Lender Capital Adequacy and Financial Covenant Strictness

43 Pages Posted: 11 Sep 2018

See all articles by Peter R. Demerjian

Peter R. Demerjian

University of Washington - Michael G. Foster School of Business

Edward Owens

University of Utah - David Eccles School of Business

Matias Sokolowski

Emory University - Goizueta Business School

Date Written: August 29, 2018

Abstract

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

Demerjian, Peter R. and Owens, Edward and Sokolowski, Matias, Lender Capital Adequacy and Financial Covenant Strictness (August 29, 2018). Available at SSRN: https://ssrn.com/abstract=3240916 or http://dx.doi.org/10.2139/ssrn.3240916

Peter R. Demerjian

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

Edward Owens (Contact Author)

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States
8015815732 (Phone)

Matias Sokolowski

Emory University - Goizueta Business School ( email )

1300 Clifton Road
Atlanta, GA 30322-2722
United States

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