The Loan Covenant Channel: How Bank Health Transmits to the Real Economy

Abstract

We document the importance of covenant violations in transmitting bank health to nonfinancial firms. Roughly one-third of loans in our supervisory data breach a covenant during the 2008 to 2009 period, allowing lenders to force a renegotiation of loan terms or to accelerate repayment of otherwise long-term credit. Lenders in worse health are more likely to force a reduction in the loan commitment following a violation. The reduction in credit to borrowers who violate a covenant can account for the majority of the cross-sectional variation in credit supply during the 2008 to 2009 crisis.