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

Published online by Cambridge University Press:  18 July 2016

Matthew T. Billett ,
Redouane Elkamhi ,
Latchezar Popov  and
Raunaq S. Pungaliya
Matthew T. Billett
Affiliation:
mbillett@indiana.edu, Indiana University, Kelley School of Business, Bloomington, IN 47405
Redouane Elkamhi
Affiliation:
redouane.elkamhi@rotman.utoronto.ca, University of Toronto, Rotman School of Management, Toronto, ON M5S 3E6, Canada
Latchezar Popov*
Affiliation:
lpopov@virginia.edu, University of Virginia, Department of Economics, Charlottesville, VA 22903
Raunaq S. Pungaliya
Affiliation:
raunaq@skku.edu, Sungkyunkwan University (SKK), Graduate School of Business (GSB), Seoul110-745, Korea.
*
*Corresponding author: lpopov@virginia.edu
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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.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 51 , Issue 3 , June 2016 , pp. 839 - 873
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2016 

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