Using a large set of individual loan covenants attached to bank loan agreement, we investigate the determinants of loan covenant strictness and show how this loan covenant strictness affects borrowing firm's investment and payout policies. We find that the number of debt covenants contained in a loan contract is positively related to borrowing firm's risk and the number of private lenders with which a firm is maintaining relationship, but is negatively related to borrowing firm's profitability and growth opportunity. Consistent with the argument by Diamond (1991), we find that as the ratio of bank loans to total debt of a firm increases, the number of debt covenants also increases. However, the previous lending relationship with one of lenders in current loan syndication has a negative effect on debt covenant strictness. This result suggests that banks with previous proprietary information about their borrowers are less likely to be reliant on debt covenants to monitor firms. We also find that banks use relatively fewer covenants during the period of economic downturns than during the period of economic booms. Finally, we find that debt covenants significantly reduce borrowing firm's ex post payout ratio and capital expenditure, but lead to significant improvement in ex post operating performance. Taken together, our findings suggest that banks provide efficient monitoring services to their informationally opaque borrowers and loan contracts are optimally designed to fit the specific needs of the contracting parties.
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