Tough Love: The Effects of Debt Contract Design on Firms’ Performance

I investigate whether restrictive loan covenants disrupt or improve firms’ operating performance. Using an instrumental variables approach to address the endogenous relationship between covenant strictness and firms’ efficiency, I find that stricter loan covenants lead to an increase in profitability and firm value even when firms do not violate a covenant. Stricter covenants improve performance only in firms with managerial agency conflicts: those without large shareholder ownership, facing softer competition in their product market, or with weaker shareholder rights. The evidence suggests that by designing stringent contracts ex ante, creditors create positive externalities in poorly governed firms through managerial incentives. Received December 7, 2018; editorial decision May 31, 2019 by Editor Uday Rajan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Part II Commercial Banking, 11 Netting, Collateral, and Credit Risk Mitigation

Credit risk mitigation is the umbrella term that covers the various different ways in which an exposure can be reduced for regulatory reporting purposes. This chapter discusses the three ways of doing this: netting against an existing exposure owed by the bank to the borrower; taking (certain types of) collateral; and obtaining cover from third parties in the form of guarantees or similar contracts. Banks use a several techniques to improve their position as lenders which are simply disregarded by the regulatory system, of which the most important are probably loan covenants. No matter how restrictive the undertakings which a borrower gives a bank as to the way in which it manages its business, or the way in which it will repay its loan, this protection will not be recognized for regulatory purposes.