Financial shocks to lenders and the composition of financial covenants

• Published in: Journal of accounting & economics 2022-02, Vol.73 (1), p.101426, Article 101426
• Main Authors: Christensen, Hans B., Macciocchi, Daniele, Morris, Arthur, Nikolaev, Valeri V.
• Format: Article
• Language: English
• Subjects: Accounting-based covenants; Debt contracting; Financial market shocks
• ISSN: 0165-4101; 1879-1980
• DOI: 10.1016/j.jacceco.2021.101426

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. •Lenders exhibit preferences over the use of accounting-based covenants in debt contracts.•Lenders use stricter control rights following adverse financial shocks.•Lenders shift to stricter control rights when adverse shocks convey negative information about lenders' screening ability or when the shocks deplete lenders' capital.