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

44 Pages Posted: 11 Jun 2015 Last revised: 17 Jul 2020

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

University of Kansas - School of Business

Date Written: July 16, 2020

Abstract

We propose a novel role for accounting covenants in credit lines. Accounting covenants protect banks against severe aggregate liquidity shocks and firms against losing liquidity at will of banks. During aggregate liquidity shocks, banks need to ration liquidity, and covenants allow banks to revoke credit lines if firms' accounting-performance measures fall below a threshold. Thereby, accounting covenants constrain banks' discretion in rationing liquidity in a systematic way. Transitory shocks to accounting-performance measures play an important role. First, the effect of adverse economic conditions on transitory shocks can increase the likelihood of covenant violations in states of severe aggregate shocks and reduce the cost of liquidity in normal times. Second, idiosyncratic transitory shocks introduce randomness in covenant violations that limits bank discretion when banks have to ration liquidity. Implicit liquidity insurance complements accounting covenants, inducing banks not to revoke credit lines after covenant violations in normal times. Thus, covenants in normal times appear tight.

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 (July 16, 2020). 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 the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Angel Tengulov

University of Kansas - School of Business ( email )

1654 Naismith Dr
Lawrence, KS 66045
United States

HOME PAGE: http://www.angeltengulov.com/

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