Bank Skin in the Game and Loan Contract Design: Evidence from Covenant-Lite Loans

Abstract

In a model of dual agency problems where borrower-lenders and bank-nonbank incentives may conflict, we predict a hockey stick relation between bank skin in the game and covenant tightness. As bank participation declines covenant tightness increases until reaching a low threshold, at which point the relation sharply reverses and covenant protection is removed with a commensurate increase in spread. We find support for the hockey stick relation with banks stake in covenant-lite loans averaging 8% (0% median). We also find that covenant-lite loans are more likely when borrower moral hazard is less severe and when bank relationship rents are high.

Keywords: Covenants, Debt contracting, Syndicated Loans, Bank loans, Agency Costs

JEL Classification: D86, G21, G23, G32, L14, M41