Do banks still monitor when there is a market for credit protection?

• Published in: Journal of accounting & economics Vol. 68; no. 2-3; p. 101241
• Main Authors: Shan, Chenyu, Tang, Dragon Yongjun, Winton, Andrew
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.11.2019
• Subjects: CDS; Collateral; Covenants; Credit default swaps; Credit protection; Monitoring; CDS; Credit protection; O16; G21; G32; Collateral; Credit default swaps; Monitoring; L14; Covenants
• ISSN: 0165-4101; 1879-1980
• DOI: 10.1016/j.jacceco.2019.101241

The rise of credit default swaps (CDS) provides creditors with a market-based approach to obtaining protection, but it can also affect lenders' monitoring of the borrowers. We find that after CDS begin trading on a given firm, new loans to that firm are less likely to require collateral and have less strict financial covenants, even controlling for endogeneity. The effects are stronger when lenders have easier access to CDS, for safer firms, credit lines, and performance-based covenants. Our evidence is consistent with the theory that the introduction of CDS trading makes loan contracting more effective for better quality borrowers. •Loans issued to firms require less collateral and less strict financial covenants after CDS on the firm's debt start trading.•These effects are more pronounced when the CDS market is more liquid and when the lender is a CDS user.•These effects are stronger for firms that have better credit quality.•Our results suggest that CDS may improve contracting efficiency, especially for high-quality borrowers.