On Financial Covenants as Incentives to Borrowers

Abstract

This article focuses on financial maintenance covenants as incentive instruments for borrowers under both moral hazard and adverse selection. We explain why maintenance covenants are conditioned on public information. We examine the effect of the firm's incentive to risk-shift, debt amount, and renegotiation costs on optimal covenants. In an extension of the model, we find that a reduction in financial signal quality 1) moves the equilibrium from pooling to separating, to no covenants at all, and 2) has a non-monotone effect on covenant strictness. We also allow for uncertainty in macroeconomic conditions and characterize state contingent covenants within our framework.