Abstract:

We document the importance of covenant violations in transmitting bank health to nonfinancial firms using a new supervisory data set of bank loans. Roughly 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 more likely to force a reduction in the loan commitment following a violation. The reduction in credit to borrowers who violate a covenant can account for the majority of the cross-sectional variation in credit supply during the 2008-09 crisis. 

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