The Transformation of Banking: Tying Loan Interest Rates to Borrowers' CDS Spreads
U.S. Securities and Exchange Commission
João A. C. Santos
Federal Reserve Bank of New York
University of Rochester - Simon Business School
August 26, 2013
Simon School Working Paper No. FR 13-25
We investigate how the introduction of market-based pricing -- the practice of tying loan interest rate spreads to credit default swaps -- has affected the cost of bank debt. Our results indicate that market-based pricing has reduced the cost of bank loans. Borrowers with CDS-based loans have benefited from a decline in interest rate spreads both at the time of loan origination and during the life of the loan. We find that banks simplify the covenant structure of market-based pricing loans and that market-based pricing lines of credit are associated with lower fees than standard revolvers. These findings suggest that the decline in the cost of bank debt is explained, at least in part, by a reduction in monitoring costs. Overall, market-based pricing might lead to a reduction in the cost of bank debt, but it may also have some adverse effects resulting from its negative impact on banks' monitoring efforts.
Number of Pages in PDF File: 49
Keywords: Market-based pricing, loan spreads, loan covenants, CDS spreads
JEL Classification: G21, G30Accepted Paper Series
Date posted: August 27, 2013
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