Playing Hardball: Relationship Banking in the Age of Credit Derivatives

Abstract

This paper develops a contracting framework in order to explore the effects of credit derivatives on banks’ incentives to monitor loans, their incentives to intervene, and, ultimately, borrowers’ incentives to perform. We show that (i) credit derivatives with short term maturity strengthen incentives to intervene, incentives to monitor, and managerial incentives to perform; (ii) while credit derivatives with long term maturity weaken incentives to intervene, intervention incentives can be maintained by sourcing more short term credit insurance; (iii) long term credit insurance nevertheless weakens managerial incentives through a dilution effect. These findings suggest that properly designed credit derivatives strengthen monitoring incentives and result in efficiency gains, rather than impeding economic efficiency.