Financial Innovations, Credit Default Swaps, and Syndicated Loans

Abstract:     
Loan syndication suffers from two types of agency problems – an adverse selection problem (lead arrangers pass on bad loans to the participants) and a moral hazard problem (lead arrangers shirk on their costly monitoring duties). Therefore, a lead arranger has to take a big share of the loan to certify the quality of borrower and to credibly commit to its monitoring duty. I argue that the invention of the CDS provides an instrument to reduce these agency problems when participant lenders purchase CDS protections from lead arrangers, which then allows lead arrangers to take smaller shares of loans.

The interest rate on loan and the premium on CDS can serve as a reconciliation mechanism to reduce adverse selection problem because if a lead arranger bluffs the quality of a borrower and under-charge loan interest rate and CDS premium, the lead arranger will suffer two immediate losses – lower interest and CDS incomes, which will not be a feasible long term strategy for institutions willing to maintain their reputations. In the event of borrower default and physical settlement is used, lead arrangers have to take the loans back and pay the face values of loans to participants. The monetary interest can provide lead arrangers enough incentives to monitor borrowers. Therefore, besides explicitly managing risk, participant lenders can use CDSs to “trade” the monitoring duty back to lead arrangers.

Using the credit derivatives data from Y-9C and more than 10,000 loan facilities, I found strong evidence supporting the syndicate expansion hypothesis that CDS plays a significant role in expanding loan syndicates, reducing lead arrangers’ capital contributions in the syndicates resulting in large loans for borrowers. The paper thus provides empirical evidence to show how financial innovations can profoundly impact banking practices.

Number of Pages in PDF File: 44

working papers series