Covenants and Collateral as Incentives to Monitor
Raghuram G. Rajan
University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)
University of Minnesota - Twin Cities - Carlson School of Management
Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do so. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make the effective maturity of a loan contingent on monitoring by the lender. The ability to secure a loan makes the effective priority of the loan contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in bank lending.
JEL Classification: G21
Date posted: September 19, 1994