Restrictive Loan Covenants and Risk Adjustment in Small Business Lending

Banks use loan covenants to address agency problems and their own portfolio risks. Based on a sample of banks and loan agreements in the Dallas-Fort Worth area, a paired-comparison t-test and regression techniques are used to examine the relationship between the number of loan covenants and firm and bank characteristics. In addition, regression analysis is used to determine the relationship between interest rates and and the number of covenants. The results indicate that more loan covenants are used with small firms. On average, the number of covenants used by large, independent, state-chartered banks is greater than for other banks. These banks also have interest rates that are more sensitive to the number of covenants. The results suggest that small firms should be more selective in the types of banks they approach for debt capital, seeking greater benefit for the covenants imposed by loan agreements.