Financial Shocks to Lenders and the Composition of Financial Covenants
46 Pages Posted: 5 Dec 2017 Last revised: 13 Apr 2020
Date Written: November 29, 2017
We show that financial shocks to lenders affect the composition of covenants in new debt contracts in a way that cannot be explained by borrower fundamentals. Using two distinct measures of lender-specific shocks — defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies — we show that lenders respond to financial shocks by increasing the use and strictness of performance-based and negative covenants, while reducing the use of capital covenants. We investigate two possible channels for these effects, specifically, the capital channel (lenders are concerned about capital depletion) and the learning channel (defaults carry information about lenders’ screening ability), and find evidence in support of both. Overall, our results indicate that lenders’ preferences influence the use of accounting information in debt contracts.
Keywords: covenants, debt contracting, financial market frictions
JEL Classification: M4, G32
Suggested Citation: Suggested Citation