We develop a model of financial maintenance covenants under moral hazard, adverse selection, and informative signals of varying quality. We explain how public signals can improve the outcome for lenders and borrowers by reducing inefficient risk-taking (in both the pooling and separating equilibrium), and by shielding good firms from the actions of bad (separating) ones. We find that a reduction in signal quality moves the equilibrium from pooling to separating, to no covenants at all. We also demonstrate that signal quality has a non-monotone effect on covenant strictness. In an extension, we model manipulation of the accounting signal and show that it is isomorphic to a particular kind of noise.
Bank loansCovenantsAdverse selection equilibriumCorporate governance
Redouane Elkamhi、Latchezar Popov、Raunaq S. Pungaliya
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University of Toronto, 105 St. George Street, Toronto, Canada
Texas Tech University, P.O. Box 41014, Lubbock, TX 79409-1014, USA
Sungkyunkwan University, International Hall 338 SKK Graduate School of Business 25-2 Sungkyunkwan-ro Jongno-gu, Seoul 03063, South Korea
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NSTL
Springer Nature
