The Supply‐Side Determinants of Loan Contract Strictness

Abstract

Using a measure of contract strictness based on the probability of a covenant violation, I investigate how lender‐specific shocks impact the strictness of the loan contract that a borrower receives. Banks write tighter contracts than their peers after suffering payment defaults to their own loan portfolios, even when defaulting borrowers are in different industries and geographic regions from the current borrower. The effects persist after controlling for bank capitalization, although bank equity compression is also associated with tighter contracts. The evidence suggests that recent defaults inform the lender's perception of its own screening ability, thereby impacting its contracting behavior.

Corporate Bond Covenants and Social Responsibility Investment

“…Since bond covenants are meant to protect creditors from corporate risk, high-risk firms are likely to be associated with more covenants (Billett et al 2007;Demiroglu and James 2010b;Murfin 2012). Taking into account together with the impact of reputation and information, we would expect high CSR investment to be negatively associated with the number of covenants.…”

“…Finally, CSR can affect the number of covenants through risk. High-risk firms are likely to be associated with more covenants (Billett et al 2007;Demiroglu and James 2010b;Murfin 2012), but better CSR performance would reduce corporate risk (Hong and Kacperczyk 2009;Waddock and Graves 1997). Taking into account all the above, we would expect high CSR investment to be negatively associated with the number of covenants.…”

“…However, to measure the restrictiveness of debt covenants, previous studies suggest that at least two different dimensions, the intensity and the tightness, should be covered (Demiroglu and James 2010b). Different to the intensity gauges, the tightness measurements gauge the initial covenant slack as the distance between the borrower's accounting numbers at the time the contract is written and what is allowable under the covenants specified (e.g., Demiroglu and James 2010b;Panyagometh et al 2013;Murfin 2012).…”

“…In this study, we follow previous studies (e.g., Bradley and Roberts 2004;Demiroglu and James 2010b;Murfin 2012) to use the count number of indicators to measure the intensity of debt covenants. The rationalization is that a contract with more covenants can bind more of the borrower's financial ratios and thus give the lender more contingent control.…”

“…Bradley and Roberts (2004), Demiroglu and James (2010b), and Murfin (2012) all use data from Dealscan database of loan pricing corporation (LPC). Dealscan provides detailed information about loan covenants and thus enable them to investigate the covenant tightness dimension.…”