Lender Capital Adequacy and Financial Covenant Strictness

Evidence of the effect of lender financial reporting incentives on debt contract design is sparse. We examine whether regulatory capital adequacy, a first-order reporting concern for banks, is associated with the strictness of financial covenants included in loan contracts. We provide evidence that lenders with lower regulatory capital issue loans with lower financial covenant strictness. This is consistent with lenders viewing Type I errors (i.e., spurious technical defaults) as costlier when regulatory capital is low, because borrower covenant violation can trigger accounting that further reduces the lender's regulatory capital. Consistent with lenders loosening covenants that are more likely to lead to Type I errors, we find that this association is concentrated in performance covenants, as opposed to capital covenants. We also find that lenders with lower capital adequacy shorten their loan maturities and reduce their loan amounts, consistent with a trade-off between financial covenant strictness and other contract parameters