Covenants and Collateral as Incentives to Monitor

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentive to engage in costly monitoring. Thus loan contracts must be structured so as to enhance this incentive. Short-term debt gives the lender the power to force renegotiation or liquidation when the debt matures, but this ability is not contingent on monitoring. By contrast, covenants make the loan's effective maturity, and the ability to collateralize makes the 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