Lender Capital Adequacy and Financial Covenant Strictness
43 Pages Posted: 11 Sep 2018
Date Written: August 29, 2018
Because financial covenant violation by a borrower may necessitate accounting by the lender that lowers reported regulatory capital, we examine whether lender capital adequacy affects the strictness of financial covenants included in its loan contracts. We provide evidence that lenders with lower regulatory capital issue loans with lower financial covenant strictness, consistent with lenders viewing Type I errors (i.e., spurious technical defaults) as being costlier when regulatory capital is low. Consistent with lenders loosening covenants that are more likely to lead to Type I errors, we find that this association is concentrated in performance covenants, as opposed to capital covenants. We also find that lenders with lower capital adequacy shorten their loan maturities and reduce their loan amounts, consistent with a trade-off between financial covenant strictness and other contract parameters.
Keywords: financial covenants, covenant violations, Tier 1 capital
JEL Classification: G21, M40, M41
Suggested Citation: Suggested Citation