Accounting Covenants in Credit Lines: Protecting Banks Against Aggregate Liquidity Shocks
44 Pages Posted: 11 Jun 2015 Last revised: 17 Jul 2020
Date Written: July 16, 2020
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: Suggested Citation