The Transformation of Banking: Tying Loan Interest Rates to Borrowers' CDS Spreads
Board of Governors of the Federal Reserve System
João A. C. Santos
Federal Reserve Bank of New York
University of Rochester - Simon Business School
July 11, 2014
Simon School Working Paper No. FR 13-25
We investigate how the introduction of market-based pricing, the practice of tying loan interest rates to credit default swaps, has affected borrowing costs. We find that CDS-based loans are associated with lower interest rates, both at origination and during the life of the loan. Our results also indicate that banks simplify the covenant structure of market-based pricing loans, suggesting that the decline in the cost of bank debt is explained, at least in part, by a reduction in monitoring costs. Market-based pricing, therefore, besides reducing the cost of bank debt, may also have adverse consequences resulting from the decline in bank monitoring.
Number of Pages in PDF File: 55
Keywords: Market-based pricing, loan spreads, loan covenants, CDS spreads
JEL Classification: G1, G21, G30
Date posted: August 27, 2013 ; Last revised: July 12, 2014
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