We are interested in understanding how credit crises spread through the real economy. To this end we focus on an understudied aspect of financial crises, the effect of borrowers' defaults on the contracts the bank writes with other borrowers. In a crisis this is one means by which restrictive credit environments pass from borrower to borrower.

We provide evidence that financial shocks to lenders influence the composition of financial covenants in debt contracts. Using two distinct measures of lender-specific shocks—defaults in a lender's corporate loan portfolio that occur outside the borrower's region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the number and strictness of performance-based but not of capital-based covenants in debt contracts. We examine two possible channels for this result. We find evidence consistent with lenders using stricter control rights because of concerns about capital depletion (a capital channel) and because of new information about lenders' own screening ability (a learning channel). Our results indicate that lender preferences influence how accounting information is used in debt contracts. Because these contract are long lived, their effects may outlast the impulses that create them.