In a new paper, we explain that variation in prospective liquidity in an industry or economy prompts changes in corporate lending and banking, including changes in the level of corporate borrowing, the type of debt contracts issued, the covenants contained in them, and the role and leverage of banks.
We start with the basic principle that the nature of business lending in an economy changes over a financial cycle. This includes the amount of debt that a borrower can take on and the extent to which banks play an important role or become dominated by non-bank lenders issuing arm’s length debt. Moreover, debt may contain more or fewer covenants, and enforcing the terms of the debt could require direct lender intervention or happen automatically through performance pricing that prompts interest rates to adjust to the borrower’s situation. These changes affect not only borrowing by firms but also the capital structure of intermediaries like banks. While much research has examined various aspects of lending, relatively little explains how easy financing conditions might accentuate certain aspects over others. In our paper, we offer a theory explaining why and how the nature of lending changes with the environment in which the lending takes place.
Our model describes the various factors that affect outcomes, including exogenous factors like broad economic and financial conditions, and endogenous factors like improvements in corporate governance. Starting from a low level, higher prospective corporate liquidity will initially reduce monitored borrowing from a bank in favor of arm’s length borrowing from non-bank lenders and eventually reduce the need for internal corporate governance to support corporate borrowing, leading to covenant-lite loans. In parallel, higher prospective corporate liquidity will allow both corporations and banks to operate with higher leverage.
Beyond these insights into financial intermediation, we shed light on the role of liquidity in diminishing the consequences of moral hazard over repayment and hence the quality of the corporation’s internal governance. For example, internal governance matters little if the firm can potentially be seized and sold for full repayment in a Chapter 11 bankruptcy, which happens in an environment with high levels of prospective liquidity. Therefore, prospective liquidity encourages leverage at both the borrower and intermediary level, even while requiring less governance. Equivalently, because the intermediary performs fewer useful functions, high prospective liquidity encourages disintermediation.
Risky loans to highly leveraged borrowers, made by highly leveraged intermediaries, may therefore not be evidence of moral hazard or over-optimism, but simply a consequence of high prospective liquidity crowding out the monitoring role of financial intermediation. Such crowding out may have adverse consequences. As prospective liquidity fades and the demand for intermediation services expands again, the need for intermediary capital also increases. To the extent that the amount of intermediary capital decreased in periods when liquidity is expected to be plentiful, it may not be available in sufficient quantities when liquidity conditions turn and demand for capital rises. Prospective liquidity breeds a dependence on continued liquidity for debt enforcement as it crowds out other modes of enforcement, especially corporate governance. This will make debt returns more skewed – that is, enhance the possibility of very adverse outcomes along with good ones.
Our paper suggests a role for performance covenants, i.e., those formulated directly in terms of cash flows or in combination with balance sheet data (such as a debt to EBITDA ratio). The covenant will be tripped in practice whenever the entrepreneur diverts cash or puts in place weak governance. As argued by Christensen and Nikolaev (2012), performance covenants are associated with contract renegotiation. Our paper predicts an increasing use of performance pricing contracts when moral hazard is high, when there is aggregate risk, and when prospective liquidity is high. This prediction is consistent with Asquith, Beatty, and Weber (2005), who find performance pricing contracts are often used when the contract is predicted to contain material restrictions on the borrower’s financing and investment behavior.
Asquith, P., Beatty A., Weber, J., 2005. Performance Pricing in Bank Debt Contracts. Journal of Accounting & Economics 40, 101-128.
Christensen, Hans B., and Valeri V. Nikolaev. “Capital versus performance covenants in debt contracts.” Journal of Accounting Research 50, no. 1 (2012): 75-116.
This post comes to us from Douglas W. Diamond, the Merton H. Miller Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business; Professor Yunzhi Hu at the University of North Carolina; and Raghuram G. Rajan, the Katherine Dusak Miller Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. It is based on their recent article, “Liquidity, Pledgeability, and the Nature of Lending,” available here.