Do Banks Still Monitor When There Is a Market for Credit Protection?
63 Pages Posted: 2 Nov 2018 Last revised: 3 Mar 2019
Date Written: February 27, 2019
Lenders traditionally use specific clauses in loan contracts both to commit to monitoring and to protect their interests in credit agreements. The rise of credit default swaps (CDS) provides creditors with an alternative market-based approach to obtaining protection, but it can also affect lenders’ monitoring of the borrowers. We find that after the introduction of CDS trading on a given firm, new loans to that firm have looser creditor protection terms, as they are less likely to require collateral and have less strict financial covenants. These effects are robust to the use of instrumental variables and matching techniques to address endogeneity concerns. The effects are stronger when the firm has a more liquid CDS market, when lenders have easier access to the CDS market, and when borrower agency problems are less acute. Credit lines are more affected by the introduction of CDS trading than term loans. Moreover, the loosening is greater for performance-based covenants than for capital-based covenants. Our evidence is consistent with the theory that the introduction of CDS trading makes loan contracting and bank monitoring more effective for better quality borrowers.
Keywords: Credit default swaps, CDS, Collateral, Covenants
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