Accounting Covenants in Credit Lines: Protecting Banks Against Aggregate Liquidity Shocks
60 Pages Posted: 11 Jun 2015 Last revised: 15 Oct 2019
Date Written: October 13, 2019
We propose a novel role for covenants and accounting-performance measures in credit lines. In our model, covenants protect banks against severe aggregate liquidity shocks. During aggregate liquidity shortages, banks need to ration liquidity, and credit line covenants allow banks to revoke credit lines if firms' accounting-performance measures fall below a threshold. Idiosyncratic and transitory shocks in the accounting-performance measure play an important role. First, idiosyncratic shocks introduce randomness in covenant violations that eliminates concerns of favoritism when banks ration liquidity. Second, adverse economic conditions can result in high negative expected transitory shocks and high volatility of idiosyncratic transitory shocks, which increases the likelihood of covenant violations in states of severe aggregate shocks and reduces the cost of liquidity in normal times. Implicit liquidity insurance can complement covenants, inducing banks to revoke credit lines of covenant violators only after severe aggregate shocks, not in normal times. Consistent with this revocation pattern, we find a positive association between covenant violations and credit line revocations in the crisis of 2007-2008, controlling for firm fundamentals, but not outside the crisis.
Keywords: Credit Lines, Incomplete Contracts, Accounting-Based Covenants, Aggregate Liquidity Shocks, Financial Crisis
JEL Classification: G21, M41, G28, G32
Suggested Citation: Suggested Citation