Financial Shocks and Corporate Investment Activity: The Role of Financial Covenants
46 Pages Posted: 5 Dec 2017 Last revised: 4 May 2018
Date Written: March 1, 2018
We examine whether shocks to credit institutions affect the choice among accounting-based covenants in private debt contracts and whether this effect represents a channel through which shocks to lenders affect corporate investment. We exploit plausibly exogenous variation in the payment defaults experienced by lenders outside the borrower’s region and industry. We find that financial institutions respond to payment default shocks by shifting the composition of financial covenants towards performance-based covenants (away from capital-based covenants) in newly signed credit agreements. In turn, the increased reliance on performance covenants constrains borrowers’ future investments, particularly among relationship-based borrowers. We also find that lender-specific shocks after a contract is in place affect investments, and that this effect varies depending on the composition of the covenants in place. Overall, our results are consistent with financial covenants being a channel through which idiosyncratic shocks to lenders propagate to the real sector.
Keywords: Covenants, debt contracting, financial market frictions
JEL Classification: M4, G32
Suggested Citation: Suggested Citation