Abstract
Debt covenants have become one of the major issues that affect the operations of the firm. Many scholars have come up with different ways in which they can leverage this problem. There are many theories of corporate governance that try to solve these problems that face managers of financial institutions. Most of these theories defy the debt covenant perspective and the corporate governance problems in relation to how equity and debt holders affect the director’s ability to act in the interests of the providers of capital. Banks as financial intermediaries have special attributes that increase the standard corporate governance structures. In addition, increased government participation creates extra impediments to the efficiency corporate control. Therefore, any solutions to the corporate governance issue in the financial sectors will need special attention. This paper evaluates some of these theories and how they affect the operations of financial operations in the capital markets.
Corporate governance influence various activities that affect the efficiency of the firm’s operations at the corporate levels as well as its effectiveness in the financial subsystem (Chava & Michael, 2008). There are different models that can be used to explain this problem. One of the effective strategies is the standard agency theory that describes the corporate governance problem in terms of how equity and debtors affect the judgements of directors to act in the greatest interest of the shareholders and other stakeholders in the organization. Many countries and states have set out legal regulations that aims to establish effective relationships on debt covenants policies and corporate governance between the borrowers and lenders with the aim of increasing stability and fairness at the capital markets. This essay will explore these relations and regulations that are available.
Bank managers and other debt managers should face sufficient incentives to allocate capital efficiently for them to device operational corporate governance over the firms in which they manage. For many organizations, the issue of equity and debt has many challenges. The legal compulsions of many businesses are that to each debts holder; creditors have no need to organize to take actions against felonious firms.
Shareholders often diffuse debts holder limit managerial discretion through the bond covenants that are created by laws and regulations of the capital markets (Denis & Jing, 2014). Most of the corporate governance structures have made the small investors face difficult time in exercising their corporate governance rules because of the informational asymmetries that exist in their respective states. Besides, there are inadequate legal rules and regulatory systems. Managers must spearhead that the formation and implementation of sound corporate governance.
However, there are various problems with the lack of any predetermined violations; debt covenants are frequently made to consider renegotiations. There are different forms of renegotiations whose interests lie on the prevailing limitations and result in the economically substantial changes in the current limits. The renegotiations of the specific covenants are a response to both the distance the covenant and the variables. Furthermore the borrower's renegotiation investment and financial policies are worth mentioning. The standard agency cost framing of the firm is premised on the low ability of the financial institutions to monitor the activities of the organization. The covenants and monitoring constitute a primary corporate function or debt, whose effectiveness is taut in the traditional, close relationship between lender and borrowers.
There are various changes that are occurred in the regulations of this essential function within the different jurisdiction. In many countries, banks can buy or sell loans and other credit instruments which have resulted in the, lower cost alternatives for the customer and financial organizations. This move has led to the lender –borrow relationships changing significantly.
The increasingly wealthy credit market has led to provisions and regulations of new governance that is tangled to the price at which credit instruments trade (Charles, 2009). As these markets evolve and development in these corporate governance private debt issues may move from the traditional dependency on covenants and corporate monitoring to more reliance on liquid credit investments. (Charles, 2009). There is also a similar relationship between change in the capital markets and the corporate governance which exist for equity purposes. The alternative capital and corporate governance structure may become possible driven by costs and benefits beyond those within the traditional formation. This fact is based on the changes f expressed in the market from public to private capital.
Banks are an important source of capital. They have the ability to obtain quasi –public information about the borrowers at a lower cost than other than the financial intermediaries. They also rely on the monitoring and long-term relationship to develop any information without the cost of duplication across different lenders. The covenant levels are influenced by the amount of borrower information that a lender has(Denis & Jing, 2014). Therefore, if a lender is adequately informed, it is likely that they will push for strict covenants to have closer control of a borrowers future activities.
There is a need to have closer and close-fitting covenants that will be used to offset the lower levels of information that is available to borrowers. Many scholars, however, argue that covenants may be less effective if they are not monitored and enforced by law (Tan, 2013). Therefore the ability of financial institutions at low cost to obtain any information about the borrowers and monitor their level of compliance.
Another key factor that affects the ability of the covenants to form effective covenants is the reputation of the firms (Vashishtha, 2014). Any firms that have access to the credit markets will develop a good reputation. Many firms always relax their reliance on contracts and monitoring in debt with enterprises and personalities with established reputation in the market.
The agency model takes into consideration the use of diversification to manage risks in the capital structure (Vashishtha, 2014). On the other hand, the portfolio theory suggests that there should be a less costly mechanism for a financial organization to manage debt risk than covenants and corporate governance (Nini, David, & Amir, 2012). The organization with large equity the concentrated debt can lead to some serious problems with the diffuse debt(Denis & Jing, 2014). Most of the financial organizations governance power culminates from its legal rights in the event that the agency violates some of its covenants. Secondly, it depends significantly the short maturity of its loans. Thirdly, it mostly depends on the shared twin responsibility as the voter of substantial equity shares (Denis & Jing, 2014).. Most of the resolute debt holders in the capital markets can also review the terms of the loan hence avoid the disorganized bankruptcies.
However, most of the borrowers face significant obstacles to exerting effective corporate governance in most jurisdictions. The efficiency of this larger borrowers depends significantly on the legal and bankruptcy systems (Li, Yun, & Florin, 2015). Most of the creditors use the legal means that exert influence over the management. However, if the legal structures in the organization do not actually identify the violation of the covenants and payments, then it is likely that the creditors will lose their vital apparatus for exercising corporate governance.
In conclusion the large lenders often attempt to shift the activities of the firms to replicate their own inclinations (Denis & Jing, 2014). For example, most large organizations may induce the firm to forego good investments and to take on too little risk since the creditors bear some of the cost, but will definitely not be part of the party that would share the benefits. Besides most of the creditors may hunt to manipulate the business activities for individual gain rather than maximize the profits of the business.
Bibliography
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