Covenants and Collateral as Incentives to Monitor

TLDR

Monitoring borrowers is a key role for financial institutions, but competing claimants diminish lenders’ incentives to monitor. The study seeks to structure loan contracts—using covenants and collateral—to strengthen lenders’ incentives to monitor. Covenants adjust a loan’s effective maturity, while collateral establishes its priority, both contingent on lender monitoring. The findings align with observed patterns of covenant and collateral use in institutional lending.

Abstract

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.