Losing Control: The 20-Year Decline in Loan Covenant Restrictions

Abstract

We find that lenders today rely on less restrictive financial covenants than 20 years ago, resulting in a nearly 70% drop in the annual proportion of U.S. public firms reporting a loan covenant violation. To study this decline, we develop a simple model of optimal covenant design that balances the costs associated with violations that occur when a firm is not in danger of financial distress (“false positives”) with the costs of failing to detect a borrower in danger of financial distress (“false negatives”). Our evidence suggests that lenders have eased the restrictiveness of covenants in ways that greatly reduce the ratio of false positives relative to false negatives, including by switching to covenant packages with higher signal-to-noise ratios.