Explain how lenders use covenants as part of loan agreements to cope with the problem of moral hazard.
Labels: Exam 2 Question 9
posted by Eschenfelder at 8:51 AM
Money and Banking Spring 2006
The following posts are the questions which appeared on last semester's exams. Students should use the comment sections to answer the questions and respond to the posts of other students.
Thursday, February 22, 2007
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2 Comments:
Lenders use covenants as part of loan agreements to cope with the problem of moral hazard by having borrowers sign contracts restricting them from taking on certain risky behavior. Because lenders do not know for sure how borrowers will use money lent to them, covenants help to protect lenders from this moral hazard.
Lenders use covenants as part of loan agreements to make sure that the company is not taking any actions that are considered to be too risky. For example, the company may not be allowed to acquire other companies; it may not be allowed to pay owners/managers too much in dividends and/or salaries. If a company violates a covenant, the bank has the right to demand immediate payment of the loan. A violation occurs for one of two reasons - either the company is in financial distress or the company wants to pursue an activity that is restricted. Covenants basically give lenders the ability to protect themselves from the potential risk associated with moral hazard.
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