Banks develop expertise from their prior lending experience in monitoring borrowers’ financial activities in order to mitigate conflicts of interests between managers and creditors arising from asymmetric information. In loan contracts, covenants have classically been viewed as a method of controlling agency problems by restricting managerial behavior. Covenants can align the interests of the contracting parties’ ex ante and serve as “trip wires” and reallocate decision rights ex post.
Financial contracting models suggest both lenders and the borrowers will consider their own costs and benefits when setting contracts. However, research to date generally provides evidence that covenant design (intensity and tightness) is associated with the level of information asymmetry or agency risks, and thus they are determined based on various borrower characteristics. Less is known about the supply-side or lender-based determinants of debt covenants, which may be due in part to data limitations. A notable exception is Murfin (2012), who provides evidence that lenders increase the strictness of the financial covenants included in their debt contracts after suffering payment defaults in their own loan portfolios, holding borrowing credit quality constant. While prior studies investigate how borrowers’ management and individual loan officers can influence debt financing terms, in this study we extend the literature on the supply-side determinants of debt covenants included in loan agreements. Specifically, we empirically investigate how banks’ preference for covenants influences the future loan contracts they design as well as factors that influence the reliance of banks on their “covenant style.”
Including covenants in debt contracts is costly to lenders because they are required to expend time and effort to monitor covenants over the maturity of a loan and to renegotiate contracts after a covenant is violated. Furthermore, debt covenants are frequently renegotiated, even in the absence of any covenant violation. Beyond covenants, lenders have other tools at their disposal, such as interest spread, the requirement of collateral, and loan maturity to use when designing contracts. Different lenders may have different preferences or abilities for using covenants as a tool for screening and monitoring based on their business strategy, organizational structure, and staff composition. If some banks believe that they possess expertise in negotiating, monitoring, and enforcing certain covenants, they may prefer to include these covenants in debt contracts more frequently than other banks. In other words, the net benefits of including financial covenants are higher for some banks compared to others, and thus these banks will include more covenants in their loan contracts.
Additionally, banks may develop expertise over time related to covenant use because of the sheer number of loans that they have issued in the past which have included covenants. For example, banks may learn how to efficiently perform due diligence related to determining appropriate covenant ratio levels, given borrower characteristics. Extensive experience with a certain covenant may also allow banks to develop expertise in deciding how to respond to specific types of debt covenant violations, with covenant-specific expertise allowing a bank to quickly and efficiently renegotiate a loan contract after a covenant violation. These arguments suggest that banks may have a general preference for financial covenant use, related to their cost-benefit analysis of using different loan terms when designing contracts, and this preference may affect future contract design from the supply (lender) side, controlling for borrower characteristics. In summary, over time we argue that experience and preferences may give rise to a lender-specific debt contracting “style.”
To analyze the effect of banks’ “covenant style” on the design of future debt contracts we use a sample of private loans and construct an annual measure of a lead bank’s covenant style. We find that, controlling for borrower characteristics, the covenants included in the recent loans of a lead bank have predictive power for the covenants that will be included in subsequent loan contracts and that this effect persists for at least three years. We argue that this covenant style is related to lead banks’ expertise in negotiating, monitoring, and enforcing covenants, and it is a direct consequence of banks attempting to minimize their costs related to debt contract design.
In order to isolate the effect of supply from demand and rule out the alternative explanation that the effect is driven by the matching between certain bank and certain clients, we include firm and firm-year fixed effects in our regressions. Empirically, we use loans issued to a borrower from other different banks as the control group, which produces a strong identification strategy and controls for unobservable borrower characteristics. In these tests, we show that the “style” effect still exists, providing us more confidence that what we document is coming from the supply side, and it cannot be fully explained by a systematic matching between banks and clients or by borrower characteristics.
The use of persistent “covenant style” reduces the screening, monitoring, and renegotiating costs of contracts for lenders. Providing further strength to our interpretation of our findings, we perform a series of cross-sectional tests to investigate the conditions under which the persistence of “covenant style” varies. In our first set of cross-sectional tests, we consider the effect of bank size and the presence of collateral on “covenant style.” For small banks with limited resources, the costs of contracting are highest, and they are more likely to rely on “covenant style” in order to control their costs. When collateral is provided by a borrower, reducing lenders’ downside in the event of default, a custom-tailored debt contract is less valuable, and banks will be more likely to rely on their preferred covenant style. Consistent with both of these predictions, we find that the covenant style effect is larger for small banks and in the presence of collateral.
In a second set of cross-sectional tests, we examine the persistence of covenant style for large loans and when borrowers have recently violated a debt covenant. Banks typically subject larger loans to additional monitoring and review in order to comply with credit exposure requirements imposed by regulators and/or board committees. Therefore, in case of larger loans, banks will more carefully design loan contracts and will decrease their reliance on covenant style. Additionally, when borrowers have recently experienced a covenant violation, banks will be more likely to increase their level of due diligence before the loan issuance and will be more likely to custom-tailor a contract for a borrower, decreasing reliance on covenant style in setting contracts. In these cases, the benefits of efficiency are offset by the downside costs of inadequately controlling for a borrower’s risk. We find evidence consistent with both of these predictions. Together, these cross-sectional tests add to the plausibility of our assertion that banks have a preference for including certain covenants in their loan contracts, but we also find that banks rationally deviate from this preference in the presence of additional risk factors.
In further tests we attempt to examine how the preference for including financial covenants affects other contract terms. We find that banks’ preference for including financial covenants is associated with lower interest spreads, shorter loan maturities, and a lower likelihood of a collateral requirement, consistent with the notion that banks balance the costs and benefits of using different tools for designing loan contracts. We also find that covenant style is associated with an increased likelihood that a borrower will violate a debt covenant over the life of its loan. The increase in the likelihood of violation is consistent with an increase in the number of covenants leading generally to more violations, which perhaps is an unsurprising result. However, these covenant violations will trigger more debt renegotiation, and we argue that banks’ expertise in financial covenants makes them more willing and able to efficiently (i.e., at low cost) renegotiate contracts following violations.
Last, we examine how covenant style is influenced by changes in the CEO or CFO of lead arranger banks. We predict that new CEOs and CFOs will make changes to debt contracting guidelines based on their preferences and expertise, including changes that will influence debt covenant usage in contracts. Consistent with our prediction, we find that in the year after a new CEO or CFO starts their position, covenant style decreases. This result is consistent with style being, at least partially, attributable to individual manager preferences.
Our study partially fills the gap in the literature related to the supply-side determinants of debt contract terms, specifically for banks’ preference for financial covenants. Even though theory work clearly suggests that optimal contracts will reflect the preferences of both lenders and borrowers, with the notable exception of Murfin (2012), prior empirical research has primarily focused on the demand-side of debt contract design, or the various characteristics of borrowers that influence debt contract terms. Murfin (2012) finds that lenders write tighter contracts than their peers, holding borrower characteristics constant, after suffering payment default in their loan portfolios, providing some of the first empirical evidence that banks’ exhibit preferences in debt contract design that are not related to borrower characteristics. Our results are consistent with recent findings by Bushman, Gao, Martin, and Pacelli (2021) who find that individual loan officers exert more influence over covenant design than other loan contract terms, such as loan spread.
Generally, we provide evidence that some banks exhibit a preference to include financial covenants in their loan contracts, and we argue that this preference is a direct result of banks attempting to minimize their costs associated with debt contract design. Strengthening our argument, our cross-sectional tests provide evidence of several intuitive conditions that influence banks’ reliance on covenant style versus tailor-fitting debt contracts given the characteristics of borrowers. By considering the general supply side of covenants’ determinants, we complement both theoretical and empirical studies and provide a fuller picture of the covenant use. In so doing, our findings add to the understanding of the economic determinants of the structure of debt agreements, as called for in Skinner (2011).
Zhiming Ma is an Associate Professor at Peking University, Guanghua School of Management
Derrald Stice is an Associate Professor at the University of Hong Kong, HKU Business School
Chris Williams is an Associate Professor at the University of Michigan, Ross School of Business
This post is adapted from their paper, “What’s My Style? Supply-Side Determinants of Debt Covenant Inclusion”, available on SSRN.
 See e.g., Jensen and Meckling, 1976; Smith and Warner, 1979; and Smith, 1993.
 See e.g., Black, Carnes, Mosebach, and Moyer, 2004; Drucker and Puri, 2009; Costello and Wittenberg-Moerman, 2011; Bradley and Roberts, 2015; Chen, He, Ma, and Stice, 2016; Hollander and Verriest, 2016; Bonsall and Miller, 2017; Prilmeier, 2017.