Operational Risk and Financial Covenants

This paper examines how borrowers’ demand-side and supply-side risks shape the design of debt covenants in private loan contracts. Demand-side risk arises from customer concentration and demand volatility, while supply-side risk stems from supplier dependencies and supply chain fragility. Using new measures from 10-K risk factor disclosures, I find that demand-side risk is associated with the inclusion of performance covenants, whereas supply-side risk is associated with capital covenants. I exploit the adoption of the Volcker Rule as an exogenous shock to banks’ risk-taking capacity to show that the relation between supply-side risk and capital covenants strengthens among loans from affected lenders following the regulation. Mechanism tests show lenders tailor financial covenants to distinct operational risks in ways that reflect how these risks manifest on borrowers’ financial statements. Cross-sectional tests show the main associations vary with borrower characteristics. Validation analyses show that the operational risk proxies capture borrower-level operational outcomes, such as inventory volatility and other working-capital metrics.

Author dc:creator

• Jaehoon Lee (232646)

• Accounting
• Banking / Lending
• Financial Reporting (Risk Factor Disclosure)
• Debt Contracting
• Supply Chain
• Textual Analysis (Header-based Approach)
• Risk Management
• Corporate Finance

Statement dc:rights

• In Copyright
• Open Access after 2028-05-01

DOI dc:identifier

https://doi.org/10.25417/uic.32995274.v1

OAI identifier oai:identifier

oai:figshare.com:article/32995274