Bank Interventions and Trade Credit: Evidence from Debt Covenant Violations

What is it about?

This study examines the consequences of conflicts between creditors. Using the setting of debt covenant violations, I employ a regression discontinuity design to identify the effect of bank interventions on their borrowers' trade credit. The results show that trade credit experiences a substantial decline when banks intervene in the borrowing firm following covenant violations. The decline is mitigated by the presence of dependent suppliers and exacerbated by banks' incentives to exercise control rights. Such externalities are reflected in the loan contract design. Borrowing firms sign less restrictive loan contracts when they rely more on trade credit or trade creditors.

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Why is it important?

Recent studies have called for a more detailed examination of the implications of the conflicts of interest among classes of creditors. Whereas prior studies have found that the allocation of creditor control plays a role during borrowers' bankruptcy filings, the current study advances our understanding of creditor conflicts by showing their consequences around technical defaults. This cost is sufficiently large such that firms consider it in their ex ante contracting behaviors. Moreover, the setting of debt covenant violations enables me to use an RD design to establish causality, which is a difficult task in the literature on creditor conflicts.