Losing Control? The 20-Year Decline in Loan Covenant Restrictions

54 Pages Posted: 27 Nov 2018 Last revised: 20 Nov 2019

See all articles by Thomas P. Griffin

Thomas P. Griffin

Villanova University - Department of Finance

Greg Nini

Drexel University - Department of Finance

David C. Smith

University of Virginia - McIntire School of Commerce

Date Written: November 18, 2019

Abstract

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

Griffin, Thomas and Nini, Gregory and Smith, David Carl, Losing Control? The 20-Year Decline in Loan Covenant Restrictions (November 18, 2019). Available at SSRN: https://ssrn.com/abstract=3277570 or http://dx.doi.org/10.2139/ssrn.3277570

Thomas Griffin

Villanova University - Department of Finance ( email )

United States

HOME PAGE: http://www.thomaspgriffin.com

Gregory Nini

Drexel University - Department of Finance ( email )

LeBow College of Business
Philadelphia, PA 19104
United States

David Carl Smith (Contact Author)

University of Virginia - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States

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