bank lending

deposit insurance

banking crises

credit

banks

sovereign debt

The Journal of finance/The journal of finance

We document the importance of covenant violations in transmitting bank health to nonfinancial firms using a new supervisory data set of bank loans. More than one-third of loans in our data breach a covenant during the 2008-09 period, providing lenders the opportunity to force a renegotiation of loan terms or to accelerate repayment of otherwise long-term credit. Lenders in worse health are less likely to grant a waiver and more likely to force a reduction in the loan commitment following a violation. Quantitatively, the reduction in credit to borrowers with long-term credit but who violate a covenant accounts for an 11% decline in the volume of loans and commitments outstanding during the 2008-09 crisis, a similar magnitude to the total contraction in credit during that period. We conclude that the transmission of bank health to nonfinancial firms occurs largely through the loan covenant channel.

The Loan Covenant Channel: How Bank Health Transmits to the Real Economy