Debt Covenants and Macroeconomic Dynamics

Debt covenants are an important non-price mechanism through which credit is allocated to nonfinancial firms, and are strongly countercyclical. Macroeconomic models however abstract from this margin and focus on price measures such as credit spreads. We propose a simple extension of the canonical Bernanke-Gertler-Gilchrist (1999; BGG) model that gives a role for covenants and that allows to study both their determination, and their macroeconomic impact. In the model, covenants allocate control rights of investment across states of natures, and are determined by a trade-off between the risk of letting the entrepreneur invest excessively, and the cost of letting the lender reduce investment excessively. We demonstrate that covenants alter impulse response functions, relative to BGG, and that the pre-determined convenant tightness is an important state variable for the economy. Finally, we show that the demand for savings and expectations of future productivity are important determinants of covenant tightness.