Signaling through Dynamic Thresholds in Financial Covenants
48 Pages Posted: 23 Jan 2012 Last revised: 19 Dec 2019
Date Written: December 17, 2018
Among loan contracts with covenants originated during 1996-2012, 35% have financial covenant thresholds that automatically tighten following a predetermined schedule. Firms accepting dynamic covenant thresholds improve creditworthiness but are more likely to violate covenants relative to matched control firms. In the event of a covenant violation, these firms are less likely to receive a waiver, more likely to pay higher waiver fees, experience greater investment cuts, and are more likely to switch lead lenders. Overall, our findings suggest that signaling through dynamic thresholds in covenants on average is credible but costly to borrowers if they fail to deliver the performance as signaled.
Keywords: loan covenant design, consequences of signaling, creditor control, information asymmetry
JEL Classification: G14, G21, G32, G34, M41
Suggested Citation: Suggested Citation