The Supply-Side Determinants of Loan Contract Strictness

62 Pages Posted: 13 Dec 2011

See all articles by Justin Murfin

Justin Murfin

Cornell SC Johnson College of Business

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Date Written: November 7, 2011

Abstract

Using a novel measure of contract strictness based on the ex-ante probability of a covenant violation, I investigate how lender-specific shocks impact the strictness of the loan contract that a borrower receives. Exploiting between-bank variation in recent portfolio performance, I find evidence that banks write tighter contracts than their peers after suffering payment defaults to their own loan portfolios, even when defaulting borrowers are in different industries and geographic regions than the current borrower. The effects of recent defaults persist after controlling for bank capitalization, although compression in bank equity is also strongly associated with tighter contracts. The evidence is most consistent with lenders using their default experience to make inference about their screening ability and adjusting contracts accordingly. Finally, contract tightening is most pronounced for borrowers who are dependent on a relatively small circle of lenders, with a one standard deviation increase in lender defaults implying covenant tightening nearly equivalent to that of a two-notch downgrade in the borrower's own credit rating.

Suggested Citation

Murfin, Justin, The Supply-Side Determinants of Loan Contract Strictness (November 7, 2011). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1971400

Justin Murfin (Contact Author)

Cornell SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

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