Sophisticated Borrowing Constraints and Macroeconomic Dynamics

In traditional macro-finance models, firms’ debt contracts impose hard borrowing constraints, which require indiscriminate reductions of borrowing and investment when adverse shocks tighten these limits, giving rise to financial acceleration. We study the macroeconomic implications of “sophisticated borrowing constraints” akin to financial covenants among large U.S. nonfinancial firms, commonly specified based on firms’ debt relative to operating earnings. We model these constraints as debt thresholds that trigger a transfer of control rights to creditors when they are violated, in which case creditors influence firms’ decisions to maximize their value instead of cutting credit unconditionally to adhere to fixed ratios. At the micro level, our model is quantitatively consistent with empirical patterns of investment and earnings around covenant violations. At the macro level, sophisticated borrowing constraints do not generate financial acceleration, because constraint tightening and violations do not induce creditors to downscale firms indiscriminately.