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A bank covenants pricing model

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  • Flavio Bazzana

    (DISA, Faculty of Economics, Trento University)

Abstract

Covenants are particular clauses in firms' debt contracts that restrict business policy, giving creditors the possibility to put specific action into force when the covenants are violated. Three main reasons are accounted for in the literature: (1) covenants resolve the conflicts of interest between shareholders and bondholders, (2) they are used as instruments of business policy and (3) they are used as credit monitoring by the banks. Using this instrument the banks can also reduce the expected loss rate of the loan, offering a lower rate to the firm. In order to calculate the spread the bank must estimate the probability of covenant violation and the contribution of the covenant to the LGD when the firm respects this constraint. As a consequence, the bank can modify the elr of the loan without asking the firm for more collateral, and by choosing a combination of the financed part and of the limit of the financial ratio.

Suggested Citation

  • Flavio Bazzana, 2007. "A bank covenants pricing model," Quaderni DISA 124, Department of Computer and Management Sciences, University of Trento, Italy, revised 16 Jun 2008.
    • Handle: RePEc:trt:disatr:124
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