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

52 Pages Posted: 27 Nov 2018 Last revised: 10 Dec 2021

See all articles by Thomas P. Griffin

Thomas P. Griffin

Villanova University - Department of Finance & Real Estate

Greg Nini

Drexel University - Department of Finance

David C. Smith

University of Virginia - McIntire School of Commerce

Date Written: December 8, 2021

Abstract

The annual proportion of U.S. public firms that report a financial covenant violation fell nearly 70% between 1997 and 2016. To understand this trend, we develop a model of covenant design that shows the optimal threshold varies with covenants’ ability to discriminate between distressed and non-distressed borrowers and with the relative costs associated with screening incorrectly. We document a steady improvement in covenants’ ability to identify distressed borrowers. However, the dramatic fall in violations is best attributed to an increased willingness to forego early detection of marginally distressed borrowers in exchange for fewer inconsequential violations, particularly since 2008-09.

Keywords: financial contracting, control rights, financial covenants, credit agreements

JEL Classification: G21, G23, G32, G34

Suggested Citation

Griffin, Thomas and Nini, Gregory and Smith, David Carl, Losing Control? The 20-Year Decline in Loan Covenant Violations (December 8, 2021). Available at SSRN: https://ssrn.com/abstract=3277570 or http://dx.doi.org/10.2139/ssrn.3277570

Thomas Griffin

Villanova University - Department of Finance & Real Estate ( 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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