Why Do Loans Contain Covenants? Evidence from Lending Relationships

Abstract

Despite the importance of banks' role as delegated monitors, little is known about how non-price terms of loan contracts are structured to optimize information production in a lending relationship. Using a large sample of corporate loans, this paper examines the effect of relationship lending on covenant choice. Consistent with information asymmetry theories, covenant tightness is relaxed over the duration of a relationship, especially for opaque borrowers. In contrast, the effect of lending relationship intensity on the number of covenants included in a loan follows an inverted U shape. I discuss potential explanations for this finding.

Keywords: Relationships, Banking, Covenants, Information asymmetries, Monitoring incentives

JEL Classification: D82, G21, G30, G32, L14