Losing Control? The Two-Decade Decline in Loan Covenant Violations
Journal of Finance, Forthcoming
69 Pages Posted: 27 Nov 2018 Last revised: 30 Jul 2024
Date Written: July 30, 2024
Abstract
The annual proportion of U.S. public firms that reported a financial covenant violation fell roughly 70% between 1997 and 2019. To understand this trend, we develop an estimable model of covenant design that depends on the ability to differentiate between distressed and non-distressed borrowers and the relative costs associated with screening incorrectly. We find the drop in violations is best explained by an increased willingness to forego early detection of distressed borrowers in exchange for fewer inconsequential violations, which we attribute mostly to a shift in the composition of public borrowers and partly to heightened investor sentiment during the 2010s.
Keywords: financial contracting, control rights, financial covenants, credit agreements
JEL Classification: G21, G23, G32, G34
Suggested Citation: Suggested Citation