Finance and Economics Discussion Series (FEDS)
February 2026
Monetary Policy Exposure of Banks and Loan Contracting
Ahmet Degerli, Jing Wang
Abstract:
We provide evidence that banks use loan covenants to prepare for future monetary policy tightening, thereby facilitating the bank lending channel of monetary policy transmission. Specifically, banks with greater monetary policy exposure—those whose lending capacity contracts more as the federal funds rate increases—include stricter financial covenants in loan contracts, granting them flexibility to reduce existing loan commitments during monetary policy tightening when firms breach covenants. The resulting credit reductions to covenant violators by high-exposure banks account for over one-third of the total decline in credit during recent federal funds rate hikes.
Keywords: Loan contracting, Covenant strictness, Covenant violations, Monetary policy exposure, Monetary policy transmission, Bank lending channel
DOI: https://doi.org/10.17016/FEDS.2026.008
PDF: Full Paper
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