Do traded credit default swaps impact lenders' monitoring activities? Evidence from private loan agreements

This paper investigates how a new, opaque market for credit derivatives impacts the use of accounting information in debt contracting. Because credit default swaps allow creditors to transfer credit risk, while retaining control rights, the literature suggests these instruments may introduce a moral hazard problem and lead to decreased monitoring activities by creditors. In addition, the extent to which a lender transfers its credit risk through credit default swaps is not visible to outside parties; therefore, a credit default swap market may introduce new information asymmetries within lending syndicates. I provide evidence on these issues by studying changes in syndicated loan agreements surrounding the onset of credit default swap trading for corporate borrowers. I show that lending syndicates increase their reliance on accounting-based, financial covenants to monitor borrowers and mitigate lead lender moral hazard, when a credit default swap market for the borrower provides an opportunity for the lead lender to lay off a loan's credit risk. My findings suggest an increased role of accounting information in mitigating new information asymmetries associated with the presence of a credit default swap market.