Benign Neglect of Covenant Violations: Blissful Banking or Ignorant Monitoring?

Abstract

Theoretically, bank's loan monitoring activity hinges critically on its capitalization. To proxy for monitoring intensity, we use changes in borrowers' investment following loan covenant violations, when creditors can intervene in the governance of the firm. Exploiting granular bank-firm relationships observed in the syndicated loan market, we document substantial heterogeneity in monitoring across banks and through time. Better capitalized banks are more lenient monitors that intervene less with covenant violators. Importantly, this hands-off approach is associated with improved borrowers' performance. Beyond enhancing financial resilience, regulation that requires banks to hold more capital may thus also mitigate the tightening of credit terms when firms experience shocks.

Bondholder representatives on bank boards: A device for market discipline

“…The result ofAshcraft (2008) is in line with the theoretical literature showing that debt covenants can reduce default risk ex-ante by better aligning the interests of shareholders and managers with those of bondholders and by prohibiting actions that might increase the likelihood of distress(Colonnello et al, 2021;Holmström & Myerson, 1983;Smith & Warner, 1979). 3 Banks have to meet regulatory requirements in terms of capital.…”

Entrepreneurial financing: how global and regional export intentions affect financial and non-financial choices for small and midsized enterprises in low-income countries

“…Greenwald et al (2020) showed that firms rely on credit lines more than other types of credit after a fall in cash flow. However, if the bank or the firm show financial deterioration, the agreement can be jeopardised (Acharya et al, 2020;Colonnello et al, 2021).…”

“…However, if the bank or the firm show financial deterioration, the agreement can be jeopardised (Acharya et al. , 2020; Colonnello et al. , 2021).…”