Managerial overconfidence and bank loan covenant usage

This paper examines how managerial overconfidence affects loan covenant usage. We find that creditors significantly use more covenants; increase covenant intensity; use financial (but not general) covenants; use performance‐based and capital‐based covenants and rely on different types of covenants such as debt to cash flow, coverage ratio, net worth, debt to balance sheet and liquidity covenants to curb the default risk emanating from managerial overconfidence. Besides, creditors tighten individual covenants such as debt to cash flow covenant and current ratio covenant in order to alleviate their risk exposure. Covenants that serve to allocate the control rights ex‐post are found to be important in controlling overconfidence risk. Covenant usage is reported to be quantitatively larger in the loan contracts of firms with higher market‐to‐book ratios, reflecting that high growth firms provide the opportunities for overconfident CEOs to invest more intensively. To address endogeneity, we use propensity score matching to mitigate potential endogeneity problem. In addition, we employ the SA Index and WW Index to control for firms' financial constraint. The effects of overconfident CEOs to loan covenant remain significant regardless of the firms' financial conditions.