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December 2023
[Finance] Raunaq Pungaliya - Financial maintenance covenants in bank loans
SKK GSB Prof. Raunaq Pungaliya, with co-authors from the University of Toronto and Texas Tech University, has published a paper titled “Financial maintenance covenants in bank loans,” in Economic Theory, a premier economics journal.
Abstract
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.
Abstract
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.
Keywords
skkgsb, covenants, risk taking, accounting, financial maintenance, pricing strategy, lenders, burrower
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