Accounting Quality and Financial Covenants in Loan Contracts

We develop a model of financial maintenance covenants under moral hazard, adverse selection, and accounting signals of varying quality. We explain how public signals from accounting statements 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 accounting quality moves the equilibrium from pooling to separating, to no covenants at all, consistent with the recent surge in covenant-lite loans. We also demonstrate that accounting quality has a non-monotone effect on covenant strictness. In an extension, we allow for uncertainty in macroeconomic conditions and characterize state contingent covenants.