Financial Shocks to Lenders and the Composition of Financial Covenants
57 Pages Posted: 5 Dec 2017 Last revised: 10 Jun 2021
Date Written: November 29, 2017
We provide evidence that financial shocks to lenders influence the composition of financial covenants in debt contracts. Using two distinct measures of lender-specific shocks—defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the number and strictness of performance-based but not of capital-based covenants in debt contracts. We examine two possible channels for this result. We find evidence consistent with lenders using stricter control rights because of concerns about capital depletion (a capital channel) and because of new information about lenders’ own screening ability (a learning channel). Our results indicate that lender preferences influence how accounting information is used in debt contracts.
Keywords: accounting-based covenants, debt contracting, financial market frictions
JEL Classification: M4, G32
Suggested Citation: Suggested Citation