The Loan Covenant Channel: How Bank Health Transmits to the Real Economy
57 Pages Posted: 2 Oct 2017
Date Written: September 2017
We document the importance of covenant violations in transmitting bank health to nonfinancial firms using a new supervisory data set of bank loans. More than one-third of loans in our data breach a covenant during the 2008-09 period, providing lenders the opportunity to force a renegotiation of loan terms or to accelerate repayment of otherwise long-term credit. Lenders in worse health are less likely to grant a waiver and more likely to force a reduction in the loan commitment following a violation. Quantitatively, the reduction in credit to borrowers with long-term credit but who violate a covenant accounts for an 11% decline in the volume of loans and commitments outstanding during the 2008-09 crisis, a similar magnitude to the total contraction in credit during that period. We conclude that the transmission of bank health to nonfinancial firms occurs largely through the loan covenant channel.
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