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The Supply-Side Determinants of Loan Contract Strictness



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    • Murfin is with Yale University. I am particularly grateful to my dissertation chair, Manju Puri, for guidance and support. This paper also benefited greatly from the suggestions of Mitchell Petersen (the acting Editor), two anonymous referees, Ravi Bansal, Alon Brav, Murillo Campello, Scott Dyreng, Simon Gervais, John Graham, Kenneth Jones, Andrew Karolyi, Felix Meschke, Adriano Rampini, David Robinson, Phil Strahan, Anjan Thakor, Vish Viswanathan, Andrew Winton, and seminar participants at Cornell University, Duke University, Drexel University, Kansas University, Notre Dame, NYU, University of Illinois, University of Utah, University of Virginia, Washington University, Yale University, the WFA, the NBER, and the FDIC Center for Financial Research. I acknowledge financial support from the FDIC Center for Financial Research.


Using a measure of contract strictness based on the probability of a covenant violation, I investigate how lender-specific shocks impact the strictness of the loan contract that a borrower receives. Banks write tighter contracts than their peers after suffering payment defaults to their own loan portfolios, even when defaulting borrowers are in different industries and geographic regions from the current borrower. The effects persist after controlling for bank capitalization, although bank equity compression is also associated with tighter contracts. The evidence suggests that recent defaults inform the lender's perception of its own screening ability, thereby impacting its contracting behavior.