Losing Control? The 20-Year Decline in Loan Covenant Violations
52 Pages Posted: 27 Nov 2018 Last revised: 10 Dec 2021
Date Written: December 8, 2021
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: Suggested Citation