A central premise of financial intermediation is that creditors serve an important corporate governance role by
monitoring borrowers. Smith and Warner (1979) (among others) suggest that financial covenants are one important
contract feature creditors use to influence borrowers’ behavior. Research has shown that accounting-based covenant use in
public debt has declined dramatically over the last three decades.
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The decline in accounting-based covenants in public
debt raises questions about whether public debt holders still serve an important monitoring role, and if so, whether
outputs from the borrower’s accounting system are important in the monitoring function.