Debt Covenants and Risk-Taking

Abstract

We examine a comprehensive set of debt contracts that have different types of covenants and performance pricing provisions to determine how these contractual features relate to borrowers’ risk-taking decisions. We predict and find that the relation between covenants and operating risk depends on the type of contractual provision: covenants that restrict the amount of resources invested (capital covenants) have a positive relation with borrowers’ operating risk, while covenants related to the outcome of these investments (performance covenants) and performance pricing provisions both have a negative relation with borrowers’ operating risk. Moreover, these relations are reversed for financial risk, suggesting that lenders face tradeoffs in managing their exposure to different facets of borrowers’ risk-taking. Our estimation strategy aims at distinguishing between adverse selection and moral hazard explanations and indicates that different types of covenants address different agency conflicts, which helps explain the variety of covenants used in debt contracts. Our results are also consistent with concerns that recent banking regulations may actually increase rather than curtail risk-taking by these institutions.