Covenants and Collateral as Incentives to Monitor

JOURNAL OF FINANCE, Vol. 50 No. 4, September 1995

Posted: 13 Oct 1995  

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

Andrew Winton

University of Minnesota - Twin Cities - Carlson School of Management

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Abstract

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentive to engage in costly monitoring. Thus loan contracts must be structured so as to enhance this incentive. Short-term debt gives the lender the power to force renegotiation or liquidation when the debt matures, but this ability is not contingent on monitoring. By contrast, covenants make the loan's effective maturity, and the ability to collateralize makes the loan's effective priority, 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 institutional lending.

JEL Classification: G21 and G32

Suggested Citation

Rajan, Raghuram G. and Winton, Andrew, Covenants and Collateral as Incentives to Monitor. JOURNAL OF FINANCE, Vol. 50 No. 4, September 1995. Available at SSRN: https://ssrn.com/abstract=6804

Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

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Chicago, IL 60637
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773-702-4437 (Phone)
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International Monetary Fund (IMF) ( email )

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National Bureau of Economic Research (NBER)

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Andrew Winton (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

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Department of Finance
Minneapolis, MN 55455
United States
612-624-0589 (Phone)
612-626-1335 (Fax)

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