Time Inconsistency and Financial Covenants

Abstract

Financial covenants influence firm behavior by state-contingently allocating decision rights. I develop a quantitative model with long-term debt where shareholders cannot commit to not dilute existing lenders with new debt issuances and risky investments. Lenders intervene upon covenant violations but cannot commit either to any debt restructuring plan ex ante. Counterfactual experiments suggest that financial covenants significantly reduce default probability and increase firm value. Covenants become highly valuable when productivity reverts after a long credit boom. There exists a hump-shaped relation between covenant tightness and firm value, with the average calibration in data close to the optimum.