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Bank Skin in the Game and Loan Contract Design: Evidence from Covenant-Lite Loans

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  • Billett, Matthew T.
  • Elkamhi, Redouane
  • Popov, Latchezar
  • Pungaliya, Raunaq S.

Abstract

In a model of dual-agency problems where borrower–lender and bank–nonbank incentives may conflict, we predict a hockey stick relation between bank skin in the game and covenant tightness. As bank participation declines, covenant tightness increases until reaching a low threshold, at which point the relation sharply reverses and covenant protection is removed with a commensurate increase in spread. We find support for the hockey stick relation with bank’s stake in covenant-lite loans averaging 8% (0% median). We also find that covenant-lite loans are more likely when borrower moral hazard is less severe and when bank relationship rents are high.

Suggested Citation

  • Billett, Matthew T. & Elkamhi, Redouane & Popov, Latchezar & Pungaliya, Raunaq S., 2016. "Bank Skin in the Game and Loan Contract Design: Evidence from Covenant-Lite Loans," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 51(3), pages 839-873, June.
    • Handle: RePEc:cup:jfinqa:v:51:y:2016:i:03:p:839-873_00
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    Cited by:

    1. Sharjil M. Haque & Anya V. Kleymenova, 2023. "Private Equity and Debt Contract Enforcement: Evidence from Covenant Violations," Finance and Economics Discussion Series 2023-018, Board of Governors of the Federal Reserve System (U.S.).
    2. Mitchell Berlin & Gregory P. Nini & Edison Yu, 2017. "Concentration of Control Rights in Leveraged Loan Syndicates," Working Papers 17-22, Federal Reserve Bank of Philadelphia.
    3. Robert Prilmeier & René M. Stulz, 2019. "Securities Laws, Bank Monitoring, and the Choice Between Cov-lite Loans and Bonds for Highly Levered," NBER Working Papers 25467, National Bureau of Economic Research, Inc.
    4. Theophilus Lartey & Albert Danso, 2022. "CEO overconfidence and debt covenant violations," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 45(1), pages 162-199, March.
    5. Redouane Elkamhi & Latchezar Popov & Raunaq S. Pungaliya, 2023. "Financial maintenance covenants in bank loans," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 76(4), pages 1197-1255, November.
    6. Berlin, Mitchell & Nini, Greg & Yu, Edison G., 2020. "Concentration of control rights in leveraged loan syndicates," Journal of Financial Economics, Elsevier, vol. 137(1), pages 249-271.
    7. Lim, Jesslyn & Do, Viet & Vu, Tram, 2020. "Co-opted directors, covenant intensity, and covenant violations," Journal of Corporate Finance, Elsevier, vol. 64(C).
    8. Elkamhi, Redouane & Nozawa, Yoshio, 2022. "Fire-sale risk in the leveraged loan market," Journal of Financial Economics, Elsevier, vol. 146(3), pages 1120-1147.

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