Monetary Policy Exposure of Banks and Loan Contracting

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.