VGSF Finance Research Seminar
We discuss a novel role for covenants and accounting performance measures in credit lines. During aggregate liquidity shortages, banks need to ration liquidity. Absent complete contracts, credit line covenants that allow revocations protects banks against severe aggregate liquidity shocks where the number of firms that draw on their credit line exceed banks available liquidity. The optimal implicit contract implies that banks revoke credit lines of covenant violators only after an aggregate shock, not in normal times. Noise in accounting performance measures introduces randomness in covenant violations, which substitutes for bank discretion when banks have to ration liquidity among homogeneous firms after an aggregate shock. Consistent with the prediction of our model, we find a positive association between covenant violations and credit line revocations in the crisis of 2007 and 2008, controlling for firm fundamentals, but not outside the crisis.
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