Bank Skin in the Game and Loan Contract Design: Evidence from Convenant-Lite Loans

In a model of dual agency problems where borrow-lenders and nonbank-bank incentives may conflict, we demonstrate that bank skin in the game has a demonstrative influence on loan contract design. Our model predicts a hockey stick relation between bank participation and covenant tightness. As bank participation declines covenant strictness increase until a low threshold is reached, at which point the relations sharply reverses and covenant-lite loans emerge with a commensurate increase in spread. We test the models key predictions using a sample of leveraged loans from 2006-2011. We find strong support for the hockey stick relation our model predicts and documents that banks stake in covenant-lite loans averages only 8% with a median of 0%. We also find that covenant-lite loans 1) command higher spreads; and are more likely 2) when borrower moral hazard is less severe and 3) when bank relationship rents are high.