The transformation of banking: Tying loan interest rates to borrowers' CDS spreads |
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| Institution: | 1. Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW, Washington, DC 20551, USA;2. Federal Reserve Bank of New York and Nova School of Business and Economics, 33 Liberty Street, New York, NY 10045, USA;3. Amherst Securities Group, 5001 Plaza On The Lake, Austin, TX 78746, USA;1. Senior Concordia University Research Chair in Finance, John Molson School of Business, Concordia University, Montreal, QC H3G 1M8, Canada;2. John Molson School of Business, Concordia University, 1455 De Maisonneuve Blvd W., Montreal, Quebec H3G 1M8, Canada;1. Farmer School of Business, Miami University, Oxford, OH 45056, United States;2. Culverhouse College of Commerce, University of Alabama, Tuscaloosa, AL 35487-0224, United States;1. Bank of Sharjah Chair, American University of Sharjah, Sharjah, United Arab Emirates;2. Moore School of Business, University of South Carolina, 1014 Greene Street, Columbia, SC 29208, USA;3. School of Accounting and Finance, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong;1. Department of Finance, Peking University HSBC Business School, China;2. Department of Finance, The University of Illinois at Urbana–Champaign, USA |
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| Abstract: | We investigate how the introduction of market-based pricing, the practice of tying loan interest rates to credit default swaps, has affected bank financing. We find that market-based pricing is 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. |
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