Bank Relationship, Covenant Enforcement, and Creditor Control

Abstract

This paper investigates how banks utilize soft information to provide contractual flexibility in loan covenant enforcement. We find that relationship lenders are significantly less likely to enforce material covenant violations when borrowers breach financial covenants. In addition, covenant-breaching borrowers with such relationships are less likely to experience raises in loan interest rates, to reduce subsequent financing and investment activities, and to file for bankruptcy. The mitigation of information asymmetry along relationship lending, rather than alternative explanations, is the underlying mechanism. Our findings imply that soft information accumulated during lending relationship is vital for banks to provide contractual flexibility.