How do covenants help in managing credit risk?

Covenants play a crucial role in managing credit risk by imposing restrictions and obligations on borrowers that are designed to maintain their financial health. These covenants may require the borrower to adhere to certain financial ratios, such as maintaining a minimum level of liquidity or a maximum level of debt, which are indicators of their ability to meet debt obligations. By enforcing these terms, lenders can mitigate the risk associated with lending, as they are more likely to be informed about the borrower's financial status and take preemptive action if the borrower is at risk of defaulting.

This mechanism creates a structured environment that promotes accountability and financial discipline on the part of the borrower, thereby reducing the likelihood of default. If a borrower fails to comply with the covenants, it can lead to consequences such as penalties or even default, which serves as an early warning system for lenders about potential financial issues.

The other choices do not accurately capture the function of covenants in managing credit risk. For instance, tax incentives relate to fiscal policy, while increasing interest rates does not directly ensure a borrower’s financial stability. Collateral, on the other hand, serves as a form of security rather than a substitute for the financial health monitoring provided by covenants.