Financial shocks to lenders and the composition of financial covenants

Christensen, Hans B.; Macciocchi, Daniele; Morris, Arthur; Nikolaev, Valeri V.

doi:10.1016/j.jacceco.2021.101426

Cited by 18 publications

(5 citation statements)

References 68 publications

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“…as firms maintain an adequate amount of equity capital, capital covenants are not breached; thus, they are less useful to debt holders for timely detection of credit quality deterioration and are less effective in facilitating debt holders' intervention in firm's risk-taking behavior or CEOs' shirking when necessary. Consistent with the above discussions,Christensen et al (2022) find that performance covenants are more useful in influencing borrowers' investment decisions than capital covenants. Thus, we expect CEO contractual protection to affect debt holders' use of performance covenants but not necessarily the use of capital covenants.…”

supporting

confidence: 80%

“…Consistent with the above discussions, Christensen et al. (2022) find that performance covenants are more useful in influencing borrowers’ investment decisions than capital covenants. Thus, we expect CEO contractual protection to affect debt holders’ use of performance covenants but not necessarily the use of capital covenants.…”

Section: Main Analyses—tests Of H1mentioning

confidence: 66%

“…Capital covenants such as the maximum debt‐to‐equity ratio, on the other hand, are based on balance sheet numbers. They protect debt holders’ interest by limiting the amount of debt the firm can have, but they are less useful in detecting the deterioration of credit quality and in facilitating debt holders’ intervention in a timely manner (Christensen et al., 2022). Since our predictions pertain to debt holders’ monitoring over managers’ actions, we expect CEO contractual protection to affect the number of performance covenants in loan contracts but not necessarily the number of capital covenants.…”

Section: Introductionmentioning

confidence: 99%

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CEO contractual protection and debt contracting

Cheng

Chen

et al. 2022

Business Fin & Account

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Chief Executive Officer (CEO) contractual protection, in the forms of CEO employment agreements and CEO severance pay agreements, is prevalent among S&P 1500 firms. While prior research has examined the impact of these agreements on corporate decisions from shareholders’ perspective, there is little research on the impact from debt holders’ perspective. We find that, compared with other loans, loans issued by firms with CEO contractual protection on average contain more performance covenants and performance‐pricing provisions. This effect increases with CEOs’ risk‐taking incentives and opportunities, but it decreases with CEOs’ preference for and opportunity of enjoying a quiet life. Furthermore, for loans issued by firms with CEO contractual protection, debt holders include stricter covenants, charge a higher interest rate and use a more diffuse syndicate structure. Collectively, these results shed light on the impact of CEO contractual protection on debt contracting.

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supporting

confidence: 80%

Section: Main Analyses—tests Of H1mentioning

confidence: 66%

Section: Introductionmentioning

confidence: 99%

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CEO contractual protection and debt contracting

Cheng

Chen

et al. 2022

Business Fin & Account

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“…Similarly, we add the average covenant strictness of all loans issued by the bank in the syndicated loan market over the sixmonth period prior to a loan issuance (Avg Strictness). We do this following prior studies which find that different lenders have their own preferences related to covenant strictness (Bushman et al 2021;Christensen et al 2021;Ma et al 2022).…”

Section: Separating the Effect Of Interest Spread From Loan Covenantsmentioning

confidence: 99%

Firm innovation and covenant tightness

Novoselov

Stice

et al. 2022

Rev Account Stud

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This study explores the association between firm innovation and loan covenant strictness. We find that lenders construct stricter contracts for firms filing more patents, consistent with lenders imposing more oversight on firms when they enter the commercialization stage after having demonstrated their inventiveness. Our results hold under propensity score matching and entropy balancing, and when exploiting the American Inventors Protection Act as a shock affecting unrelated banks’ access to patent filing information. The relationship we document is stronger when the lender has more expertise and for firms with higher default risk. We demonstrate that borrowers’ patent filings are associated with more future R&D and capital investment and with a higher likelihood of their acquiring firms in the industry of their patent filings. Our results are consistent with the theoretical prediction that lenders interpret patent filings as indicative of high inventive potential that requires stricter discipline and oversight by lenders in order to be converted into actual business success, and with them designing debt contract terms accordingly.

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“…Negative experiences with borrowers affect how lenders underwrite subsequent loans. Banks respond to increased credit market risk by changing the nature of the covenants themselves (Christensen et al, 2021). During a financial shock, loan officers will impose more strict performance-based covenants surrounding profitability and firm efficiency.…”

Section: Page60 Page60mentioning

confidence: 99%

The Potential for Biases in Resolving Loan Problems

Brody¹,

Sokolowski²,

White³

2021

IJFBS

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This paper describes how behavioral biases influence the resolution of financial covenant violations. Prior literature documents that violation waivers are common; however, there is a lack of discussion on the determinants that lead loan officers to waive covenant violations. We rely on the escalation of commitment bias (or the sunk cost phenomenon) to discuss how loan officers may become attached to a selected course of action and fail to incorporate new information, increasing the likelihood of covenant waivers. We explain the implications of this bias on bank financial reports by detailing how accounting links loan quality to bank financial statements. We further draw on the psychology literature to offer potential solutions to mitigate overcommitment in the context of loan officers. Future research can examine the extent to which loan officers knowingly or unknowingly steer away from rational decision-making. This study has practical implications as users of bank financial reports, including investors, auditors, examiners, and bank managers, learn about processes and challenges on how accounting mechanics link bank loan portfolios to financial statements.

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Financial shocks to lenders and the composition of financial covenants

Cited by 18 publications

References 68 publications

CEO contractual protection and debt contracting

CEO contractual protection and debt contracting

Firm innovation and covenant tightness

The Potential for Biases in Resolving Loan Problems

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