Accounting Covenants in Credit Lines: Protecting Banks Against Aggregate Liquidity Shocks

60 Pages Posted: 11 Jun 2015 Last revised: 15 Oct 2019

See all articles by Maria Chaderina

Maria Chaderina

University of Oregon - Lundquist College of Business

Christian Laux

Vienna University of Economics and Business; Vienna Graduate School of Finance (VGSF); European Corporate Governance Institute (ECGI)

Angel Tengulov

Vanderbilt University - Owen Graduate School of Management

Date Written: October 13, 2019

Abstract

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

Chaderina, Maria and Laux, Christian and Tengulov, Angel, Accounting Covenants in Credit Lines: Protecting Banks Against Aggregate Liquidity Shocks (October 13, 2019). Available at SSRN: https://ssrn.com/abstract=2617223 or http://dx.doi.org/10.2139/ssrn.2617223

Maria Chaderina (Contact Author)

University of Oregon - Lundquist College of Business ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States

Christian Laux

Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien 1020
Austria

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Angel Tengulov

Vanderbilt University - Owen Graduate School of Management ( email )

401 21st Avenue South
Nashville, TN 37203
United States

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