Natural Disasters, Covenant Violations, and Bank Loans

Abstract

We examine the propagation of corporate borrowers’ natural disaster risks to their lenders. Using covenant violations caused by natural disasters as a channel that transmits borrowers’ natural disaster risks to lenders, we investigate how lenders respond to these violations. We first find that disaster impacted firms are more likely to violate covenants and experience decreases in financing activities. This leads lenders to impose stricter loan and covenant terms to disaster impacted firms, reflecting their heightened concerns about the natural disaster risks of borrowers. More importantly, we observe different responses from lenders to covenant violations caused by natural disasters depending on firms’ capabilities to access funds. We find that, when firms have higher capabilities, lenders show leniency toward these violations by mitigating loan margin increments after disaster impacts. On the contrary, they restrict funding to firms that do not meet these criteria. These lenders’ heterogeneous responses to the natural disaster risks of borrowers align with the subsequent business performances of the affected borrowers, indicating that lenders accurately assess natural disaster risks and covenant violations of firms. Overall, our findings suggest that lenders do not systematically penalize every climate change risk of borrowers but consider other factors affecting firm recovery.

Keywords: natural disasters, covenant violations, bank loans

JEL Classification: G21, G30, G32