| Preserving seniority, collateral and cash flow, covenants are critical in minimizing credit loss to lenders. The use (i.e., the existence and the strictness) and the subsequent violation of covenants therefore result in substantial economic impacts. This study examines what determines the use of various covenants, how to measure covenants strictness and how to model covenants violation.;We focus on the impacts of financial distress, growth potential, bargaining power and takeover risks on the use of covenants. We find that (1) loans to firms prone to financial distress and loans offered for takeover purpose tend to carry onerous and strict covenants; whereas (2) loans to firms of high growth potential, or better bargaining power, or strong anti-takeover provisions tend to carry fewer and loose covenants. The results indicate that covenants existence and covenants strictness together amount to effective tools mitigating debt agency risks and are thus used by lenders accordingly.;We construct a measure of covenant strictness based on the probability of covenants violation during loan tenor. The measure allows one to account for the potential correlation among various covenants and capture the dynamics of covenants restriction. Our approach can be directly applied to model and forecast the occurrence of covenants violation. The out-of-sample forecast accuracy of covenants violation, at one-year forecast horizon, is about 91%. |
