Financial Shocks and Corporate Investment Activity:The Role of Financial Covenants

We examine whether economic shocks to credit institutions differentially affect the use and strictness of different accounting-based covenants in debt contracts, and whether these effects represent a channel through which shocks to lenders propagate to the real sector. To capture lender-specific shocks, we use variation in payment defaults experienced by lenders outside the borrower’s region and industry. We find that lenders respond to payment defaults by shifting towards performance-based covenants (and away from capital-based covenants), and by increasing the strictness of performance covenants. In turn, these changes in covenants constrain future investments among relationship borrowers. We also find that subsequent to contract initiation, lender-specific shocks affect corporate investment. Overall, our results suggest that credit-supply frictions influence the type and strictness of covenants in debt contracts, and that financial covenants represent a channel through which shocks to lenders are transmitted to the nonfinancial sector.