Market Conditions and Contract Design: Variations in Debt Covenants and Collateral
Contracts scholars have catalogued some of the rigidities that exist 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 (1) are customized to the characteristics of the borrower and (2) evolve in response to changes in market conditions, such as expansion and contraction in the supply of credit. Building on the moral hazard and adverse selection theories of covenants and collateral, this essay argues that an expansion (contraction) of credit will not only lead to a decrease (increase) in interest rate but also necessitate a reduction (expansion) of covenants and collateral through lessening (worsening) the moral hazard and adverse selection problems. The essay concludes with observations about possible implications from the analysis.