Financial Shocks and Corporate Investment Activity: The Role of Financial Covenants
53 Pages Posted: 5 Dec 2017 Last revised: 1 May 2019
Date Written: April 29, 2019
We examine whether economic shocks to credit institutions differentially affect the use and strictness of different accounting-based covenants in debt contracts, and whether these effects represent a channel through which shocks to lenders propagate to the real sector. To capture lender-specific shocks, we use variation in payment defaults experienced by lenders outside the borrower’s region and industry. We find that lenders respond to payment defaults by shifting towards performance-based covenants (and away from capital-based covenants), and by increasing the strictness of performance covenants. In turn, these changes in covenants constrain future investments among relationship borrowers. We also find that subsequent to contract initiation, lender-specific shocks affect corporate investment. Overall, our results suggest that credit-supply frictions influence the type and strictness of covenants in debt contracts, and that financial covenants represent a channel through which shocks to lenders are transmitted to the nonfinancial sector.
Keywords: covenants, debt contracting, financial market frictions
JEL Classification: M4, G32
Suggested Citation: Suggested Citation