The optimal covenant threshold in loan contracts

Flavio Bazzana
Department of Economics and Management
Via Inama, 5
University of Trento
I38122 Trento ITALY
flavio.bazzana@unitn.it
ph. +39 0461 283107 fax +39 0461 282124
Abstract
Despite the growing importance of covenants and the increasing frequency with
which covenants are included in debt contracts, the role of covenant strength in
bank loans has not received much attention in the theoretical literature to date.
The goal of our paper is to provide a theoretical model within a standard credit
risk framework that can be used to compute the optimal covenant strength for
bank loans. In our model, a risk-neutral bank finances a firm that invests in a twoperiod, two-state project. We find that the expected loss rate (and, accordingly, the
interest rate) decreases if a covenant is used in the contract. In the most general
formulation of our model, which is composed of a loan with a covenant on the total
assets of the firm and asymmetric information, we find that the expected loss rate
depends on two sources of risk: (i) investment project risk and (ii) the risk from
the entrepreneurs behaviour. In this case, the expected loss rate for the financed
quote values is minimal for a given covenant strength.
JEL classification codes: G21, G28
Keywords: covenants, crediti risk, loans pricing

1. Introduction
Despite the growing importance of covenants and the increasing rate with which covenants are included in debt contracts (Billett, Dolly King, and Mauer 2007; Nini, Smith,
and Sufi 2009; Kwan and Carleton 2010), the role of covenant strength in bank loans
has not received substantial attention in the theoretical literature to date. Many empirical papers have investigated the relationship between covenant strength and the additional variables used to calculate expected loss rates (Asquith, Beatty, and Weber 2005;
Paglia and Mullineaux 2006; Ackert, Huang, and Ramirez 2007; Sufi 2009; Demiroglu
and James 2010; Godlewski and Weill 2011), but only a recent paper by Grleanu and
Zwiebel (2009) and a working paper by Bazzana and Broccardo (2012) provide a theo-

Electronic copy available at: http://ssrn.com/abstract=1134660

retical model that explains covenant strength. Grleanu and Zwiebel (2009) propose a
general model that analyses covenant strength in debt contracts using a property rights
approach. Bazzana and Broccardo (2012) analyse the differences in optimal covenant
strength between public and private debt. The goal of our paper is to provide a theoretical model with which to calculate the optimal covenant strength that minimises expected loss rates (elr) for bank loans.
The following variables are standard for calculating elr in the credit risk literature
(Duffie and Singleton, 2003; Lando, 2004) and the Basel II framework (Basel Committee on Banking Supervision, 2005): (i) the probability of default (PD), (ii) the loss given default (LGD), and (iii) the exposure at default (EAD).
In estimating the PD, banks (which primarily conduct the monitoring) analyse data
from their daily transactions with the firm in question. Variation in the PD could shift
the firm to a different rating class, which would render the initial spread inadequate.
The bank would then have to bear a greater expected loss than initially estimated.
Short-term operations provide the bank with considerable flexibility because the bank
may ask for a withdrawal or easily adapt the spread. In contrast, for long-term operations, the bank cannot contractually request an anticipated refund; therefore, when the
rating class changes, the bank cannot effectively change the spread or ask for such a
refund. Thus, in long-term operations, the bank may include covenants in the contract
that are calculated in accordance with the financial ratios used to estimate the PD.
Under such covenants, the bank can request repayment of outstanding debt if the covenant has been violated (i.e., if the rating class of the firm changes). As noted by Rajan
and Winton (1995), the inclusion of covenants in long-term operations increases the
flexibility of bank decisions and enables banks to use information more efficiently,
which facilitates more effective monitoring (Nini, Smith, and Sufi 2009).
For LGD monitoring, two factors are significant: the companys level of liquidity
and the seniority of the loan. In a crisis situation, assets could lower the degree of liquidity and affect the LGD. In such a case, the inclusion of covenants in the contract
that bind the company to render certain corporate assets available and reduce the LGD
enables the bank to demand the repayment of outstanding debt. Covenants are also
extremely important for safeguarding loan seniority because they reduce LGD estimated values (J Niskanen and M Niskanen 2004; Paglia and Mullineaux 2006; Moir and
Sudarsanam 2007). As with the PD, covenants also facilitate monitoring the position;
thus, an operation can be avoided in which the elr is unrelated to the initial spread.
Finally, the EAD may be affected by covenants that provide the bank with prior
knowledge of the firms risk. For example, by including covenants that address risky
events, such as loan rate non-payment or shareholder structure modification, the bank
can reduce exposure to firms that are more likely to default. This protection can reduce
the initial EAD estimation.
Despite the theoretical importance of covenants for elr estimation, the Basel II
2

Electronic copy available at: http://ssrn.com/abstract=1134660

framework does not dwell on this issue and acknowledges its importance only through
EAD evaluations. Only the banks that adopt the advanced internal rating-based approach (IRBA) can calculate the capital requirements for an operation and consider the
effectiveness of covenants in their EAD evaluations. Under the other two approaches,
the standard and IRBA foundation approaches, the supervisory institution assigns
EAD values to different types of operations. Even standard credit risk models do not
directly account for the role of covenants (for a review, see Duffie and Singleton, 2003;
Lando, 2004). In addition, the principal rating agencies do not formally consider the
importance of covenants in the rating criteria (see May and Verde, 2006, for Fitch Ratings; Standard and Poors, 2006; Padgett, 2006, for Moodys).
Herein, we propose a loan covenant model within a standard credit risk framework
in which the covenant strength is calculated by minimising the expected loss rate. This
model is based on Black and Cox (1976), but it replaces the continuous time methodology used in the study with a discrete time and state of nature approach. Loan covenant
pricing follows the Credit Metrics model (Gupton, Finger and Bhatia, 1997) by assuming that the bank is risk-neutral. We focus on covenant strength, as in Grleanu and
Zwiebel (2009) and Bazzana and Broccardo (2012). Unlike Grleanu and Zwiebel
(2009), we assume that the firm can avoid a covenant violation by increasing its capital. We also assume that the firms behaviour depends on covenant strength. Different
from Bazzana and Broccardo (2012), we use a two-stage method and a more standard
approach to compute the loans expected loss rate. We find that the elr has a minimum
value for a given financial covenant strength, and this optimal point can be calculated
using a minimisation procedure. The model introduces an innovative process and
unique results to the existing literature: (i) the model analyses how firms behave to
avoid violating the covenant, and (ii) it facilitates the identification of optimal covenant strength for the bank. To our knowledge, this is the only paper that has presented
such results.
The paper proceeds as follows. First, we present loan pricing for symmetric information and highlight the difference between a standard loan and a loan with a covenant. We then modify the model by introducing asymmetric information between the
bank and firm and present the results from the optimisation procedure. The conclusions
follow.
2. The model with symmetric information
We consider an entrepreneur investing in a two-year project with an initial cost normalised to 1. The value of the project follows a binomial stochastic process with drift
and standard deviation . A graphical representation of the investment project is
shown in Fig. 1, wherein u indicates up, d indicates down and p is the probability of a
decrease in each node. The variables are functions of the drift and standard deviation
3

(i.e., u = u ( ) , d = d ( ) , and p = p ( , ) , as is typical)1.

u2
1p
u
p

1p
1

ud
p

1p
d
p
d2

t=0

t=1

t=2

Figure 1. Graphical representation of the investment project value for the two
periods with the corresponding probabilities.

The project is financed through a bank loan, < 1 at a gross rate r > 1 , with interest paid, a capital refund r 2 at maturity, and equity for the remaining portion.
The bank receives the investment project as collateral, and the entrepreneur will sell
the investment at the end of the second year to repay the loan. Both the bank and entrepreneur understand the stochastic process followed by the investment project, and
the only risk is from the probability p; thus, we have symmetric information. To simplify the approach, we assume a single default position in period two, i.e.,

d 2 < r 2 < ud ,

(1)

and the binomial process has the property ud 1 .

2.1. The standard loan
Under the above hypothesis, the bank will have a default scenario only in period two
for a standard loan when the value of the investment project is d 2 . Fig. 2 provides a
graphical representation of the cash flow for the bank given the possible values for the
investment project.
1

In the binomial model, p is typically defined as the probability of an increase. We are interested in the

probability of a decrease, which is the risk associated with lending; thus, we reverse the meaning of the
notation.

r 2
1 p2

p2
d2

t=0

t=2

Figure 2. A graphical representation of the cash flow for the bank with the corresponding probability and a standard loan.

Given these assumptions, the expected loss rate for the bank is

EAD R
,
elr = PD LGD = PD
EAD

(2)

where PD is the probability that the firm will default and LGD is the loss given default
(i.e., the ratio between the loss upon default and exposure at default (EAD)). R is the

value of recovery upon default. In the model, PD = p 2 and LGD = r 2 d 2

r 2 ;

thus, the elr becomes

d 2
elr = p 2 1
.

r 2

(3)

Assuming risk neutrality, the bank will choose an interest rate equal to the expected
refund of the loan with the loan amount determined by the gross risk-free rate i:

p 2d 2 + ( 1 p 2 ) r 2 = i 2 .

(4)

Resolving equation (4) with respect to the interest rate, we obtain the following:

r2 =

i 2 p 2d 2

(1 p 2 )

i 2 PD R
.
( 1 PD )

(5)

Furthermore, from equation (3), the elr value can be written as

elr = p 2

i 2 d 2
i 2 p 2d 2

(6)

Defining the model variables of set S as

S {( d, p,i, ) 0 < d < 1; 0 < p < 1; i > 1; 0 < < 1 } ,

5

(7)

the overall feasible set for the standard loan (i.e., the intersection between the default
condition (1) and set S) can be rewritten as follows:

1 p 2 (1 d 2 )
d2

Sr ( d, p,i, )
<<
; ( d, p,i, ) S
.
2
2

i
i

(8)

Under these assumptions, the bank experiences the following two types of complications: (i) limited decision-making flexibility and (ii) a high level of risk. The bank has
limited flexibility because the elr can only be modified by changing the financed quote.
For example, if the entrepreneur will not accept a reduction in the portion financed and
the bank has an operational limit on the elr for new operations, the operation cannot
be completed. More important is the level of risk during the life of the loan. In the first
period, if the value of the investment project is d, the elr will increase because the PD
increases to the p value, and the R remains the same. The bank cannot increase the
interest rate to accommodate the new level of risk because it was fixed at the beginning
of the contract, but the bank cannot sell the collateral because the firm is not in default (the only payment to the bank is in period two). A covenant can provide a possible solution to both problems.
2.2. The loan with a restrictive covenant on the investment project
Suppose that the bank introduces the following restrictive covenant into the loan contract: If the value of the investment project in period one is less than d, the bank can
sell the collateral to refund the loan early. The value of the loan for early repayment
is rcp , where the subscript cp indicates the covenant on the investment project. To
eliminate trivial cases, we assume that the bank has no incentive to request the anticipated refund of the loan (i.e., the capitalised value of the collateral must be lower than
the value of the loan at maturity)2:

di < rcp2 .

(9)

If the value of the investment project is d (i.e., the firm will be in technical default),
the bank can sell the collateral to refund the loan early, or it can waive the covenant
violation. A risk-neutral bank will sell the collateral if the anticipated refund capitalised
at risk-free rate i is greater than the expected value of the loan refund in period two, as
follows3:
2

This condition contains the non-trivial condition (1) for the standard loan.

Otherwise, if the bank waives the covenant violation, the elr and corresponding interest rate r are equal

to those values in the standard case.

di > pd 2 + ( 1 p ) rcp2 .

(10)

A graphical representation of the cash flow for the bank given the possible values of
the investment project is depicted in Fig. 3.

rcp2
1p

-
p
di

t=0

t=2

Figure 3. A graphical representation of the cash flow for the bank with the corresponding probability for a loan with a restrictive covenant and anticipated refund
of the loan invested at risk-free rate i.

The only default position is in period one, when the bank sells the collateral for a
loss; thus, PD = p . The recovery is the capitalised anticipated refund at the risk-free
rate i (i.e., R = di ). Given these assumptions, the elr is as follows:

di

elrcp = p 1
.

rcp2

(11)

As in the standard model, the bank chooses an interest rate equal to the expected
refund of the loan when the amount of the loan is determined at the gross risk-free rate
i:

pdi + ( 1 p ) rcp2 = i 2 .

(12)

Resolving equation (12) for the interest rate, we obtain

rcp2 =

i 2 pdi
;
(1 p )

(13)

using equation (13) in equation (11), we obtain

elrcp = p

i d
.
i pd

(14)

As above, we can define the overall feasible set of the loan with a covenant on the
investment project (i.e., the intersection between inequality (9) and inequality (10) us-

ing expression (13)) and set S as follows:

d
d
Scp ( d, p,i, ) < < ( i dp + pi ); ( d, p,i, ) S .

i
i2

(15)

Rearranging the difference between the interest rate on the standard loan (5) and
the loan with a covenant (13), we can compare the two interest rates as follows:

r 2 rcp2 =

p 2 ( i dp + pi )
i

(1 p 2 )

(16)

For a correct comparison, we must define expression (16) at the intersection between the two feasible sets (i.e., Sr Scp Sr cp ):

Sr cp = Scp .

(17)

Thus, expression (16) becomes the following:

( r 2 rcp2 ) (d,p,i, )S

> 0,

(18)

r cp

which is consistent with empirical observations on the impact of covenants on loan contract interest rates. Using the same method,

(elr elrcp ) (d,p,i, )S

> 0.

(19)

r cp

The bank can increase its flexibility using this loan contract design and offering a
lower interest rate to the firm, but the entrepreneur cannot avoid the possibility of violating the covenant (i.e., technical default) in period one. If the latter occurs, the entrepreneur will lose all of its initial equity because the bank will sell the collateral.
However, with the opportunity to avoid technical default, the entrepreneur can achieve
a positive outcome after refunding the loan if the value of the investment project in
period two is 1. For the entrepreneur to meet the covenant, the bank can define the
covenant based on the total assets of the firm instead of the value of the investment
project.
2.3. The loan with a restrictive covenant on total assets
Suppose now that the bank composes the restrictive covenant in the loan contract as
follows: If the value of the total assets of the firm is lower than a fixed threshold q,
the bank can sell the collateral to refund the loan early. Because the total assets of the
firm in period zero are equal to the investment project with its value normalised to 1,
the possible range for q is between d and 1 (or d q 1 ). The strength s of the cove8

nant ( 0 s 1 ) is the relative distance between q and d, as follows:

s=

q d
.
1d

(20)

Thus, the covenant is stronger for higher values. In period one, if the value of the investment project is d, the firm has a negative net income. If the value of the asset decreases from 1 to d, the value of the debt remains constant at because the loan will
be refunded only upon its maturity. Consequently, the value of the equity will decrease
from 1 to d (i.e., 1 ( 1 d ) ). According to this hypothesis, if the value
of the investment project at period one is d, the covenant is violated, and the firm is in
technical default. However, the entrepreneur can meet the covenant with an equity increase, q d = s ( 1 d ) , and by investing the money at gross risk-free rate i.
The entrepreneur must consider the two different alternatives: (i) do not increase
the capital with a loss of initial capital, 1 , or (ii) meet the covenant with possible
revenue in period two if the value of the investment project is 1. As an example, a riskneutral entrepreneur will prefer the second alternative only if the discounted expected
revenue in period two is greater than the capital increase, i.e.,

(1 p )(1 rca2 )
i

> s (1 d ) ,

(21)

where the subscript ca indicates a covenant on the total assets. From the banks perspective and assuming that the entrepreneur respects the covenant upon its violation, if
the value of the investment project in period two is d 2 , the bank receives

d 2 + s ( 1 d )i . To eliminate trivial cases, we assume that even with the equity increase, the bank loses the following:
2
d 2 + s ( 1 d )i < rca,r
,

(22)

where the subscript r indicates respect for the covenant. Fig. 4 shows a graphical representation of the cash flow for the bank if the entrepreneur increases the capital given
the possible value of the investment project.

2
rca,r

1 p2

p2

d 2 + s ( 1 d )i
t=0

t=2

Figure 4. A graphical representation of the cash flow for the bank with the corresponding loan probability and a restrictive covenant on the total assets if the entrepreneur respects the covenant.

We derive the elr using PD = p 2 and R = d 2 + s ( 1 d )i as follows:

elrca,r

d 2 + s ( 1 d )i

= p 1
,
2
rca,r

(23)

where the subscript r indicates respect for the covenant. The bank will choose an interest rate equal to the expected loan refund, with the loan amount determined at the
gross risk-free rate i as follows:
2
p 2 d 2 + s ( 1 d )i + ( 1 p 2 ) rca,r
= i 2 .

(24)

The interest rate becomes

2
rca,r
=

i 2 p 2 d 2 + s ( 1 d )i

,
2
(1 p )

(25)

and the expected loss rate, using expression (25), becomes

elrca,r

i 2 d 2 + s ( 1 d )i

.
=p
i 2 p 2 d 2 + s ( 1 d )i

(26)

We can now define the overall feasible set of the loan with a covenant on total assets (i.e., the intersection between inequality (22) using expression (25)) and set S; the
strength of the covenant is as follows:

d 2 + s ( 1 d )i
Sca,r ( d, p,i, ,s )
< < 1; ( d, p,i, ) S;0 s 1 .

i2

(27)

Rearranging the difference between the interest rate on the standard loan (5) and

10

the loan with a covenant on the total assets (25), we obtain the following:
2
r 2 rca,r
=

p 2 ( 1 d )is

(1 p 2 )

(28)

which is always greater than zero for each model variable value in set S. This is also
true at the intersection between the two feasible sets, as follows:

Sr ca,r

1 p 2 (1 d 2 )
d2

= ( d, p,i, ,s )
<<
; ( d, p,i, ) S;0 s 1 ;

i2
i2

(29)

thus, expression (28) becomes

2
( r 2 rca,r
) (d,p,i,,s )S

> 0,

(30)

r ca,r

which is also consistent with empirical observations on the impact of covenants on the
interest rates of loan contracts.
However, if an entrepreneur will not increase the capital upon violating the covenant, a bank will sell the collateral in period one. This the same outcome as for a loan
with a covenant on an investment project ( PD = p and R = di ). The expected loss
rate becomes

di

elrca,v = p 1
,
2

rca,v

(31)

where the subscript v indicates a covenant violation. The interest rate becomes
2
rca,v
=

i 2 pdi
= rcp2 ,
(1 p )

(32)

and the direct elr is as follows:

elrca,v = p

i d
= elrcp .
i pd

(33)

The feasible set is the same for a covenant on an investment project (i.e.,

Sca,v = Scp ) and the intersection of the two feasible sets (i.e., Sr ca,v = Scp ). Thus, from
inequality (18), we obtain
2
( r 2 rca,v
) (d,p,i, )S

0.

r ca,v

This result is consistent with empirical observations.

11

(34)

3. The model with asymmetric information

We now introduce asymmetric information into the latter case (i.e., the loan with a
restrictive covenant on the total assets of the firm). We assume that at period zero, the
bank does not know the behaviour of the entrepreneur at period one if the value of the
investment project is d (i.e., if the firm is in technical default). We implicitly assume
that the entrepreneur will increase the capital upon a covenant violation not only for
risk-neutral expected equity cash flow, as in the previous case, but also for additional
variables not directly observable by the bank. These variables can include, for example,
bankruptcy costs, reputational costs and limited funds at the entrepreneurs disposal.
However, it is realistic to assume that the bank knows the past behaviour of entrepreneurs with regard to covenant strength. If the covenant is relaxed (i.e., a lower s), a
large number of entrepreneurs will decide on a capital increase because it has low value.
With a tighter covenant (i.e., a higher s), a large number of entrepreneurs will likely
place the firm in technical default and violate the covenant. Thus, we assume that the
bank knows the cumulative density function F ( s ) , which is the probability that the
entrepreneur will not increase the capital if the covenant strength is s.
In this case, the firm is in technical default because the covenant has been violated
and the entrepreneur did not increase the capital. The bank has two possibilities: (i)
sell the collateral or (ii) waive the covenant violation. The bank, as in equation (10),
will sell the collateral only if the money generated, capitalised at risk-free rate i, is
greater than the expected value of the loan refund in period two, i.e.,
2
di > pd 2 + ( 1 p ) rca,s
,

(35)

in which s indicates selling the collateral. Fig. 5 shows a graphical representation of the
loan values for the bank in this case.

12

2
rca,s

1p

1p
p

d 2 + s ( 1 d )i

1 F(s)

F(s)
di
t=0

t=1

t=2

Figure 5. A graphical representation of the loan values for the bank and the corresponding probability with asymmetric information with a covenant on total assets. The bank will sell the collateral if the entrepreneur does not increase the capital to avoid a covenant violation.

To eliminate trivial cases, we assume that even with an equity increase, the bank incurs a loss, i.e.,
2
d 2 + s ( 1 d )i < rca,s
.

(36)

In accordance with these hypotheses, the expected loss rate for the bank is calculated as a weighted average elr of the loan upon violation and respect, as follows:

elrca,s = F ( s ) elrca,v + 1 F ( s ) elrca,r ,

(37)

where F ( { 0,1 } ) = { 0,1 } . Using expressions (23) and (31) and defining a unique interest rate, we generate the following:

d 2 + s ( 1 d )i
di

p 2 1
elrca,s = F ( s ) p 1
+
1

F
s

(
)
.

2
2

rca,s
rca,s

(38)

The bank will choose an interest rate equal to the expected refund of the loan with
the amount of the loan determined at the gross risk-free rate i. To determine the loan
interest rate, we must solve the following equation:
2
2
p { F ( s )di + ( 1 F ( s ) ) p ( d 2 + s ( 1 d )i ) + ( 1 p ) rca,s
+ 1 p ) rca,s
= i 2 , (39)

} (

which becomes

13

2
rca,s
=

i 2 p F ( s )di + ( 1 F ( s ) ) p ( d 2 + s ( 1 d )i )

.
1 p ( F ( s ) + ( 1 F ( s ) ) p )

(40)

Otherwise, the bank waives the covenant violation when equation (35) is false (i.e.,
the money generated from selling the collateral, capitalised at risk-free rate i, is lower
than the expected value of the loan refund in period two). Fig. 6 shows a graphical representation of the loan value changes.

2
rca,w

1p

1p

d 2 + s ( 1 d )i

1 F(s)
2
rca,w

F(s)

1p
p

t=0

t=1

d2
t=2

Figure 6. A graphical representation of the loan values for the bank and corresponding probability with asymmetric information and a covenant on the total assets. The bank will not sell the collateral if the entrepreneur does not increase the
capital upon a covenant violation.

In this case, the expected loss rate for the bank is calculated as the weighted average
elr of the standard loan and the loan with a covenant on the total assets and respect,
as follows:

elrca,w = F ( s ) elr + 1 F ( s ) elrca,r ,

(41)

where the subscript w indicates waiver of the covenant violation. Using expressions (3)
and (31) and defining a unique interest rate, we obtain the following:

d 2 + s ( 1 d )i
d 2

elrca,w = F ( s ) p 2 1
+
1

F
s
p
1

( )
.
2
2

rca,w
rca,w

(42)

The bank will choose an interest rate equal to the expected loan refund with the
14

loan amount determined at the gross risk-free rate i. To determine the loan interest
rate, we must solve the following equation:
2
p { F ( s ) pd 2 + ( 1 p ) rca,w
+

, (43)
2
2
+ ( 1 F ( s ) ) p ( d 2 + s ( 1 d )i ) + ( 1 p ) rca,w
+ ( 1 p ) rca,w
= i 2
}

which becomes
2
rca,w

i 2 p F ( s ) pd 2 + ( 1 F ( s ) ) p ( d 2 + s ( 1 d )i )

=
=
{1 p F ( s ) p + ( 1 F(s) ) p }
.
i 2 p F ( s ) pd 2 + ( 1 F ( s ) ) p ( d 2 + s ( 1 d )i )

=
(1 p 2 )

(44)

3.1. Comparison and optimisation

We can now draw a comparison between the two expected loss rates4 from the model
with asymmetric information, and the elr for the standard loan and the loan with a
covenant on the investment project. First, under the hypothesis for the cumulative
density function, the following holds:

elr = elrca,w

s=0

= elrca,s

elrcp = elrca,s

s=0

= elrca,w

s=1

(45)

s=1

Second, we must assign a value to the remaining variables in the model (i.e., from
the investment project (p and d), gross risk-free rate i, and financed quote ). Third,
we must analytically define the cumulative density function F ( s ) . The simplest function for our limited interval 0,1 is triangular5, which is defined as follows:

s2

with 0 s c

F ( s,c ) =
,
2

1s)

1
with c s 1

1 c

(46)

where c is the parameter shape ( 0 c 1 ). When c is lower, the probability is greater

4

Similar results, both qualitative and quantitative, can be obtained analysing the interest rates of the

model. There is a direct connection between elr and the corresponding interest rate; thus, to simplify the
analysis, we only use the elr.
5

Another possible cumulative density function defined over a limited interval is the Beta function. We

obtain results similar to those from the triangular cumulative density.

15

that an entrepreneur will not increase the capital at a given s. However, when c is
higher, it is more likely that an entrepreneur will not violate the covenant through a
capital increase. Thus, formally, the following inequality is true:

F ( s,c )
c

0.

(47)

Under these hypotheses, we obtain the graph depicted in Fig. 7, which shows a minimum value for the two expected loss rates (the two dashed lines) with asymmetric information on covenant strength s.
elr

elr

0.040
0.035

elrca,w

0.030
0.025
0.020

elrca,s
elrcp

0.015
0.010
0.2

0.4

0.6

0.8

1.0

Figure 7. The expected loss rate as a function of covenant strength s for a loan
with a total asset covenant when the bank waives the covenant violation (elrca,w)
and for a loan with a total asset covenant when the bank sells the collateral upon a
covenant violation (elrca,s). Also depicted is a comparison between the expected loss
rate for the standard loan (elr) and for the loan with a covenant on the investment
project (elrcp). The values for the remaining model variables are as follows:
p = 30% , d = 60% , i 1 = 4% , c = 0.85 , and = 60% .

Thus, the bank can reduce the expected loss rate not only by reducing the quote financed but also by modifying the covenant strength; thus, the following minimisation
problem has an internal solution:

min elrca, s,w ( s, ) .

s 0,1

(48)

Reordering the first-order conditions from expression (48) and using the hypothesis
for the model variables, we find the condition for the minimum value of an expected
loss rate (elrca,w) when the bank waives the covenant violation. This condition is valid
for a covenant strength s that satisfies the following equation:

F ( s,c ) + s

F ( s,c )
s

1 = 0.

(49)

The optimal value depends only on the shape parameter c; thus, if the bank waives
16

the covenant violation, the optimal strength only depends on the expected behaviour of
the entrepreneur. The other source of risk in the model, the investment project, does
not play a role in determining s . If the bank sells the collateral upon a covenant violation, the optimal covenant strength must satisfy the following equation:

(1 d )ip 1 F ( s,c ) 1 + p (1 F ( s,c )) +

F ( s,c )
+ di ( 1 + p + p
s ) i ( p
s + i ) d 2p
=0

(50)

In this case, the optimal value of the covenant strength depends on the two sources
of risk for the model: the expected behaviour of the entrepreneur and the investment
project.
1.0

0.1067
0.0414
0.0345

0.8

0.097
0.0873
0.0776

elrca,w

0.0679
0.0582
0.0485
0.0388
0.0291

0.6

0.4
0.0207
0.0345

0.2

elrca,s

0.0276

0.0
0.4

0.5

0.0414
0.6

0.7

0.8

0.9

Figure 8. Level curves of the expected loss rate for covenant strength s and financed quote on the loan with a total asset covenant: (i) when the bank waives
the covenant violation (elrca,w) on the left-hand side and (ii) when the bank sells
the collateral upon a covenant violation (elrca,s) on the right-hand side. The dashed
line represents the optimal covenant strength for each financed quote value. The
values for the remaining model variables are as follows: p = 30% , d = 0.6 ,
i 1 = 4% , and c = 0.85 .

We can now analyse the expected loss rate for the bank control variables, financed
quote and covenant strength ( ,s ), by changing the two risk sources in the model: the
expected behaviour of the entrepreneur (c) and investment project (p, d). In Fig. 8, we
use numerical values for the model parameters to plot the level curves of the elr for
( ,s ), where the dashed line represents optimal strength s for each financed quote
value. On the right-hand side of Fig. 8, the optimal covenant strength decreases as a

17

function of the quote financed as the loan risk for the bank, the elr, increases.
We can change the first type of risk in the model, the expected behaviour of the entrepreneur, by modifying the value of the shape parameter c. A reduction in this value
increases the probability that the entrepreneur will place the firm in technical default,
which is expressed by inequality (47); thus, the banks risk, the elr, also increases (see
the elr values in the level curves, Fig. 9).
1.0
0.044
0.8

0.1067

elrca,w

0.6

0.097
0.0385

0.0873
0.4

0.0776
0.0582 0.0679
0.0485
0.0388
0.0275

0.2

elrca,s

0.033
0.0
0.4

0.5

0.0385 0.044
0.6

0.7

0.8

0.9

Figure 9. A more risky entrepreneur. Level curves for the expected loss rate as a
function of covenant strength s and financed quote for a loan with a total asset
covenant (i) when a bank waives the covenant violation (elrca,w) on the left-hand
side and (ii) when a bank sells the collateral upon a covenant violation (elrca,s) on
the right-hand side. The dashed line represents the optimal covenant strength for
each financed quote value. The values for the remaining model variables are as follows: p = 30% , d = 0.6 , i 1 = 4% , and c = 0.25 .

We can also change the risk for the investment project by changing the value of d.
Even in this case, a reduction in this value implies an increased risk for the project, as
demonstrated by the elr values in the level curves (Fig. 10).

18

1.0

0.1027

0.1264 0.1422
0.1343

0.1106
0.8

0.0948
0.031

0.1185

0.0869

0.6

0.079

elrca,w
0.4

0.2

0.0186

0.031
0.0316

0.0248

0.0372
0.0395

0.0711

0.0632

elrca,s

0.0474
0.0
0.4

0.0434
0.0496 0.0553
0.5
0.6

0.0632
0.7

0.8

0.9

Figure 10. A more risky project. Level curves for the expected loss rate as a
function of covenant strength s and financed quote for a loan with a total asset
covenant (i) when a bank waives the covenant violation (elrca,w) on the left-hand
side and (ii) when a bank sells the collateral upon a covenant violation (elrca,s) on
the right-hand side. The dashed line represents the optimal covenant strength for
each financed quote value. The values for the remaining model variables are as follows: p = 30% , d = 0.5 , i 1 = 4% , and c = 0.85 .

Lastly, we can alter the two risk sources in opposing directions. In Fig. 11, we reduce the entrepreneur risk and increase the investment project risk. In this case, the
overall risk for the bank, which is measured using the expected loss rate for a loan, is
still similar to the first case, as demonstrated by comparing the level curves in Figs. 8
and 11.

19

1.0

0.1422
0.12640.1343
0.1027
0.1185
0.0948

0.8

0.1106

0.0869
0.026
0.079

0.6

0.0711

0.013

elrca,w

0.4

0.0195

0.0632

0.0316
0.0395

0.2

0.0325

0.0474

0.039
0.0
0.4

0.0553

elrca,s

0.0632

0.0455 0.052
0.5

0.6

0.7

0.8

0.9

Figure 11. A less risky entrepreneur and a more risky project. Level curves for
the expected loss rate as a function of covenant strength s and financed quote
for a loan with a total asset covenant (i) when a bank waives the covenant violation (elrca,w) on the left-hand side and (ii) when a bank sells the collateral upon a
covenant violation (elrca,s) on the right-hand side. The dashed line represents the
optimal covenant strength for each financed quote value. The values for the remaining model variables are as follows: p = 30% , d = 0.5 , i 1 = 4% , and c = 1 .

To analyse the movements of the function for optimal covenant strength that result
from changing the two risk sources in the model, we compile the results from the four
cases in Fig. 12.
1.0

0.1027

Less risky entrepreneur 0.1264 0.1422

and more risky project 0.1106 0.1343
Fig. 11
0.1185

0.8

0.0948

0.031

0.0869
Starting
function
Fig. 8

0.6

0.079

0.0711
0.4

0.031
0.0316
More0.0186
risky project

Fig. 10

0.0248
0.2

0.0632
0.0372
0.0395
0.0474

More risky entrepreneur

Fig. 9
0.0434

0.0
0.4

0.0632

0.0496 0.0553
0.5
0.6

0.7
a

20

0.8

0.9

Figure 12. The optimal covenant strength s for each financed quote value in
the four cases. The continuous line is from Fig. 8 ( d = 0.6 and c = 0.85 ), the dotted line is from Fig. 9 (more risky entrepreneur, c = 0.25 ), the dashed line is from
Fig. 10 (more risky project, d = 0.5 ), and the dot-dashed line is from Fig. 11 (less
risky entrepreneur, c = 1 , and more risky project, d = 0.5 ). The values of the remaining model variables are as follows: p = 30% and i 1 = 4% .

Fig. 12 shows an indirect relationship between the loan risk, expressed both by entrepreneur risk and investment project risk, and covenant strength; if the risk increases,
the bank must optimally reduce covenant strength. This result is also true for a given
risk with an increasing financed quote but only in cases in which the bank sells the collateral after the entrepreneur does not increase the capital upon a covenant violation. If
the bank waives a covenant violation, the optimal covenant strength remains constant
as the financed quote changes.
4. Conclusions
Despite the attention to covenant strength in the empirical literature, its role in bank
loans has received insufficient attention in theoretical papers. This study proposes a
theoretical analysis of the impact of covenant strength on the expected loss rate of a
bank loan, which can be used to compute the optimal covenant strength for bank loans.
In our model, a risk-neutral bank finances a firm that invests in a two-period, twostate investment project. We compute the expected loss rate for the loan using two different covenant types and for symmetric and asymmetric information between the bank
and the firm. In general, the expected loss rate (and the corresponding interest rate)
decreases when a covenant is used in the contract. These results are consistent with the
empirical literature on loan covenants.
In the most general formulation of our model, for a loan with a covenant on the total assets of the firm and asymmetric information, we find that the expected loss rate
depends on two sources of risk: (i) risk from the investment project partially financed
with the loan and (ii) risk that the entrepreneur will not prevent a covenant violation
with a capital increase. In this case, the expected loss rate for each financed quote value is minimal for a given covenant strength. The optimal covenant strength value computed is indirectly correlated with two risk types in the model (i.e., the lower the risk
of the investment project or the entrepreneur risk, the higher the covenant strength).
To our knowledge, these results have not been previously described in theoretical literature on bank loan covenants.
The policy application for these results may be appealing to banks. A bank can better define loan pricing with a covenant by looking at the investment project and entrepreneur risks. If both types of risk can be measured using historical internal data, a
bank can also determine the optimal covenant strength to minimise the expected loss
21

rate.
5. Acknowledgements
We would like to thank four anonymous referees, Franck Moraux, and the seminar participants at the AFFI 2008 Conference in Montpellier for providing comments that
were helpful in developing this study. The usual disclaimer applies.
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