Covenant Violations, Loan Contracting, and Default Risk of Bank Borrowers

42 Pages Posted: 26 Jun 2013

See all articles by Anthony Saunders

Anthony Saunders

New York University - Leonard N. Stern School of Business

Sascha Steffen

Frankfurt School of Finance & Management

Felix Freudenberg

Goethe University Frankfurt - Department of Finance

Bjorn Imbierowicz

affiliation not provided to SSRN

Date Written: January 2012

Abstract

Are borrowers rewarded for repaying their loans? This paper investigates the consequences of covenant violations on subsequent loans to the same borrower using a hand-collected sample of US syndicated loans during the 1996 to 2010 period. We find that covenant violations have substantial negative effects for borrowers in subsequent loans. Our results show that the loan spread increases by 22 basis points in the loan following the violation. We also find that the new contract includes more financial covenants which are also more restrictive. Switching banks after a violation does not reduce these effects and even leads to a further increase in loan spreads. We also provide empirical evidence that borrowers who have violated covenants in the previous contract are significantly more likely to violate covenants again in the next loan. Moreover, they violate earlier compared to borrowers who have not violated covenants before. Most importantly, these borrowers also exhibit a substantially higher likelihood to default, particularly in the first 100 days after a violation. Our results suggest that there is an important role for covenants in monitoring borrowers and that covenant violations provide an early warning signal for a severe deterioration of borrower credit quality.

Suggested Citation

Saunders, Anthony and Steffen, Sascha and Freudenberg, Felix and Imbierowicz, Bjorn, Covenant Violations, Loan Contracting, and Default Risk of Bank Borrowers (January 2012). NYU Working Paper No. 2451/31417. Available at SSRN: https://ssrn.com/abstract=2284660

Anthony Saunders

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
9-190, MEC
New York, NY 10012-1126
United States
212-998-0711 (Phone)
212-995-4220 (Fax)

Sascha Steffen

Frankfurt School of Finance & Management ( email )

Adickesallee
32-34
Frankfurt, 60322
Germany
16097326929 (Phone)

HOME PAGE: http://www.sascha-steffen.de

Felix Freudenberg

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany

Bjorn Imbierowicz

affiliation not provided to SSRN

No Address Available

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