Financial maintenance covenants in bank loans

Redouane Elkamhi (), Latchezar Popov and Raunaq S. Pungaliya ()
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Redouane Elkamhi: University of Toronto
Raunaq S. Pungaliya: Sungkyunkwan University

Economic Theory, 2023, vol. 76, issue 4, No 6, 1197-1255

Abstract: Abstract We develop a model of financial maintenance covenants under moral hazard, adverse selection, and informative signals of varying quality. We explain how public signals can improve the outcome for lenders and borrowers by reducing inefficient risk-taking (in both the pooling and separating equilibrium), and by shielding good firms from the actions of bad (separating) ones. We find that a reduction in signal quality moves the equilibrium from pooling to separating, to no covenants at all. We also demonstrate that signal quality has a non-monotone effect on covenant strictness. In an extension, we model manipulation of the accounting signal and show that it is isomorphic to a particular kind of noise.

Keywords: Bank loans; Covenants; Adverse selection equilibrium; Corporate governance (search for similar items in EconPapers)
JEL-codes: G32 G34 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1007/s00199-023-01490-4

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