the leading source of problems

in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred

2.3.1 Covenant types

Covenants can be divided into three basic forms (Day, Taylor 1998):

Negative covenants – terms under which a borrower agrees not to take certain actions which might adversely affect the status of the claims of the investor such as issue additional debt or sell certain assets A negative loan covenant is used

to create boundaries for the company and its owners Such boundaries are usually related to financial and ownership matters Lenders may include negative loan covenants which require the business owner to seek the bank‟s permission to take certain actions as such actions may change the business‟ capital structure,

Positive covenants – terms which aim to provide security to the investors by requiring the borrower to continue with certain specified actions such as provide periodic financial and other information An affirmative loan covenant is used to remind the borrower they should be doing certain activities to maintain the financial health and well-being of the business,

Financial covenants (also called as accounting-based covenants) – terms which constitute minimum or maximum level of accounting figures related for

example to liquidity and profitability They can be expressed in relative or absolute value and take the form of positive or negative covenants, financial loan covenants are used to measure how closely the business performs against the financial projections provided by the business owner, CFO, or management Financial covenants mostly base on financial numbers (financial ratios) In many papers authors indicate that their influence on the relations between debt holders and shareholders is different from other types of covenant

Researchers suggest that covenants are often based on accounting measures

On the basis of the literature review we can indicate three main study areas on financial covenants concerning the following:

– Determinants and role of financial covenants,

– Restrictiveness of financial covenants,

– Violation of financial covenants

However, in the event of a more serious violation (e.g taking out another loan without lender‟s permission), the lender may have the right to suspend the loan, demand early repayment, seize the assets the company pledged as collateral, halt any additional lending or initiate legal action (Owens, 2013)

Debt financing creates an agency problem between shareholders and debt holders (see e.g Gajdka 2002) The conflict of interest between the two parties arises because managers, acting on behalf of shareholders, can have incentives to take actions that increase wealth of shareholders at the expense of debt holders The most common ways in which managers can expropriate wealth from debt holders are (see e.g Jensen, Meckling 1976, Smith and Warner 1979, Bradley, Roberts 2004):

1 Asset substitution – investing in projects of higher risk than accepted by debt holders,

2 Under investment – refusing to take positive net present value projects which benefit only the debt holders and not the shareholders,

3 Dividend payment – increasing payments to shareholders in the form of dividends or share repurchases and financing the payments by selling assets or reducing investments,

4 Claim dilution – issuing new debt of equal or higher priority than existing debt

The theory of agency problems developed by Jensen and Meckling (1976) and expanded by Myers (1977), Smith and Warner (1979), among others, suggests that the conflict of interest between shareholders and debt holders can be reduced

by including appropriate covenants in debt contracts that restrict management‟s future actions Violation of covenants is commonly referred as technical default and gives investors certain rights indicated in the debt contract like the right to require early repayment Therefore, covenants are designed to protect investors from possible opportunistic behavior of managers and therefore to lower the firm‟s cost

of debt (see e.g Smith, Warner 1979, Bradley, Roberts 2004, Moir, Sudarsanam

2007, Reisel 2010)

Citron (1995) examining the incidence of accounting-based covenants in UK public debt issued during the period 1987–1990 states that among 108 public contracts 30% contain accounting-based covenants majority of which are gearing covenants The author notices that while in US, public debt covenants are almost universally negative in UK there are more affirmative covenants Citron finds that the presence of accounting-based covenants in UK public contracts is associated with long-term unsecured debt and high values for assets-inplace but is unrelated to gearing

Demerjian (2011) examining the sample of 8527 private debt agreements of publicly traded, non-financial borrowers found out that over the period from 1996

to 2007 the income statement covenants (covenants based on income statement variables such as interest coverage, fixed charge coverage and debt-to-earnings covenants) were included in between 74% and 82% of deals, and the balance sheet covenants (covenants based on balance sheet variables such as leverage, net worth, and current ratio covenants) were included in more than 80% of the debt contracts

in 1996 but in the next years their use declined to 32% of deals in 2007 The author concludes that the decline in use of balance sheet covenants is associated with changes in accounting standards which made the balance sheet less useful for contracting

Achleitner et al (2012) indicate that financial covenants can be classified into two fundamental types: incurrence and maintenance financial covenants Incurrence financial covenants restrict the actions of borrowers that might extract wealth from debt holders (like an acquisition or an issuance of additional debt) if certain accounting-based thresholds are not satisfied Whereas issuers have to meet maintenance financial covenants on an ongoing basis over the term of the debt and

it is independent of their actions to transfer wealth The authors examine the structure and determinants of financial covenants in leveraged buyouts and they indicate that leveraged loans traditionally use maintenance financial covenants but

if credit markets are overheated leveraged loans might incorporate incurrence covenants instead of maintenance covenants

J Wang (2017) stated that financial covenants are grouped into 3 types based on the sources of information used in calculating the covenant variables and the specific aspects on which the covenants put restrictions: capital covenant, performance covenant and capital expenditure covenant Capital covenants restrict the amount of debt in a firm‟s capital structure; they may restrict the maximum amount of leverage used in a firm, or the minimum amount of capital shareholders have to keep within a firm to assure the consistency of interests between shareholders and creditors Performance covenants specify detailed thresholds on a borrower‟s financial performance, which means they will set the lower boundary of the borrower‟s profitability to exclude borrowers who do not expect to achieve the required performance thresholds Capital expenditure restricts the maximum amount of capital investment that the borrower can spend in a year; it can prevent moral hazard problems

Christensen and Nikolaev (2011) focus in their research on examining the role of accounting-based covenants in limiting agency costs and they classify covenants into two groups: capital covenants which are based on information about sources and uses of capital (balance sheet information only) and performance covenants which are formulated in terms of current-period profitability and efficiency indicators The authors argue that the two groups of covenants reduce agency costs in two different ways Capital covenants align the interests of

shareholders and debt holders by restricting the level of debt in a firm‟s capital structure directly and because they demand appropriate level of equity capital shareholders‟ wealth is sensitive to opportunistic actions that decrease firm value

On the contrary, performance covenants prevent suboptimal managerial actions by reallocating control to debt holders when they are at risk of expropriation their wealth This type covenants act as tripwires, or timely indicators of weak performance Christensen and Nikolaev provide evidence that financially constrained firms use performance rather than capital covenants (the latter require a certain level of equity capital and therefore reduce financial flexibility which is problematic for financially constrained borrowers) On the other hand the authors find that the use of capital covenants increases (relative to performance covenants) when contractibility of accounting information declines (performance covenants are effective if the accounting information is contractible) They also find that performance covenants are used in combination with negative covenants which restrict managers‟ actions It is worth to note that this classification is related to the classification on balance sheet and income statement covenants made by Demerjian but Christensen and Nikolaev prefer the labels “capital” and “performance” because they better describe the economic nature of these covenants and the underlying mechanisms through which they address agency problems and furthermore the authors claim that classifying some covenants to the group of balance sheet or income statement covenants is somewhat arbitrary

In this study, author will mainly focus on financial covenants than other two types of covenants

2.3.2 Basic financial covenant structure

Largely because of the lack of federal oversight, there is no standard set of bank lending covenants Managing directors at Standard & Poor‟s (Miller, 2008) notes that the five most commonly used financial covenants are as follows:

1 Coverage: minimum levels of cash flow or earnings relative to specific

expenses or charges

2 Leverage: a maximum debt level relative to cash flow or equity

3 Tangible net worth: a minimum tangible net worth

4 Capital expenditures: a maximum amount that may be spent on capital Expenditures

5 Liquidity: a minimum current ratio and/or quick ratio

Using a sample of 238 bank loans, Pagila and Mullineaux (2006) determined that there are several categories of covenants, which have been reorganized for Table 1

Table 1 - Types of Loan Covenants

(in order of frequency of occurrence in loan agreements)

Preserving collateral, primarily maintaining the value of collateral, purchasing

insurance and restricting borrower liens

Reporting and disclosure, primarily providing financial statements

Operating activity, including maintaining the business, paying liabilities,

compliance with laws, other business restrictions

Restricting new financing, including debt and/or equity

Managing and controlling, primarily restrictions on important changes in

ownership and/or senior management

Investing activity, primarily limiting capital expenditures

Selling assets

Limiting cash payouts

Cash flow covenants, primarily the coverage of debt obligations

Financial leverage, primarily the relationship of debt to equity

Liquidity

Source: An Empirical Exploration of Financial Covenants in Large Bank Loans

Banks have obviously attempted to safeguard principal and assure the repayment of loans, but there does not appear to be a standard approach to the use

of financial data Rather, the most commonly used restrictions apply to qualitative measures, including operations, reporting, management and ownership, the preservation of collateral, and the protection of assets

In the US Bradley and Roberts (2004) examining 12425 private corporate loans provided to 3012 firms during the period 1993–2001 report that the sample of

loans contains covenants on 17 different accounting variables and there are 25 financial measures contained in loan on average, with the most popular covenants restricting the ratio of debt to operating income and tangible net worth

Moir and Sudarsanam (2007) examining financial covenants associated with private debt for a sample of 72 UK corporate borrowers report that 53% use one or two financial covenants The authors observe the dominance of covenants relating

to gearing, interest cover and minimum tangible net worth but they emphasize that there is some small trend towards using cash flow-based measures Their results indicate that among such firm related characteristics as size, reputation, risk or liquidity only the borrower size significantly influences the decision of borrowers

to provide these covenants

Operating performance is a major driver of borrowers‟ credit risk which leads to academic articles supporting the view of using financial ratios as informative source of credit assessment (Demerjian, 2007) Smith and Warner (1979) noted that violation of covenants provided a signal to the lender Dichev and Skinner (2002) found that financial ratio covenants were used as “trip wires” in debt contracts Lundholm and Sloan (2004) illustrated that financial ratio covenants were useful because “ if the company starts to look sufficiently sick, the bank can rush back and grab assets before they are all gone.” Beaver (1966) presented empirical evidence that certain financial ratios gave statistically striking signals before actual business failure Beaver tried to predict the probability of firm failing

in paying back debt using their financial ratios However, this study mainly focused

on leverage and liquidity ratios, which may not provide adequate financial information to give an exact forecast

Financial ratios have also been considered by a vast number of rating agencies when evaluating credit quality Standard & Poor‟s (2006) used an improvement in debt to cash flow and coverage ratios as an explanation to the credit upgrade for Staples, Inc Or as Moody‟s (2006) noted in a ratings affirmation for Limited Brands, Inc., that deterioration or stabilization of coverage and debt to cash flow would impact future rating changes In Viet Nam, Huong (2002) also introduced a new method using financial indicators to classify loan applicants

Depending on the level of accuracy required, the time length of information that need gathering could be up to 10 years or even more Having high quality data from a recent period of history is among the most important requirements for building models that will accurately predict how firms are likely to behave in the future (Finlay, 2010)

After gathering all firms‟ financial information, the central task now is to determine which predictor variables will be tested for significance during model training This is a parsimonious process that aims to identify a minimal set of predictors for the maximum gain (predictive accuracy) (Natasha, 2017) Predictor variables are also known as independent variables, predictors, attributes, model factors, covariates, repressors, features, or characteristics Typically, these variables are formed to standardize the available information

Demerjian (2007) stated five types of financial ratio covenants commonly used in debt contracts as a basic to predict borrowers‟ credit risk:

1 Minimum Coverage (earnings / periodic debt-related expense)

2 Maximum Debt to Cash Flow (total debt / earnings)

3 Minimum Net Worth (assets – liabilities = shareholders‟ equity)

4 Maximum Leverage (total debt / total assets)

5 Minimum Current (current assets / current liabilities)

Moody‟s and Standard and Poor‟s provided some key variables in their rating processes comprising: Asset-liability ratios; Coverage ratios (cash flows or EBIT relative to debt service payments); Business prospects (growth of cash flows

or return on assets); Dividends and other payouts; Business risks (volatility of cash flows or value of assets); Asset liquidity and recovery ratios in default

Moody‟s report (2001) suggested a quantitative credit assessment model for evaluating upper middle market companies in Japan called RiskCalc This model employed seven factors, which felt within the following broad categories: profitability, leverage/gearing, liquidity, debt coverage, interest coverage, size, and activity to examine their relations to the default probability of companies

Table 2 Input ratios of RiskCalc™ for Japanese private company models

Profitability Ordinary profit over total assets

Leverage Liabilities over total assets

Liquidity Cash over current asset

Debt coverage Retained earnings over current liabilities Interest Coverage Gross profit over total interest expense

Activity Total inventories over sales

Source: Moody’s report: RiskCalc for Japanese private companies, 2001

Hayden (2003) pointed out the need of the following extended categories of financial ratios as possible predictors of the default event: leverage, debt coverage, liquidity, activity, productivity, turnover, profitability, size, and growth Engelmann and Rauhmeier (2010) has extended Hayden‟s work with 14 financial ratios were chosen and divided into nine risk categories including leverage, liquidity, productivity, turnover, activity, profitability, firm size, growth rates and leverage development While Moody‟s work only employed one ratio for each category, that

of Engelmann and Rauhmeier required more For example, to present Leverage factor, three ratios were used, which were Total liabilities over Total asset, Equity over Total asset and Bank debt over Total Asset Similarly, for Liquidity factor, the two authors make a division between Short-term debt and Total asset, then between Current asset and current liability In case of Profitability, division was made between EBIT and Total Asset then between Ordinary Business Income and Total Asset while for Activity factor, similar calculation were done for Account receivable and Net sales or Account Payable and Net sales Only to determine firm‟s size and growth were just one figure employed, which were Total asset and Current net sales over previous net sale respectively Each ratio above carried different meaning of enterprise‟s operating performance For example, the division between Net Sale and Total asset reflected earnings per total assets and enabled a comparison of the profitability of firms in different size A comparison between current to past levels made for Net sale and Total liability was believed to be useful for default events prediction