Market Conditions and Contract Design : Variations in Debt Contracting

Scholars have cataloged rigidities in contract design. Some have observed that boilerplate provisions are remarkably resistant to change, even in the face of shocks such as adverse judicial interpretations. Empirical studies of debt contracts and collateral, in contrast, suggest that covenant and collateral terms are customized to the characteristics of the borrower and evolve in response to changes in market conditions, such as expansion and contraction in credit supply. Building on the adverse selection and moral hazard theories of covenants and collateral, we demonstrate that an expansion (contraction) of credit will lead not only to a decrease (increase) in the interest rate but also a reduction (expansion) of covenants and collateral through lessening (worsening) adverse selection and moral hazard problems. We conclude with some empirical implications of this analysis