Regulatory monitoring as a substitute for debt covenants☆

Abstract

Both debt covenants and federal monitoring restrict banks’ discretion. We examine whether banks substituted monitoring for covenants by investigating debt issues of 105 banks between 1979 and 1984, a period when monitoring increased. We hypothesize that bank shareholders take advantage of the intersection between debt covenants and regulatory monitoring to reduce agency costs. We find a decrease in the number of debt issues containing such covenants and the total debt subject to such covenants. We find no such decrease during the same period for a sample of non-banking firms, or for banks during a subsequent period.