Losing Control? The 20-Year Decline in Loan Covenant Restrictions
54 Pages Posted: 27 Nov 2018 Last revised: 20 Nov 2019
Date Written: November 18, 2019
This paper finds that lenders today rely on less restrictive financial covenants compared to 20 years ago, resulting in a nearly 70% drop in the annual proportion of U.S. public firms reporting a covenant violation. To study this decline, we develop a simple model of optimal covenant design that balances the costs associated with violations that occur when a firm is not in danger of financial distress (“false positives”) with the costs of failing to detect a borrower in danger of financial distress (“false negatives”). We present evidence that lenders have eased the restrictiveness of covenants in ways that greatly reduce the ratio of false positives relative to false negatives, including by switching to covenant packages with higher signal-to-noise ratios.
Keywords: loan covenants, covenant violations, creditor control, corporate governance
JEL Classification: G21, G32, G34
Suggested Citation: Suggested Citation