Debt and equity are like sibling rivals within the traditional agency cost framing of the firm. Shareholders, within that construct, may be inclined to resist new investment that principally benefits creditors, with the result that value-enhancing projects are delayed or abandoned. Lenders, as well, risk the loss of wealth in the face of management opportunism that favors equity over debt. One response, ultimately at cost to the borrower, is increased covenants that restrict its actions and potentially furnish control rights to lenders. Covenants and monitoring were presumed to be the least costly means to manage credit risk in the absence of alternatives, such as portfolio risk management, that did not exist for debt at the time the agency cost construct was introduced.

Most corporate debt is private, and most private lenders are banks. Consistent with the role of debt within the traditional framing, covenants act as early warning trip wires? that assist banks to manage credit risk, permitting them to reassess a borrower’s managers when weakened financial conditions increase the risk of opportunism and mitigate loss by renegotiating loans in anticipation of, or following, a breach. Banks are able to monitor a borrower’s compliance at low cost, reinforcing the importance of loan covenants to corporate governance. The trade-off for banks is the relative inability to transfer the loans they originate to others, further boosting their reliance on covenants and monitoring.