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Financial maintenance covenants in bank loans

Author

Listed:
  • Redouane Elkamhi

    (University of Toronto)

  • Latchezar Popov

    (Texas Tech University)

  • Raunaq S. Pungaliya

    (Sungkyunkwan University)

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.

Suggested Citation

  • Redouane Elkamhi & Latchezar Popov & Raunaq S. Pungaliya, 2023. "Financial maintenance covenants in bank loans," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 76(4), pages 1197-1255, November.
    • Handle: RePEc:spr:joecth:v:76:y:2023:i:4:d:10.1007_s00199-023-01490-4
    DOI: 10.1007/s00199-023-01490-4
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    More about this item

    Keywords

    Bank loans; Covenants; Adverse selection equilibrium; Corporate governance;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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