Competition and loan contracting

A theoretical model of the borrower–lender relationship predicts that increased competitive threats lead to a reduction in loan covenant restrictiveness that is stronger for groups of borrowers who face constraints to their ability to raise external financing or compete in the product market. These predictions arise because competition impacts the dynamics of borrower performance so that lenders must trade off the benefit of controlling agency problems against a heightened cost of lost product market opportunities for the borrower, ultimately lowering the optimal use of covenants. We find strong empirical support for these predictions, highlighting an important role of competition for optimal financial contracting rooted in underlying agency problems.