RDP 2022-05: The Real Effects of Debt Covenants: Evidence from Australia 1. Introduction

Financial frictions can be important determinants of macroeconomic outcomes. They can lead to sub-optimal credit allocation, create a smaller and less efficient economy (Berk, Stanton and Zechner 2010; Agrawal and Matsa 2013) and amplify macroeconomic shocks (Bernanke, Gertler and Gilchrist 1999; Jeenas 2019). A key cause of financial frictions is informational asymmetries and misalignment in incentives between lenders and borrowers (Stein 2003). This paper studies the macroeconomic consequences of debt covenants, a contractual device designed to address these information frictions in debt financing, using Australia as a case study.

There are a number of reasons to focus on the role of debt covenants. First, while they facilitate access to credit in the presence of information frictions, they also restrict businesses' behaviour by setting conditions they need to satisfy (Jensen and Meckling 1976; Aghion and Bolton 1992; Tirole 2006). These conditions typically involve maintaining financial indicators within certain bounds, and therefore place some limits on the businesses' activities. This means that covenants can directly affect businesses' behaviour even in the absence of default.

Second, debt covenants are widely used in financial contracts (Bradley and Roberts 2015), and violations of their terms occur more frequently than defaults or bankruptcies (Dichev and Skinner 2002; Nini, Smith and Sufi 2012). As such, they can have first-order effects on economic activity. This was brought into sharp focus after the global financial crisis (GFC) and again following the COVID-19 pandemic.

Third, despite their importance, little is known about corporate debt covenants outside of the United States (Nini et al 2012; Lian and Ma 2021) and the United Kingdom (Moir and Sudarsanam 2007; Chatterjee et al 2021), reflecting a lack of information about corporate debt covenants. My paper is the first to examine the macroeconomic implications of corporate debt covenants in Australia, employing the newly constructed dataset for Australian non-financial listed firms outlined in Nguyen (2021).

In this paper I first show how exposure to covenants in debt contracts can affect investment and employment expenses as firms try to avoid breaching the covenants (‘disciplining channel’). This influence occurs over and above any direct effect of actual breaches (‘punishing channel’), suggesting that covenants can have far reaching implications for firm behaviour even if breaches remain rare. These findings provide further evidence for the disciplining channel of covenants outside of the US context, which is explored in Nini, Smith and Sufi (2009) and Adler (2021). My paper also supplements the empirical literature that focuses on the effects that a breach can have on business activity (Chava and Roberts 2008; Nini et al 2009; Roberts and Sufi 2009; Falato and Liang 2016).

Having demonstrated the substantive direct effects of covenants, I study their role in the transmission of monetary policy, building on the approach of Greenwald (2019) and using monetary policy shocks developed in Beckers (2020) to address endogeneity concerns. I find that the transmission of monetary policy to real business activity is amplified where the firm is subject to an interest coverage requirement, as higher interest rates have a direct effect in making the requirement more binding (and vice versa). This is akin to the financial accelerator mechanism outlined in Kiyotaki and Moore (1997) and Bernanke et al (1999). In contrast, transmission is dampened when the firm is subject to covenants that limit the stock of debt to some multiple of assets or earnings, as interest rates do not directly influence whether the requirements bind or not. By focusing on the debt covenants, my paper also contributes to the literature on the role of financial frictions in the transmission of macroeconomic shocks, and more generally the macroeconomic role of corporate financing (Christiano, Motto and Rostagno 2014; Jeenas 2019; Ottonello and Winberry 2020; Singh, Suda and Zervou 2022).

Finally, I quantify the aggregate effects of changes in the types of covenants used on the transmission of monetary policy. Using a simple counterfactual, I show that the shift in the composition of covenants away from interest coverage requirements over time has lowered the aggregate responsiveness of non-mining investment by around 15 to 25 per cent. While the calculation is not precise, it demonstrates the potential importance of covenants in explaining part of the weakness in non-mining business investment over the 2010s despite the availability of finance and relatively low borrowing costs in Australia (Debelle 2017; Lowe 2018; Dynan 2021). That said, more needs to be done to understand the reasons behind the apparent shift in the composition of covenants, that is, whether it reflects an actual shift or changes in reporting.