Covenants and Collateral as Incentives to Monitor




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    • Rajan is at the Graduate School of Business, University of Chicago. Winton is at the J.L. Kellogg Graduate School of Management, Northwestern University. Part of our research was funded by a grant from the Banking Research Center at Northwestern University. Rajan also thanks the Center for Research on Securities Prices and the William Ladany Fellowship for financial support. Ben Wilner provided valuable research assistance. In addition, we are grateful to Daniel Beneish, Dave Brown, Mike Fishman, Mark Flannery, Stuart Greenbaum, Joe Haubrich, Chris James, Jeff Lacker, Stan Longhofer, Helena Mullins, Anjan Thakor, Subu Venkataraman, John Weinberg, and seminar participants at Duke University, Northwestern University, the Universities of Florida and Minnesota, the Federal Reserve Banks of Philadelphia and Richmond, and the 1994 Northern Finance Association and Western Finance Association Meetings for their comments and advice. All errors remain our responsibility.


Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.