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Definition: Covenant

It is a contractual restriction placed by the lender on the borrower.  These restrictions are set such that the borrower’s future performance and conduct follow certain minimum standards. If these covenants are not set, the borrower may not utilize the money for the required purpose or may misuse the money thereby increasing the agency cost.

Higher the borrower’s financial risk- more the restrictions. I.e. the complexity and severity of covenants increases with the borrower’s financial risk. If the borrower has a good reputation and a strong financial background, the covenants attached are less severe. It acts like a “RISK-MANAGEMENT”strategy.

Covenants may also act as a mechanism to solve the borrower-lender conflicts. If the borrower violates the covenants, the lender can accelerate the maturity of the contract. Covenants may also be placed for the benefit of the borrower such that the lender does not do anything detrimental to the interest of the borrower.

Example of covenant: If a borrower has taken a working capital loan, there may be a covenant placed by the lender restricting him from taking further working capital loan from another borrower.

Hence, this concludes the definition of Covenant along with its overview.

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