Discretion and Systemic Risk in Credit Line Contracts: Theory and Evidence

We provide evidence that credit lines are a contingent source of liquidity and, therefore, an imperfect substitute for cash holdings. We consider the role of credit line covenants in rationing scarce liquidity in the banking sector. While firms use credit lines as insurance against liquidity shocks, banks use covenants to ration scarce liquidity during systemic liquidity shocks. When liquidity is abundant banks preserve firm’s access to credit following a covenant violation because of reputation concerns. Consistent with the predictions of our model, covenant violations outside the recent crisis did not lead to a higher likelihood of credit-line revocations. During the credit crisis period the revocation probability for firms violating a covenant was higher by seven percent relative to non-violating firms. Banks with high credit-line reputation revoked less outside of the crisis but during the crisis they revoked similarly to banks with low reputation due to liquidity concerns.