Bond Covenants and Delegated Monitoring

Authors

  • MITCHELL BERLIN,

  • JAN LOEYS

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    • Federal Reserve Bank of Philadelphia and J. P. Morgan and Company, respectively. We have benefited from suggestions by John Boyd, Joe Haubrich, George Pennacchi, Tony Saunders, and an anonymous referee, who cannot, of course, be blamed for any mistakes. The views expressed do not necessarily represent the views of the Federal Reserve Bank of Philadelphia, the Federal Reserve System, or J. P. Morgan and Co. Research for this paper was completed while Jan Loeys was an economist at the Federal Reserve Bank of Philadelphia.

ABSTRACT

This paper examines alternative contracting arrangements available to a firm seeking to finance an investment project. The authors consider the choice between loan contracts with covenants based on noisy indicators of the firm's financial health and loan contracts enforced by a monitoring specialist. In one interpretation, the specialist is a financial intermediary. The firm's choice is shown to depend upon the firm's credit rating, the accuracy of financial indicators of the firm's condition, the loss from premature liquidation of the firm's project, and the cost of monitoring.

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