Usable Credit Is Selective: Contracts, Covenants, and Syndicates

This chapter examines the borrower-side boundary of LCR-buffer insurance: even when a bank has room above its regulatory floor, who can actually use the credit that appears to be available? The answer depends on two connected systems. A borrower's contract may narrow its own capacity, and a syndicated facility may distribute one firm's draw across several banks with different amounts of regulatory room. These constraints explain why the Federal Reserve paper finds selective support rather than universal liquidity insurance.

The distinction is important because “undrawn” sounds like a simple quantity. If a company has not used a committed line, the unused amount appears to be available. But a credit commitment is not a cash account reserved in the borrower's name. It is a contractual right subject to conditions, while the bank must manage the same liquidity shock across many borrowers and lenders. Economic usability lies at the intersection of what the contract permits, what the borrower can satisfy, and what the bank is willing to fund.

A line can be undrawn without being fully available

The Federal Reserve study uses a standard undrawn ratio to measure contractual credit-line availability. At a basic level, it compares the unused portion of a committed line with the total commitment. This is a useful starting point because firms with a large undrawn share are more exposed when they rely on the bank as a source of emergency liquidity. But the standard measure can overstate the amount the firm can economically draw if another condition in the debt contract becomes binding.

The paper therefore constructs a covenant-adjusted measure. It considers the borrowing room permitted by financial covenants and takes the minimum of three quantities: the contractual unused capacity, the debt room under an interest-coverage covenant, and the debt room under a debt-to-EBITDA covenant. In simplified form:

[ \text{Actual unused capacity} = \min(\text{contractual unused capacity},\ \text{interest-coverage room},\ \text{debt-to-EBITDA room}). ]

An interest-coverage covenant limits debt by requiring operating earnings to remain large enough relative to interest expense. A debt-to-EBITDA covenant limits the ratio of total debt to earnings. A firm can therefore have a line that has not been drawn while still lacking room to add the full amount without violating one of these tests. The commitment remains part of the contract, but the economically available portion is smaller.

The paper's numerical example makes the distinction concrete. A hypothetical firm has $10 million of EBITDA, $2 million of interest expense, $25 million of existing debt, a 5% average interest rate, and $50 million of stated unused credit capacity. Its interest-coverage room is calculated at $32.73 million, while its debt-to-EBITDA room is $12.5 million. The actual unused capacity is therefore the minimum of $50 million, $32.73 million, and $12.5 million: $12.5 million. Three quarters of the apparent capacity is restricted by the debt-to-EBITDA covenant.

The example is not a claim that every facility has those terms or that the paper's covenant assumptions are a legal determination of drawability.