The equilibrium price of loan covenant

The equilibrium price of loan covenant

2 PM - room 3G, Department of Economics and Management

Speaker: Flavio Bazzana, University of Trento

Abstract

Despite the growing importance of covenants and the increasing frequency with which covenants are included in debt contracts, the role of covenant strength in bank loans has not received much attention in the theoretical literature to date.
The goal of our paper is to provide a theoretical model within a standard credit risk framework that can be used to compute the optimal covenant strength for bank loans. In our model, a risk-neutral bank finances a firm that invests in a two period, two-state project. We find that the expected loss rate (and, accordingly, the interest rate) decreases if a covenant is used in the contract. In the most general formulation of our model, which is composed of a loan with a covenant on the total assets of the firm and asymmetric information, we find that the expected loss rate depends on two sources of risk: (i) investment project risk and (ii) the risk from the entrepreneur’s behaviour. In this case, the expected loss rate for the financed quote values is minimal for a given covenant strength.

JEL classification codes: G21, G28
Keywords: covenants, credit risk, loans pricing