How Does CDS Trading Affect Bank Lending Relationships?*

Credit default swaps (CDS) make it easier for lenders to lay off their credit risk exposure on their CDS-referenced borrowers, potentially helping banks retain clients. However, this new instrument of credit risk transfer may reduce banks’ monitoring incentives that could alter the firm-bank relationship. We document that borrowers are more likely to switch to new lenders after the inception of CDS trading on their debt. Moreover, all else being equal, loan spreads increase after CDS trading than before, but bond spreads remain intact. CDS trading on their debt also leads firms to increase the use of public bonds relative to bank loans for new debt financing. The evidence indicates that CDS trading weakens firm-bank lending relationships and affects borrowers’ debt structure. * We thank Viral Acharya, Tim Adam, Edward Altman, Thorsten Beck, Allen Berger, Chun Chang, Jaewon Choi, Greg Duffee, Phil Dybvig, Lijing Du, Rohan Ganduri, Todd Gormley, John Griffin, Jean Helwege, Paul Hsu, Grace Hu, Victoria Ivashina, Dimitrios Kavvathas, Dan Li, Feng Li, Jay Li, Chen Lin, Tse-Chun Lin, Jun Liu, Christian Lundblad, Spencer Martin, Ronald Masulis, Ernst Maug, Greg Niehaus, Neil Pearson, Francisco Pérez-González, “QJ” Jun Qian, Stephen Schaefer, Philipp Schnabl, Amit Seru, Sascha Steffen, Philip Strahan, René Stulz, Sheridan Titman, Cong Wang, Tan Wang, Yihui Wang, John Wei, Andrew Winton, Deming Wu, Yu Yuan, Haoxiang Zhu, and seminar participants at the Office of Financial Research, University of Hong Kong, Australian National University, University of Melbourne, Institute for Financial Studies of Southwestern University of Finance and Economics, Shanghai Advanced Institute of Finance, Central University of Finance and Economics, Renmin University of China, University of South Carolina, Zhejiang University, Chinese University of Hong Kong, Wuhan University, Shanghai University of Finance and Economics, George Mason University, the Office of the Comptroller of the Currency (OCC), the 2014 NUS RMI Symposium on Credit Risk, the 2014 Fixed Income Conference, the 2014 Conference on Financial Markets and Corporate Governance, the 2014 CICF, the 2014 C.R.E.D.I.T Conference, the 2014 FMA, the Australian Banking and Finance Conference, and the 2014 TCFA Best Paper Symposium for comments and suggestions. We acknowledge the support of the National Science Foundation of China (project #71271134). How Does CDS Trading Affect Bank Lending Relationships? Abstract Credit default swaps (CDS) make it easier for lenders to lay off their credit riskCredit default swaps (CDS) make it easier for lenders to lay off their credit risk exposure on their CDS-referenced borrowers, potentially helping banks retain clients. However, this new instrument of credit risk transfer may reduce banks’ monitoring incentives that could alter the firm-bank relationship. We document that borrowers are more likely to switch to new lenders after the inception of CDS trading on their debt. Moreover, all else being equal, loan spreads increase after CDS trading than before, but bond spreads remain intact. CDS trading on their debt also leads firms to increase the use of public bonds relative to bank loans for new debt financing. The evidence indicates that CDS trading weakens firm-bank lending relationships and affects borrowers’ debt structure.